Clearing Up Confusion About Disregarded Entities
A disregarded entity is a business that is separate from its owner but which elects to be disregarded as separate from the business owner for federal tax purposes.
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. The business pays tax as part of the owner's personal income tax return.
Details on the Disregarded Entity
LLCs are registered with a state as a legal entity, but the IRS doesn't recognize this business type for tax purposes. It regards LLCs as partnerships if the business has more than one member (owner), and as a sole proprietor if the LLC has only one member.
An LLC is usually taxed as a sole proprietor (single-member LLC) or partnership (multiple-member LLC). But an LLC can elect to be taxed as a corporation or S corporation. In this case, the LLC's legal status doesn't change, but its tax status has changed. An LLC taxed as a corporation or S corporation is not a disregarded entity.
The legal separation between a business and its owner(s) separates or limits the liability of the business for lawsuits and debts. Corporations, partnerships, and limited liability companies are separate entities from their owners.
The Only Disregarded Entity: A Single-Member LLC
The IRS says that, for income tax purposes, an LLC with only one member, called a single-member LLC (SMLLC) is a disregarded entity, as long as has not elected to be a corporation or S corporation.
The Single-Member LLC is a separate legal entity, but it is taxed through the owner's personal tax return, using Schedule C for business income.
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.
Single-Member LLCs and Employer ID Numbers
If your single-member LLC is a disregarded entity, use your social security number (SSN) for income tax purposes.
A single-member LLC that doesn't have employees or excise tax liability doesn't need an EIN. It should use the tax ID number of the owner for federal tax purposes. But if you need an EIN for your single-member LLC for other purposes (like opening a bank account), you can certainly do that.
When a single-member LLC applies for an EIN on Form SS-4, there's no specific box to check for electing disregarded entity status. Item 8a asks if the business is an LLC. If "yes," Item 8b asks for the number of members.
If your business is applying for an EIN because you have employees or you must pay excise taxes, check the "other" box for line 9a (Type of entity) and write "Disregarded entity" (or "Disregarded entity-sole proprietorship" if the owner is an individual). (See the instructions for Form SS-4 for more options.)
Don't Forget About State Income Tax
If you have a single-member LLC that's a disregarded entity, you may also need to check the income tax reporting requirements. Some states want you to use a specific form to report your business taxes on your personal return.
Disregarded Entities and Employment Tax
The disregarded entity status of a single-member LLC does not apply to employment taxes. The LLC must use its name and employer ID (EIN) of the LLC to report and pay employment taxes, Don't use your personal Social Security Number. You must also use your business EIN to register for excise tax activities.
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. LLCs are legal entities and the entity functions within state laws, so its liability isn't affected by its tax status.
The Two-Spouse Business: A Special Case
If two spouses own a business, they may treat the entity as disregarded for federal tax purposes. The IRS calls this a Qualified Joint Venture, and it allows the spouses to file two Schedule C's, splitting the net income of business between them.
This election is only available for couples
- In a community property state
- if the two spouses are the only owners
- If the business isn't taxed as a corporation
This IRS calls this special status an election for married couples in unincorporated businesses. If you aren't sure if you are eligible for this election, check with your tax professional.
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.