A disregarded entity is a legal entity that's ignored for federal and some state income tax purposes. The IRS uses the disregarded entity designation for single-member limited liability companies (LLCs) that don't elect to be taxed as a corporation. It also treats subsidiaries of S corporations (called QSubs) as disregarded entities.
What Is a Disregarded Entity?
A disregarded entity is a business structure other than a corporation that hasn't elected to be treated as a separate entity for federal tax purposes. The business has just one owner. It must meet all three of these criteria. For tax purposes, the IRS treats the disregarded entity as part of the owner's tax return.
For example, a sole proprietorship isn't a disregarded entity even though it has only one owner because it's not a legal entity separate from its owner. A sole proprietorship can operate under a trade name, but the sole proprietorship and its owner/operator are the same legally and for tax purposes.
Similarly, an S corporation isn't a disregarded entity because it's a form of corporation. S corporations determine their own income, deductions, and credits—often collectively referred to as "tax attributes"—then allocate these among their owners or shareholders, or to their sole owners. Allocations are made in proportion to share ownership.
The Internal Revenue Code (IRC) doesn't recognize a disregarded entity as a distinct business formation.
How Does a Disregarded Entity Work?
Liability for business debts and lawsuits is another important factor that comes into play with disregarded entities. Liability generally depends on the legal status of a business entity, which is based on state law.
All states allow the formation of LLCs. An LLC is a legal entity that can own property, make contracts, sue, and be sued in its own name. The owner or owners of the LLC only have liability for LLC operations up to the amount of their investment.
Federal income tax treatment is determined by the Internal Revenue Code (IRC). The IRC ignores a single-member LLC's separate existence and treats its activities as those of its owner. Most states that have an income tax follow the IRC and disregard single-member LLCs for state income tax purposes while recognizing their separate existence for other purposes.
The tax law permits an otherwise disregarded entity (a single-member LLC) to elect to be taxed as a regular corporation or as an S corporation, but the entity would no longer be disregarded if this election is made.
A qualified Subchapter S subsidiary (QSub) can also be a disregarded entity if its parent S corporation elects to treat it as a QSub. The QSub must also be wholly owned by the S corporation and it cannot be an ineligible corporation.
Single-Member LLCs and Tax IDs
A single-member LLC must use its own employer identification number (EIN) or its owner's Social Security number when filing all tax documents if it's to be treated as a disregarded entity for tax purposes. The EIN of the LLC must also be used for certain employment tax and excise tax requirements.
Paying Income Taxes As a Disregarded Entity
An individual owner of a disregarded entity reports the tax liability of the business directly on Schedule C of their personal income tax return. Each individual owner of an S corporation receives a Schedule K-1 from the corporation, even if there's only one owner, and reports their allocation on Schedule E of their income tax return (Form 1040/1040-SR).
- A disregarded entity is effectively ignored for state and federal tax purposes.
- It’s a business other than a corporation that hasn’t taken an affirmative action to elect to be treated as a separate entity from its owner.
- The owner of a disregarded entity reports business profits and takes business deductions on their own personal tax return.
- The IRS doesn’t technically recognize disregarded entities, but states can do so.
NOTE: 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.