There are a few different business entity types. From sole proprietorships to corporations, the way a business is set up will determine the number of things, especially regarding taxes. So what exactly is a disregarded entity? Essentially, this is a business type that the IRS ignores as far as taxes are concerned, as the taxes for that business are passed through to the company owner. In this article, we look at the concept of a disregarded entity as well as the benefits associated with this business type of structure.
Disregarded Entities: A Basic Understanding
If we look at the various types of business structures, we see that as far as taxes go there are a few different ways in which companies can be taxed. The simplest business entity is a sole proprietorship. This is where a single person owns a business, and the company and owner are considered one. For this reason, a sole proprietorship is not thought of as a disregarded entity as with this particular business structure the owner is not protected by being separate from the business. A corporation on the other hand is an entity separate from the business owner. As such the owner is protected from the company's debts and liabilities. So if for example, a lawsuit gets filed against the corporation, the owner's assets and money are not susceptible to this action.
With a corporation, however, there are multiple owners and is therefore usually not considered a disregarded entity, as a corporation is taxed twice. They pay business income taxes and then the owners pay taxes on the dividends as well. An LLC (limited liability corporation/) also offers protection for the owner and yet there is no double taxation involved with this business structure. An LLC can have more than one member; in this case, the business can opt to be taxed as a partnership or an S corp. This means that they can claim the allowable business deductions and then the remaining income is passed through to the owners. Some LLCs have a single member; these single-member LLCs are considered disregarded entities.
Also, there are certain types of trusts that are treated as disregarded entities. A trust is separate from the owner of that trust. The owner is therefore protected from liabilities. The profits from the trust are passed through to the owner and then they will have to pay taxes on those profits.
The Benefit of Being a Disregarded Entity
The primary benefit here is that the disregarded entity is not being taxed twice as is the case with some corporate entities. There is one drawback though in that the owner is limited as far as what business deductions that they can claim on their taxes. The key to understanding a disregarded entity is that the IRS ignores the business as far as taxes are concerned. So while some LLCs and corporations may have pass-through taxation, the IRS isn't ignoring the entity. Whereas at the state and federal level, a single-member LLC is ignored and is therefore considered a disregarded entity for tax purposes.
Another benefit of being a disregarded entity is that tax filing is made much easier than if the IRS were to tax the business as well. There is only one set of returns that the SMLLC needs to file versus the more complex business returns. Much as a sole proprietor would, the single-member LLC claims business income on their taxes, and yet unlike the sole proprietorship, they are offered protections as far as the owner is recognized as separate from the business.
Some of the Drawbacks of a Disregarded Entity
One major issue that can arise as a result of being a disregarded entity is the fact that investors may be less likely to want to invest in the company. Corporations tend to be better bets when it comes to investments. So while yes, the benefit of the pass-through taxation is major, a single-member LLC is ultimately less likely to attract investors. This is why it's key to map out your goals at the beginning of the company's life cycle and consequently choose a business structure that aligns with those goals.
Another potential drawback to being a disregarded entity is the amount that you might have to pay in terms of self-employment tax. Sole proprietors as well as single-member LLCs may have a higher self-employment tax. This is why companies often incorporate. Upon incorporation, the owner can classify themselves as an employee of the company and thereby avoid some of these higher self-employment taxes that are associated with disregarded entities. That said, keep in mind that as an employer you would then be responsible for payroll taxes along with other relevant taxes. Some opt to form S corps; in this way, they take a small salary and can also take disbursements from the business. Tax implications can be quite complex to understand whether you're a disregarded entity or not, which is why before making such a decision you may want to discuss your options with an attorney or tax professional.
Setting Up a Disregarded Entity
There is no specific form that needs to be filled out if you intend to establish your company as a disregarded entity. For single-member LLCs, the IRS will automatically recognize you as such. You will therefore just follow your state's guidelines as far as establishing an LLC. There are generally documents that will need to be filed as well as a fee connected to LLC formation. You also want to be sure and establish a separate business account in the name of the LLC/disregarded entity and in this way, ensure that you maintain your liability protections.
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