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Disregarded entity

For sole-owned businesses, a disregarded entity can have numerous tax advantages.

  • Definition

  • Pros and cons

What is a disregarded entity?

In the US, disregarded entity refers to any single-owner business that is exempt from federal tax purposes. This type of entity is considered a pass-through entity, meaning that its profits and losses are passed through to you as the owner for tax purposes. It's a type of classification given by the Internal Revenue Service (IRS) to certain types of business entities.

For disregarded entities, all of the business's income, deductions, and credits are reported directly on the owner's tax return rather on a separate business tax return. The IRS disregards the business entity and treats it as an extension of the owner's finances. In fact, when an LLC has only one owner or member, the IRS automatically classifies it as a disregarded entity unless the owner chooses to have it treated differently.

The most common type of disregarded entity is a single-member limited liability company (SMLLC). This means there is only one owner running the LLC rather than a group of individuals. Sole owners who choose to start a business have three main options to choose from:

  • Sole proprietorship

  • Corporation

  • LLC

Both the sole proprietorship and the single-member LLC are automatically considered disregarded entities for tax purposes. All income and expenses pass through to the business owner on their individual tax returns. However, the LLC offers additional legal protections and flexibility compared to a sole proprietorship.

A business classified as a C-Corporation will be taxed as a separate entity from the owner. The corporation will be taxed on any income as will any compensation paid to the owner. This is referred to as "double taxation" because both the business and the owner will be taxed as separate entities.

However, if the business qualifies for a S-Corporation status, all tax obligations are passed through to the owner, to be paid on their personal tax return.

There are two lesser-known options for establishing a disregarded entity: S subsidiaries (QSub) and REIT subsidiaries. These are specialized forms of disregarded entities that are created for specific purposes.

A QSub is a subsidiary of an S-Corporation that is recognized as a disregarded entity. The ownership structure is not affected, but it allows the parent company to have separate entities for liability purposes. A REIT subsidiary is created by a Real Estate Investment Trust (REIT) to hold its real estate assets without exposing them to tax liabilities at the REIT level.

Hiring internationally complicates tax filings for disregarded entities. You may be required to fill out additional paperwork such as the to determine the specific tax rates for international employees.

What are the advantages and disadvantages of a disregarded entity?

Depending on what you want to accomplish, there are a number of advantages and disadvantages to forming a disregarded entity.

Advantages

One of the main advantages for business owners is the . Instead of filing taxes for both yourself and your business, all expenses and income are reported on your personal tax return. This can potentially save time and money compared to filing separate business taxes. It can also eliminate human error as you file through multiple tax returns.

Another advantage is the extra liability protection you receive from forming an LLC or an S-Corporation. Even though you chose to disregard the entities and file taxes under your personal return, you still enjoy the additional legal protection the entities provide under their organizational structure.

Structuring a business as a disregarded entity also means not forming a C-Corporation, which allows you to avoid being double taxed. As a C-Corporation, you would have to file two separate tax returns, one for you and one for your business, resulting in more money for the IRS.

Disadvantages

The money you'll save from a disregarded entity may not be worth it in the long run if you are trying to raise additional capital. Having a disregarded entity means your business's capital is tied to your own personal finances. Potential investors may be wary of investing in a structure that doesn't separate its assets.

In the same respect, bank institutions may be more hesitant to extend their business credit lines if finances are not separate from the owner because it creates more risk for the banks. This will severely limit financing for future operations or growth.

You also need to be aware of liability protection for the organizational structure you choose. In some states, single-member LLCs don't receive the same level of liability protection as multi-member LLCs. This can potentially expose your personal assets to business debts and liabilities.

Since various states have different governing laws for LLCs and business entities, it's important to research your best options and choose a structure that aligns with your business needs, goals, and circumstances.

Key takeaways
Remember:
  • A disregarded entity is a legal structure for tax purposes, where a business entity is not recognized separately from its owner. It is commonly used for single-member LLCs.

  • The income and expenses of a disregarded entity are reported on the owner's personal tax return (Form 1040) rather than a separate tax return for the entity.

  • While providing flexibility and simplicity, a disregarded entity still offers limited liability protection to the owner, shielding personal assets from business liabilities.

  • A disregarded entity is typically owned and managed by a single individual, and the owner has full control over business decisions.

  • While there are fewer formalities compared to other business structures, it's important to comply with local regulations and file the required documents, such as articles of organization for an LLC.

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