What are Tax and Liability Issues for a Disregarded Entity?
The concept of "disregarded entity" is confusing, and the IRS does not address liability issues of disregarded entities. Attorney Robert Warwick of ThompsonMcMullan Law Firm answers questions about disregarded entities:
For income tax purposes I would define a disregarded entity as a legal entity that is ignored for federal (and many state) income tax purposes. The most common disregarded entity that I deal with is a single-member limited liability company ("LLC").
Is a sole proprietorship a disregarded entity?
No, because a sole proprietorship is not a legal entity separate from its owner. A sole proprietorship may operate under a trade name, but the absent formation of a legal entity under state law, the sole proprietorship, and its owner/operator are legally the same.
Are S corporations disregarded entities?
No; although an S corporation is not itself generally subject to income taxes, the S corporation determines its own income, deductions, credits, etc. (often collectively referred to as "tax attributes") and then allocates the tax attributes among its owners (or to its sole owner) in proportion to share ownership. In contrast, with a disregarded entity, no tax attributes are determined at the entity level. Unlike a disregarded entity, an S corporation is required to file an annual information tax return.
Paying Income Taxes As a Disregarded Entity
An individual owner of a disregarded entity reports the tax attributes of the business directly on Schedule C of their income tax return, whereas each individual owner of an S corporation (even if there is only one owner) receives a Schedule K-1 from the corporation and reports their allocation on Schedule E of their income tax return.
A provision in the tax law permits an otherwise disregarded entity to elect to be taxed as a regular corporation or as an S corporation. But, if the election is made, the entity would no longer be disregarded.
Disregarded Businesses and Liability
Liability for business debts and lawsuits generally depends on the legal status, which is based on state law. Most, if not all, states provide for the formation of LLCs (as noted above, a single-member LLC is the most common domestic disregarded entity). An LLC is a legal entity that can own property, make contracts and sue and be sued in its own name; the owner(s) of the LLC generally does not have personal liability for the LLC's obligations.
Federal income tax treatment, on the other hand, is determined by federal law, i.e., the Internal Revenue Code, which ignores a single-member LLC's separate existence and treats its activities as those of its owner. Most states that impose income taxes follow the Internal Revenue Code and disregard the single-member LLC for state income tax purposes while recognizing its separate existence for other purposes.
A disregarded entity (rather than its owner) may be required to pay taxes other than income taxes, for example, property taxes on property owned by the entity.
The information contained in this article is not tax or legal advice and is not a substitute for such advice. State and federal laws change frequently, and the information in this article may not reflect your own state’s laws or the most recent changes to the law. For current tax or legal advice, please consult with an accountant or an attorney.