Pros and Cons of a Disregarded Entity

pros and cons disregarded entity

A disregarded entity is an IRS label given to single-member LLCs for tax purposes.

Learn about the benefits of being an LLC disregarded entity and how we can help you.

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As a new business owner, you’ve likely heard of LLCs and corporations. But what about a disregarded entity? It’s a taxation term that’s most often applied to an LLC with only one owner. Let’s discuss what a disregarded entity is and its pluses and minuses.

What is a disregarded entity?

The disregarded entity definition comes from the IRC (Internal Revenue Code). It describes the tax filing method where the IRS “disregards” or ignores the entity for income tax purposes. The term “disregarded entity” refers to a tax classification instead of a business entity. You must create a disregarded tax entity (like an LLC) before you can receive disregarded entity tax treatment.

What is a disregarded entity for tax purposes?

When the IRS considers your business a disregarded entity for tax purposes, it doesn’t pay federal business income taxes. Instead, the entity owner pays income tax for the disregarded entity on their personal income tax return.

It’s important to remember that the IRS disregarded entity classification only applies to federal taxes. Your state’s Department of Revenue will tax your business under state law, which could require business income taxes, depending on your state.

Who can be a disregarded entity?

Only certain business structure options can be disregarded entities. Single-member LLCs are considered disregarded entities. Multi-member LLCs, S corps, and partnerships don’t fall under this label.

Single-Member LLCs

An LLC is a popular business structure for freelancers and entrepreneurs. It’s also a relatively new type of business structure formed under state law. As a result, the IRC doesn’t provide a specific taxation method for LLCs. Instead, the IRS taxes an LLC under the existing tax structures in the IRC. By default, an LLC is taxed as a partnership or sole proprietorship (disregarded entity).

The default tax classification for your LLC depends on how many members it has. If your LLC has at least two members, the IRS taxes it as a partnership by default. The default classification for a single-member LLC is disregarded entity. So, if you start an LLC as a single member, it’s a disregarded entity. Your LLC won’t file a federal tax return, but you must report the business income on your individual return.

Trusts

You may come to find that a trust can also be a disregarded entity. However, only “grantor trusts” are disregarded entities. A grantor trust is when the owner controls the income and assets of the trust. In that case, the grantor (not the trust) must pay taxes on the trust’s income.

Advantages of a Disregarded Entity

There are advantages to being a disregarded entity. Some of the pros include tax benefits and easy tax filing.

Pass-Through Taxation

The biggest advantage of the disregarded entity is pass-through taxation. Single-member LLC taxes eliminate corporate double taxation by passing on profits to owners. LLC members aren’t considered employees and won’t pay employment taxes on a paycheck. Instead, you pay self-employment taxes on the business income. When you provide a client with a W-9 for your disregarded entity, you’ll receive a disregarded entity 1099 (1099-NEC).

Additionally, you can choose to change the taxation method for your disregarded LLC in a future tax year. You can elect corporate taxation by filing Form 8832 as a single-member LLC, if you think that will benefit your company. If you qualify, you can file Form 2553 for S corp classification. Disregarded entity vs. S corp taxation means you can pay yourself a salary when you file as an S corp and pay employment taxes on that salary and not pay self-employment taxes on the remaining profits you receive. For some LLCs, this could add up to thousands of dollars in tax savings.

Easy Tax Filing

As a disregarded entity, an LLC doesn’t file a tax return as a separate entity. Instead, owners report taxable income on their personal tax returns by filing Schedule C with Form 1040. You’ll pay self-employment tax on business earnings, but you don’t have to file a corporate income tax return.

Limited Liability Protection

An LLC is one of the most popular options for small businesses because it provides its owners with liability protection. Since an LLC is a legal entity, owners are protected from personal liability for business debts and obligations. Personal liability protects your personal assets separate from your business.

If you’re the only member of an LLC, your LLC is a disregarded entity. An LLC owner gets personal liability protection while enjoying the tax advantages we talked about above. As a single owner, you can remain an unincorporated business. However, the difference between the LLC (disregarded entity) vs. sole proprietorship is liability protection.

Disadvantages of a Disregarded Entity

While treating your LLC as a disregarded entity has several advantages, there are also downsides to consider.

Impact on Investors

As opposed to a corporation, as a disregarded entity, it’s harder to get money from investors if you want to grow your business. Disregarded entities are considered less credible than larger business entities, such as corporations. Most investors choose to put their money into corporations since they can buy shares in a company that provides more security.

Self-Employment Taxes

As a disregarded entity, you’re responsible for self-employment taxes, which are the taxes earmarked for Social Security and Medicare.

The owner of a disregarded entity is considered self-employed. They’re compensated by receiving their share of profits from the LLC, but they can’t be employed by the LLC. Being self-employed means paying self-employment taxes (about 15.3%) on all profits they receive from the LLC. This is more than the taxes they’d pay when working for someone else because their employer would pay part of them.

This can be partially offset by electing to be taxed as an S corp. When the disregarded entity elects S corp status, they can be compensated in two ways, by receiving their share of the profits and by being paid as an employee. Once they do that, they only pay self-employment taxes on their salary and not the profits they receive. (Of course, this is only for self-employment taxes; LLC members still must pay income and other applicable taxes on their profits.) This can add up to quite a lot for certain profitable LLCs. To get a better idea, check out our page for calculating your S corp taxes.

One caveat to S corp election is that the IRS expects you to pay yourself a “reasonable salary” as an employee of the LLC. Otherwise, you could pay yourself an annual salary of $1 and avoid contributing anything to Social Security and Medicare. The IRS considers “reasonable” to be something similar to what others in your field are earning.

How to Set Up a Disregarded Entity

To set up a disregarded entity, start by forming an eligible legal business entity. Starting an LLC is a great option for a small business. Still, it’s a good idea to consult your accountant about the tax consequences.

We can make the tax process easier and help you send invoices and track expenses with ZenBusiness Money.

State Guidelines to Form an LLC

To form your LLC, head to your state’s Secretary of State or Division of Corporations office. Forming an LLC usually requires filing Articles of Organization. It’s important to review your state’s requirements before filing. Or, let’s help you with our LLC Formation Services.

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Disclaimer: The content on this page is for informational purposes only, and doesn’t constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.

Disregarded Entity FAQs

  • A disregarded entity is a federal income tax classification, while an LLC is a business structure formed under a state statute. The IRS doesn’t have a set taxation method for LLC income. Instead, the IRS taxes LLCs by default, depending on the number of members. A multi-member LLC is taxed as a partnership, and a single-member LLC is a disregarded entity.

  • The IRS ignores disregarded entities for federal tax purposes. Thus, disregarded entities don’t pay income taxes. It’s the individual owner’s responsibility to pay income taxes on the business’s profits.

  • Yes. Single-member LLC owners must report income from the disregarded entity on their individual income tax returns.

  • A disregarded entity isn’t inherently good or bad. It’s another approach to paying your business taxes. If you’re wondering about the specific impacts on your tax liability, it’s best to consult your tax professional.

  • If you live in a community property state, a husband and wife can share joint ownership of an LLC. In that case, the IRS will honor the couple’s decision to treat the LLC as a disregarded entity. In non-community property states, an LLC owned by a husband and wife can’t be a disregarded entity.

  • No. A corporation can’t be a disregarded entity because it uses corporate taxation. However, an LLC can elect to be taxed as a C corporation and pay the corporate tax rate.