Clearing up Confusion About Disregarded Entities
A disregarded entity is a business entity that is separate from its owner but which elects to be disregarded as separate from the business owner for federal tax purposes. That is, it's an entity that doesn't want to be a separate entity from the business owner. If this sounds like a double negative, it is. Another way to say this is that the business is not separated from the owner for tax purposes.
There are two pieces to the disregarded entity puzzle, both of which must be present for the business to be a disregarded entity:
The business type is separate from the individual for liability purposes, and
The business is taxed through the individual's personal tax return, based on its net income on Schedule C.
Breaking this down:
A business is typically a separate entity from the business owner. That separation is good for the owner because it also separates or limits the liability of the owner and the liability of the business for things like debts and lawsuits. Corporations, partnerships, and limited liability companies are separate entities from their owners.
The one business entity that is not separate from the business owner is a sole proprietorship.
The second part of this puzzle is taxes. The business is taxed through the individual's personal tax return. This means that the business income is taxed using Schedule C, is part of the owner's personal tax form. Only two business types use Schedule C: sole proprietorships and single-member LLC's.
As noted above, a sole proprietor business is NOT SEPARATE from the owner. But a single-member LLC is.
The Only Disregarded Entity: A Single-Member LLC
The IRS says that
"an LLC with only one member is treated as an entity disregarded as separate from its owner for income tax purposes, unless it affirmatively elects to be treated as a corporation."
So a Single-member LLC (SMLLC) meets both of the criteria for being a disregarded entity.
How to Elect to Be a Disregarded Entity
There is nothing you need to do to be a disregarded entity. You just file your single-member LLC taxes using Schedule C and include the net income or loss on your personal income tax return.
Disregarded Entity and Employment Tax
The disregarded entity status of a single-member LLC does not apply to employment taxes. The business has several options for which employer ID number to use when filing unemployment taxes. Read more about these options for filing employment taxes.
This article does not constitute tax or legal advice. The American Bar Association offers further information about how and why the disregarded entity was created.
Liability Issues for a Disregarded Entity
A disregarded entity is considered the same entity as the owner for tax purposes, but not for liability purposes. For more information on this subject, read this article in which attorney Robert Warwick discusses disregarded entity tax and liability issues.
Examples: A single-member LLC may decide to use the "disregarded entity" designation when the LLC files its Application for Employer Identification Number (EIN) on Form SS-4.
Are These Other Business Types Disregarded Entities?
Businesses are set up under state regulations, through the secretary of state for each state, and no state recognizes a "disregarded entity" as a business type. Look at each of the legal types of business to see how it compares to the requirements for a disregarded entity:
- Sole proprietorship, in which you and the business are the same entity. The sole prop is taxed on Schedule C, but there is no separate business entity to provide liability protection for you if the business can't pay its bills or gets sued.
- A multiple-member LLC is registered with the state and this business type provides liability protection, but this entity pays income taxes as a partnership.
- A partnership, as noted above, is not a disregarded entity (including a limited partnership or limited liability partnership) because partnership taxes are not figured on Schedule C. Partnerships pay income Taxes in particular ways.
- A corporation is a separate business entity from the owners, providing liability protection, and it pays taxes on Form 1120.
- A subchapter s corporation, on the other hand, provides liability protection and it files an information return on Form 1120-S. The owners are taxed on their personal income tax return, but not on Schedule C.
A Note on LLCs Taxed as Corporations
An LLC can elect to be treated as a corporation for income tax purposes. If your SMLLC has elected to be taxed as a corporation or S corporation, it is not considered a disregarded entity for income tax purposes. To make this election when electing for an LLC, the SMLLC must file Form 8832, Entity Classification Election.
Disregarded Entity on Business Tax Forms
You may have seen the term "disregarded entity" on a tax form. For example, it might be included in a discussion of the single-member LLC business entity.
You may also have seen this term when you are applying for a tax ID number (an Employer ID Number) for your business.
The IRS says,
If a “disregarded entity” is owned by an individual, it is treated as a sole proprietor.
Some Background on the Disregarded Entity
The Internal Revenue Code (the regulations governing federal taxes) states that a business entity is a corporation by default. If the entity is not a corporation it is an "eligible entity," and it can elect its classification for federal tax purposes.
The Code says, "an eligible entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner." The only business type that fits all the qualifications to be a disregarded entity is a single-member LLC (SMLLC).
LLC Not Electing to Be a Corporation
The IRS says, "An SMLLC that does not elect to be a corporation will be classified by the existing federal guidance as a 'disregarded entity' which is taxed as a sole proprietor for income tax purposes." An LLC can file an election to be taxed as a corporation.
So, basically, any SMLLC that is not taxed as a corporation is a disregarded entity for tax purposes. That is, the SMLLC is taxed as a sole proprietor. But here's where the confusion comes in: a sole proprietor is NOT a disregarded entity because the company is not separate from the owner.
The relevant term in the previous paragraph is "taxed as." A sole proprietor files business taxes using Schedule C, and the profit/loss from the Schedule C is included with the individual income tax return. So a Single-Member LLC "taxed as" a sole proprietorship file a Schedule C.
A Single-Member LLC doesn't need to do anything to "elect" to be a disregarded entity, even though it does sound like that. The SMLLC needs to file its business taxes on Schedule C. The alternative, which is for the SMLLC to be considered an association and taxed as a corporation, is filing an entity election for an LLC, which is known as Form 8832