What is a Disregarded Entity? Explained with Examples

A disregarded entity is a business that has a single owner, is not organized as a corporation, and isn’t taxed separately from its owner. It’s just that simple. It is called a disregarded entity because while it is a business, the Internal Revenu Service (IRS) does not regard it as a separate entity for tax purposes. In this article, we will talk in some details about disregarded entities. We’ll talk about the benefits and disadvantages of having disregarded entities and we’ll also have a disregarded entity vs partnership discussion. 

What are the essential components of a disregarded entity?

In order for a business to qualify as a disregarded entity, it needs to meet a few pre-conditions.

1. There can be only one owner
2. The business structure must be separate from the owner in terms of liability
3. The owner doesn’t elect it to be taxed separately

What types of businesses can be disregarded entities?

A sole proprietorship is by default a disregarded entity. A single member limited liability corporation or a SMLLC is the most common example of a disregarded entity. Any qualified subchapter S subsidiary or a qualified Real Estate Investment Trust (REIT) subsidiary is also considered disregarded entities.

What is a single member LLC?

In the case of LLCs the owners are called members. Therefore, the if an LLC has one owner, it is called a single member LLC. It does not mean that the LLC has only one employee or one person working for it.

A single member LLC is disregarded by IRS by default. If the owner wishes for the LLC to be taxed separately, they can request that by filing form 8832.

A single member LLC is different from a sole proprietorship though both are considered disregarded entities. If you start conducting business without forming a legal business entity like an LLC, your business is considered to be under a sole proprietorship. 

Both single member LLCs and sole proprietorships are disregarded entities, that means the owners do not have to file separate income tax for the businesses, instead the income tax is filed as a part of their personal incomes.

Disregarded entity vs corporation

A disregarded entity is not recognized as separate from its owner for tax purposes. This means, the income earned from the business along with the expenses are reported on the owner’s personal tax return. 

A corporation is separate entity from the stakeholders for both legal and tax purposes. This means, a corporation can enter into contracts, sue or be sued. It can own property, and is responsible for filing and paying its own tax returns.

Disregarded entity vs partnership

Also Read – What is a Land Trust? How It Works. Types and Examples

What are the benefits of a disregarded entity

• Straightforward tax filing

Since the income and expenses of the disregarded entity is reported on the owner’s tax returns, the filing process becomes much simpler for the owner.

• Liability protection is maintained

Despite taxed along with the owner’s income, a disregarded entity retains the liability protection afforded to LLCs and S corporations.

• No double taxation

In a C corporation, the owner pays taxes on the income shown by the company as well as on his personal income from the business. It doesn’t happen in the case of disregarded entities.

Disadvantages of a disregarded entity

• Hard to raise capital: A single owner business finds it difficult to raise capital. If the owner wants to raise funds by selling equity, it would no longer be a disregarded entity.
• Payroll, sales and other taxes: The disregarded entity is not exempted from payroll taxes, sales taxes, or any other relevant taxes.

5 things to remember for owners of disregarded entities

1. Report your business income, deductions, and credits on your personal tax return: Since a disregarded entity is not a separate legal entity from you, you must report its financial activity on your personal tax return using Schedule C (for sole proprietors) or Schedule E (for single-member LLCs).

2. Keep accurate financial records: It’s important to keep accurate financial records for your disregarded entity, including income, expenses, and receipts. This will help you file your taxes correctly and make informed business decisions.

3. Obtain any necessary licenses and permits: Depending on the nature of your business, you may need to obtain licenses or permits from your state or local government. Make sure you research the requirements for your particular industry and comply with all regulations.

4. Consider liability protection: Since a disregarded entity does not provide personal liability protection, you may want to consider forming a separate legal entity, such as an LLC or corporation, to protect your personal assets from business liabilities.

5. Consult with a tax professional: As a business owner, it’s important to stay up-to-date on tax laws and regulations. Consider consulting with a tax professional who can advise you on the best strategies for minimizing your tax liability and complying with all applicable laws.

Also Read – What is Marginal Analysis in Business? Explained with Examples

Conclusion

Disregarded entities come with numerous benefits for small business owners. The tax filing and reporting process is simpler and administrative costs are comparatively lower. However, owners of disregarded entities should be aware of their personal liability for the business’s debts and obligations, and may want to consider forming a separate legal entity for additional protection. By understanding the advantages and limitations of disregarded entities, entrepreneurs can make informed decisions about the best business structure for their needs. It’s always a good idea to consult with a tax professional or business attorney to ensure compliance with all applicable laws and regulations. Ultimately, with careful planning and management, a disregarded entity can be a viable option for many small business owners.