Oh, the irony of the disregarded entity – a term so important in the business world, yet it feels like it’s constantly asking, “Can I get a little recognition, please?” Talk about an existential tax crisis!
If you have a disregarded entity, then you’ll be happy to know that there’s more than just disregard around it! Here’s everything you need to know about disregarded– or pass-through– entities.
What Is a Disregarded Entity?
A disregarded entity is a business that’s treated as a separate entity for tax purposes but isn’t an independent taxpayer. It’s a single-owner business entity that the Internal Revenue Service (IRS) “disregards” for tax purposes, having that business owner file their taxes on their personal returns instead of a separate business return.
As a business owner, this doesn’t mean you’re not paying taxes on your business! Just that you’re filing your personal taxes reports, and filing your taxes on your personal tax return.
One of the most commonly disregarded entities is the LLC, or Limited Liability Company where the business owner is reporting all of their taxes as a pass-through entity, avoiding double taxation.
Is a Single-Member LLC Automatically a Disregarded Entity?
Yes! It’s an easy way to affiliate your business without needing to break the bank (or get stockholders). This is a popular business structure for new business owners who want an official organization without any in-depth leg work. If, for some reason, an LLC owner wants to be a separate entity (which is the opposite of a disregarded entity), they’ll have to file Form 8832, which will give them the option to report as a different business classification come tax season, like as a partnership or as a corporation.
What Types of Businesses Can Be a Disregarded Entity?
Income, deductions, gains, losses, and credits of a separate entity, like a partnership or a corporation, are usually filed on a separate tax return compared to a business owner’s personal tax returns. But with disregarded entities? Not so much!
Here are those special businesses that can be regarded as disregarded entities:
Sole Proprietorships, or unestablished businesses owned and operated by one person. The sole proprietor is personally liable for the debts and obligations of the business, and may not be able to take advantage of certain business benefits like opening a business bank account.
Single-Member LLCs (Limited Liability Companies) or businesses owned by one person. The owner of a single-member LLC isn’t personally liable for the debts and obligations of the business, being protected by personal damages if they ever get sued by a client or another business for something.
Partnerships, or businesses owned by two or more people. The partners are personally liable for the debts and obligations of the business jointly, having limited protection since they’re not an established business. Now, partnerships aren’t always disregarded entities, but can sometimes be. They’re a little tricky, as partnerships can be established or unestablished.
Does a Single-Member Owner Have to File Tax Returns?
Yes, a single-member owner of a disregarded entity must file a tax return. Just like any other business, single-member owners have to file tax returns just like multi-member LLCs or partnerships, including income, deductions, gains, losses, and any credits they might have earned throughout the year of the disregarded entity.
Let’s break down some single-owner established businesses so you can differentiate them based on their tax return types.
As a pass-through entity, sole proprietors file taxes based on what they’re liable for. If they’re liable for income tax, then they’ll file a Schedule C and either a 1040 or a 1040-R. They’ll also have to cover things like self-employment tax using Schedule SE, excise tax, and more, depending on their business type.
Limited Liability Company (LLC)
LLCs are super fun and flexible because you can either file as an LLC or as a corporation on your tax returns. Your decision will dictate the forms you’ll have to fill out every spring but will include lots of similar tax forms as sole proprietors as well as Form 8832 if a said business owner decides to file as an entity other than an LLC.
Things get a little more tricky when you’re filling out tax forms for a corporation since there are so many different types of corporations.
If reporting tips, you’ll go ahead and fill out a W-2 and a W-3, and if you’re paying wages of $1,500 or more in a calendar quarter and have had “one or more employees working for the corporation for at least some part of a day in any 20 different weeks during the calendar year,” then you’ll be filling out and sending in a 940.
Advantages of a Disregarded Entity
Disregarded entities can be plenty of fun (and simple!) when you work them in the right way. There are a ton of benefits to having a disregarded entity, like:
Simpler Tax Filing
No need to fill out both a personal and business form during tax season. Just your personal tax return will do just fine!
Remember that fun Form 8832? That gives pass-through entities the ability to file as separate entities during tax season, which sometimes makes sense tax-wise for certain businesses.
Avoidance of Double Taxation
Larger C corporations have to pay tax twice, both on their income and shareholders paying on their dividends. S corporations, LLCs, and Sole Proprietorships (our disregarded entities) get exempt from that rule.
Disadvantages of Disregarded Entity
One of the not-so-fun parts of being a disregarded entity is having to pay self-employment taxes. Since you’re not working as an employee, you have to pay the 15.3% of self-employment tax that employers typically pay, covering half Social Security and half Medicare taxes.
Employment and Excise Taxes
On top of self-employment tax, select businesses also have to pay federal unemployment tax and other potential employment and excise taxes that, as an employee, you wouldn’t otherwise pay. It’s part of the nature of being in business, but a big pay-off when you’re working for yourself and doing what you love.
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Why is it called a disregarded entity?
Because the entity is not technically regarded as a separate business from the business owner on its tax forms.
What is an example of a disregarded entity?
A limited liability company, since the LLC owner only needs to report its taxes on their personal tax records, not a separate business one (like a C corporation would need to).
How do you determine if an entity is a disregarded entity?
Take a look at the entity’s classification election, which is a document that the IRS can provide. You can also work with a business specialist to determine your entity’s classification type and which type might work best for you.
What is the difference between a single-member LLC and a multi-member LLC?
It’s pretty simple: a single-member LLC has one member (or owner), while a multi-member LLC has two or more.
What is not a disregarded entity?
A C corporation is not a disregarded entity, since the business must file a separate tax document from the business owner’s personal tax returns.