When starting a business, one of the most critical decisions the owner has to make is determining the company’s business identity. To do so, they must answer the question: what is a disregarded entity?
Defining the business entity determines the amount of taxes an owner has to pay.
Hence, depending on the size and type of company, the owner must carefully consider the kind of business form that would be the most appropriate choice for them.
What is а Disregarded Entity?
A disregarded entity definition: A disregarded entity (DRE) is a type of entity that is legally separate from its owner. The separation is disregarded for tax purposes.
A DRE is characterized by three elements:
- It has a single owner.
- It is not constructed as a corporation.
- The owner hasn’t chosen to be taxed separately.
As the name suggests, the central aspect of a DRE is that the IRS ignores the legal separation for federal tax reasons.
What is a Disregarded Entity for Tax Purposes?
When it comes to taxes, a DRE is not separate from its owner. This means the IRS associates the business with the owner for income tax purposes.
In other words, instead of filling out separate business and personal tax forms, the owner pays the taxes owned by this kind of business as part of their income tax return. They can claim business losses on their individual tax return as well.
Disregarded Entity Examples
The main business types include sole proprietorships, limited liability companies, partnerships, and corporations.
A single-member limited liability company (SMLLC) is the most common DRE example. Limited liability means that its members have protection for their personal assets. Therefore, if someone is suing the business, they can’t touch the owner’s home, car, or personal bank accounts.
The IRS automatically classifies an LLC with only one member as a single-member disregarded entity unless it chooses to be treated otherwise if the company qualifies. Hence, an LLC can be treated as a corporation by filing Form 8832.
An LLC owned by spouses as community property owners is generally considered a partnership, but depending on their community property laws, the IRS might allow the business to be treated as a DRE in some states.
Two other types of businesses that are less common but can also be classified as disregarded entities are a qualified real estate investment trust (QREIT) subsidiary and a qualified subchapter S subsidiary.
Sole Proprietorship Taxation
A small business proprietor can choose how to own and operate their business. There are three options to decide upon: a sole proprietorship, a single-member LLC, or a solely-owned corporation.
Entrepreneurs should consider various aspects when deciding on the business form. One is how the business’ gross income will be taxed for federal income tax purposes.
In the case of a sole proprietorship, there is no legal separation between the company and its owner. Hence, it cannot be treated as a DRE. That means the owner can be personally responsible for any business liabilities or debts.
The sole proprietorship entity is the only one that is a pass-through entity since it is not separate from its owner. Sole proprietors file their business taxes under Schedule C as part of their personal income taxes.
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Single Member Disregarded Entity
According to IRS regulations, an LLC is classified as a single-member disregarded entity for employment tax and some excise taxes.
If it is not regarded as a corporation, the LLC’s activities are reflected on the owner’s federal tax return, specifically on Form 1040. A single-member LLC uses the owner’s social security number (SSN) or employer identification number (EIN) for federal income tax purposes.
If the LLC has employees or the state tax law requires a federal EIN, it must obtain one by filing Form SS-4, Application for Employer Identification Number.
Disregarded Entity vs. Partnership
A domestic limited liability company with at least two members is regarded as a partnership regarding federal income tax unless it elects to be treated otherwise.
The main difference between a disregarded entity vs. a partnership is that the IRS doesn’t regard the partnership as separate from its owners.
Since a partnership’s profits go directly to the partners, they must file Form 1040 and Schedule SE. Partners deduct business expenses as part of their tax filings, which lowers the company’s overall net income.
Partnerships are required to submit IRS Form 1065, an informational return of the business’s profits and losses, as well as a Schedule K and K-1 filings for each partner, each of which details the distributive share of profits and losses as well as allocations.
Disregarded Entity vs. Corporation
Depending on the type of corporation, there are similarities and differences between a disregarded entity and a corporation regarding taxes.
A C corporation is taxed as a separate legal entity from its owner and shareholders. The income and expenses of a C corporation are taxed on a corporate level. However, apart from profits being taxed on a corporate level, owners must also pay personal income tax upon distribution.
If a corporation meets the requirements, it can be taxed as an S corporation, the most common business model among small businesses. In this case, profits “pass-through” to the owner and shareholders, and they include them on their tax returns. This means this type of corporation doesn’t have to pay federal taxes at a corporate level, and the double taxation of profits is eliminated.
Disregarded Entity & Filling Tax Returns
A DRE is not required to file tax returns since its owner pays the federal taxes due to the entity on their personal return.
However, some states have different regulations and requirements, so it is best to consult with the state’s tax or revenue office.
Advantages of a Disregarded Entity
A disregarded entity enjoys various benefits compared to typical corporations, including:
- Simple tax filing process: The most considerable benefit of disregarded entities is that the filing process is more straightforward. Proprietors who manage a DRE don’t have to file separate returns.
- Tax advantages: Apart from making filing taxes easier, disregarded entities enjoy certain tax advantages. The most substantial one is that it is not subject to double taxation.
- Legal security: Since a DRE is legally separate from the owner, it protects the proprietor and the SMLLC. Therefore, legal action against the entity will not affect the owner and vice versa.
Disadvantages of a Disregarded Entity
Although a disregarded entity has advantages, it also has its downsides.
- Additional taxes: A DRE is recognized only for the purpose of federal taxes. Since they are self-employed, owners must pay self-employment taxes and income taxes. However, the amount paid is tax-deductible up to a maximum cap. In addition, if the SMLLC has employees, it must also pay payroll taxes. Additional required taxes include an excise tax on goods and services, sales, or franchise taxes.
- Difficulty obtaining financing: While a disregarded entity has advantages in workforce management, it is generally easier for corporations to raise more capital.
Understanding what a disregarded entity is is crucial in selecting the type of business entity that would be the best choice for new business entrepreneurs. Weighing the pros and cons of a disregarded entity can help make a more informed and reasonable decision.