What is a Disregarded Entity?

Last updated on March 16, 2023

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One of the most confusing parts of starting a business is choosing the right entity that fits your situation. Since there are many different entities to choose from, you should consider talking to a legal professional to ensure that you are starting on the right foot.

When it comes to taxation of your new business, this can be even more overwhelming if you are not familiar with the terms. It is important to know whether or not your new company will be considered a disregarded entity by the IRS.

If you want to learn more about what a disregarded entity is, keep reading because you will need to know how this will affect your business.

What is a Disregarded Entity?

By definition, a disregarded entity is a business that has a single owner which the IRS disregards for tax purposes. This typically means that the business owner will not be required to file taxes for the business itself, but will file them under their personal income tax return.

In most cases, filing for a single-member limited liability company means you have a choice as to whether you want to file the taxes with the business or on your personal tax return. The disregarded entity just means that there is a distinct separation between the individual and business, at least for tax purposes.

Which Business Types Can Be Considered a Disregarded Entity?

Most people who have started their businesses know that there are several different business types to choose from. Depending on the business you are attempting to form and how many people are starting it with you will determine the type of business entity you need to start.

Because there are so many different types of businesses, there are different regulations that apply to each one. This includes how they are required to file their income tax returns at the end of each year.

Some of these business entities are automatically given the status of a disregarded entity by the Internal Revenue Service. This means that business owners are not required to apply for the status or do anything to qualify as long as they file a certain entity.

Sole Proprietorship

For this type of business entity, it is important to keep in mind that there is no formal legal structure. This means that there is no separation between the business and the individual when it comes to filing taxes.

It may be important to note that even though the taxes are filed with the owner’s personal taxes, they are required to report any income that is brought in. Because of this, it should also be noted that this type of business does not qualify as a disregarded entity since there is no legal structure in place.

Limited Liability Company (LLC)

This type of business entity is formed and the owners are referred to as members, which can be one or more people. In this type of entity, depending on the number of members, how the company is classified determines how they are taxed.

For example, if there are more than two or more members, they must either choose to structure their business as a partnership or a corporation. Because of this, the taxes are handled differently and the IRS has specific rules regarding them.

Another type of LLC is the Single-Member Limited Liability Company, or SMLLC, which means that there is only one member. In this case, the member can choose whether or not they want to structure as a corporation or not.

If an SMLLC chooses not to structure its business as a corporation, then the IRS views them as a disregarded entity. This means that all business income will be filed under the individual’s personal income tax.

Corporations

Businesses that structure themselves as a corporation can be classified as either a C Corporation or an S Corporation. Depending on their choice, there are specific taxation rules and regulations.

It is important to keep in mind that if your business is structured as a corporation, you will not be classified as a disregarded entity. This is because the company is solely responsible for filing taxes under the regulations that exist for corporations.

Benefits of a Disregarded Entity?

As you sift through all the information that is required for setting up your new business, you will find many views on the business structure you should choose. This is especially true for individuals who are deciding whether or not to classify themselves as a corporation.

Since SMLLCs can choose to be structured as a corporation or not, you should be aware of the benefits of being a disregarded entity. Since creating this type of business structure comes with many advantages, it is important to break them down for understanding.

Simple Tax Filing

Most people who have structured themselves as single-member LLCs, choose not to classify as a corporation since it simplifies the tax process. For these types of entities, the owner does not have to file two separate tax returns.

This type of entity, like a sole proprietorship, allows the business owner to claim the income on their tax return, thus making the process easier. If they were to structure as a corporation, they would be required to file separate returns which take more time and money in the long run.

Liability Purposes

When an individual structures their business as an LLC, the limited liability means that the owner has some protection against wrongdoing. This means that if a customer comes after the business for any reason, they can only do so with the business itself and not the individual.

What many people get confused about the LLC and being a disregarded entity is that it is only disregarded for income taxes. This means that the legal structure of the company is still a separate entity, but they are disregarded in the eyes of the IRS.

Double Taxation

When you have an LLC that you have classified as a corporation, you are likely being taxed twice since you are required to file as a business entity and an individual. Choosing the disregarded entity route can save you both time and money and keep you from having to file two separate income tax returns.

Disadvantages of a Disregarded Entity?

Like most things, there are both advantages and disadvantages to being classified as a disregarded entity. When you are trying to decide which type of entity works best for you, it is important to consider all of the factors.

Keep in mind that while starting a new business can be an exciting adventure, many factors need to be considered before opening your doors. Filing income taxes is only one of the factors and is the main reason to be considered a disregarded entity, but should not be the only consideration.

Taxes on Self-Employment

Being classified as a disregarded entity may save you time and money when it comes to filing your income tax returns, however, it does not save you from other types of taxes. One in particular that you will still be liable for is a self-employment tax.

No matter if you have classified your business as a corporation or single-member company, you will be responsible for paying a self-employment tax. Keep in mind that the amount you must pay to run your business is separate from the taxes you have to pay for your income.

Payroll Taxes

If you have employees in your company, you must realize that you are required to pay certain taxes for them. Being considered a disregarded entity does not mean that you are exempt from paying these types of taxes since that classification is only for federal income taxes.

Included in the payroll taxes are various line items that are required by all employers to pay on behalf of employees, such as Social Security and Medicare taxes.

Investors

Another reason some LLC owners choose not to be classified as a disregarded entity is that it is difficult to bring in investors down the road. This is because if you bring in investors, they must be listed on the business as members.

This means that your single-member LLC will not be as attractive to investors since they would end up having to pay partnership taxes to invest.

Do You Need an EIN if Your Business is a Disregarded Entity?

In most cases, when you are starting a business, it is considered a best practice to apply for an employer identification number or EIN. This number is often used in place of a business owner’s social security number on various forms.

As a general rule, if you are a single-member LLC and are classified as a disregarded entity with no employees, you are not required to have an EIN. Although this is the case, most LLCs choose to apply for an EIN just in case they decide to have employees down the road.

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