When you are a small business owner, you need to be aware of the different business structures to decide which one works best for you. One of the lesser-known business structures is called a disregarded entity. You may be wondering what this could possibly mean.
In this post, we’ll discuss what a disregarded entity is and compare it to other common types of business structures to find out if it may be right for your business.
What Is a Disregarded Entity?
A disregarded entity refers to a business with one owner that is not recognized for tax purposes as an entity separate from its owner. Sole proprietorships and single-member LLCs are considered to be disregarded entities.
In other words, a disregarded entity is a business entity with one owner that is not recognized for tax purposes as separate from its owner.
This means that the business does not file a tax return, and the income and loss are reported on a single tax return filed by the owner. If the owner is an individual, they will report the income and loss on their own individual tax return. If the owner is a corporation, the loss and income will be reported on that corporation’s tax return.
A key thing to remember is that while a disregarded entity is not recognized as separate by the IRS, it still allows the business and the owner to have separate liabilities (the owner can’t lose personal assets due to lawsuits, for example).
What does it mean to be a disregarded entity for tax purposes?
When filing your taxes, your company, as a disregarded entity, won’t have to file separated taxed form your individual taxes. The profits and losses of your business will be declared in your individual, personal taxes.
LLCs, S Corporations, and S Corporations are not disregarded entities.
Pros and Cons of Disregarded Entities
Advantages of Disregarded Entities:
- Pass-Through Taxation- Simply put, the taxes of the entity are passed to the owner to report. This helps avoid the double taxation of corporations while letting the owner take care of the entity’s taxes on the same form, preventing further paperwork and hassle.
- Less Liability– A disregarded entity is still considered to have separate liability at a state level. With limited liability, the owner and the business are the same, so the business debts would become the owner’s debts, etc. A disregarded entity separates the owner’s from the business’s liability. This means that the owner’s house or car can’t be collected to pay a debt, for example.
Disadvantages of Disregarded Entities:
- Employment and Sales Taxes- Disregarded entities only help for filing federal taxes, which means the company will still owe employment and sales taxes. This is obviously less of a big deal if you have no employees and aren’t forced to pay sales taxes.
- Self-Employment Taxes- Owning a disregarded entity does not entitle you to not pay self-employment taxes, so that disadvantage of a sole proprietorship remains for disregarded entities (this tax may have a deductible in some cases, which you should be aware of).
How to File Taxes as a Disregarded Entity
If you do choose to incorporate your business as a disregarded entity, filing taxes will be pretty simple. Since the IRS disregards the business entity, the business owner will have to account for all of their company’s income, losses, and deductions in their own taxes. They will do this in a few different ways:
- They will file a regular Form 1040 along with a Schedule C, just like you would do with a sole proprietorship. This is understandably quite confusing (since we explained that a sole proprietorship and a disregarded entity is not the same), but remember that the only difference between a disregarded entity and sole proprietorship is in terms of liabilities, they are functionally the same tax-wise.
- If the owner has no employees, they will pay self-employment taxes the same as a sole proprietorship would.
- If the owner does have employees, they will file taxes using the company’s employer identification number (EIN).
- For social security, Medicare, and income taxes IRS Form 941 is used.
- For excise taxes (another name for Sales Tax), reports will have to be sent every quarter using Form 720.
Read this post to know in detail how to file taxes as a single owner and to access all the forms you need.
When Should You Consider a Different Structure?
Keep in mind that once you incorporate your business you can always change the structure down the road. There are a few situations where you may want (or need) to change your business structure:
You Aren’t the Sole Owner Anymore
Once a partner or multiple shareholders enter the picture a disregarded entity is no longer sufficient. You will have to either reform into a partnership or corporation depending on the circumstances.
You No Longer Want to Pay Self Employment Taxes
If you can get shareholders or investors on board, it might be a viable option to start a corporation. This allows you to forego self-employment taxes you are forced to pay as a disregarded entity. Instead, you merely pay taxes on your designated salary like a regular employee.
When more partners or shareholders enter the picture, consider converting your disregarded entity into a different structure.
What’s The Difference Between a Disregarded Entity and Other Structures?
In order to get a better idea of what this type of business structure entails, it may be helpful to compare it to other common business structures:
Reading the definition above, you may think there is no distinction between a sole proprietorship and a disregarded entity. This is a very common misconception, but there is a critical distinction between the two. In a sole proprietorship, the owner and business entity are considered the same in both taxes and liabilities. That means that the owner of a sole proprietorship can lose personal assets due to debts, bankruptcy, or lawsuits.
Multiple Member LLC
A multiple-member LLC is an LLC that has more than one owner. This would not qualify as a disregarded entity because it would pay taxes as a partnership. A partnership does not report taxes on a Schedule C Form (Form 1040) as a disregarded entity would. Partnerships pay taxes in their own specific ways.
A corporation, especially a small corporation (or S corporation), is always considered separate from the owners in terms of liabilities and taxes, so it would not qualify as a disregarded entity (which is not considered separate for tax purposes). These types of businesses typically report tax information on shareholders’ tax returns.
A C Corporation is one where the entity (or corporation itself) and shareholders are both taxed separately, which is also known as double taxation. Obviously, this is not a disregarded entity, as the whole point of having one is that the entity and owner are not considered separate for tax purposes.
Other FAQs on Disregarded Entities
How do I know if I am a disregarded entity?
When filing your taxes, as the owner of a disregarded entity you must use your own Social Security Number (or the separate EIN or ITIN by default) on all returns and forms related to income tax., even if your business has its own EIN.
Can a corporation be a disregarded entity for tax purposes?
When there is more than one business owner, the business is generally not considered as a disregarded entity for tax purposes. Corporations pay taxes on business income before it is passed on to the owners or shareholders.
Can a disregarded entity have an EIN?
Yes. Most single-member LLCs classified as disregarded entities need to obtain an EIN. However, a single-member LLC that is a disregarded entity and does not have employees, and does not have an excise tax liability does not need an EIN. It should use the name and TIN of the single-member owner for tax purposes.
Is a Disregarded Entity Right for You?
We hope that this post has opened your eyes to what a disregarded entity actually is. For more helpful articles and explanations, be sure to join our Camino Financial Newsletter.
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