What is a disregarded entity? A disregarded entity is a tax classification reserved for single-member limited liability companies (LLC). For federal and state tax purposes, the entity is “disregarded,” meaning the entity does not file a separate tax return.
Is a disregarded entity the most advantageous tax classification for your single-member LLC (SMLLC)? Let’s explore the following:
- A disregarded entity’s meaning for tax purposes
- The advantages and disadvantages of this tax structure
- A look at the single-member LLC disregarded entity alternative — the S-corporation tax status.
What Does a Disregarded Entity Mean for Tax Purposes?
Structuring your business as a limited liability company (LLC) has many benefits—the most obvious of which is liability protection. Another and equally beneficial quality is tax flexibility.
When LLCs were introduced as new business structures in the 1980s, they weren’t given their own federal income tax classification. Instead, the IRS applied its existing tax statuses for businesses: sole proprietorship, partnership and corporation. As such, LLCs choose how they want to be taxed.
However, by default, the IRS classifies a single-member LLC as a disregarded entity and treats the business as a sole proprietorship for income tax purposes. This means a company’s income, expenses, losses, gains, deductions and credits are reported on the owner’s personal income tax return.
Tax Considerations for a Disregarded Entity
- Flow-Through Taxation: The IRS will ignore your LLC’s entity status. This means the profits of your LLC won’t be taxed at the corporate level, but will pass through to you, and you’ll be responsible for accounting for those profits on your personal tax return.
- Self-Employment Tax: As a single-member LLC, you are subject to self-employment tax. You’ll pay Social Security and Medicare taxes on your company’s entire net income. This amounts to roughly 15% of your net earnings, though 50% of the self-employment tax is deductible.
- Payroll and Excise Taxes: The IRS treats your company as a separate entity when it comes to payroll and excise taxes. This means if you hire employees or deal with goods that are subject to excise tax, you’ll need to obtain an employer identification number (EIN) for your LLC and use this number to report and pay for employment and excise taxes.
- Changing Tax Status: While a single-member LLC’s default tax status is a disregarded entity, you can elect to change this tax classification and be treated as a corporation—even if your business structure stays the same. This might be advantageous for some single-member LLC business owners. Note: If you add LLC members, it will change your tax status from sole proprietorship to partnership.
Pros and Cons of Disregarded Entities
Now that you know the disregarded entity meaning, let’s examine its advantages and disadvantages.
Pros of a Disregarded Entity
- Simple Tax Filings: A disregarded entity, a single-member LLC by name, is taxed as a sole proprietorship. As such, you don’t have to file a separate business tax return. Report your business’s income and expenses on Schedule C of your Form 1040 individual income tax return. This can save you the time and expense that comes with the complexities of filing corporate tax returns.
- Avoid Double Taxation: As a disregarded entity, your filing requirements are paying taxes only once at the personal level. This is in contrast to C-corporations that are subject to double taxation. With this status, business proceeds are taxed as corporate income, and shareholders must pay personal taxes on dividends.
Cons of a Disregarded Entity
- Self-Employment Tax: Disregarded entities are responsible for self-employment tax. And because all business proceeds pass-through as personal income, you pay more in self-employment tax as your business generates more profit. By contrast, single-member LLCs classified as S-corporations pay employment taxes only on salary, not on dividends.
- Less Investor-Friendly: Perhaps the biggest disadvantage for a disregarded entity is that it’s harder to raise money from investors. Most investors prefer to invest in C-corporations as these entities can issue different classes of stock. This allows investors to claim and divest their ownership easily.
Electing S-Corporation Status for a Single-Member LLC
Given the tax consequences of a disregarded entity and its filing requirements, we recommend consulting with a CPA or other tax professional. They can examine your financial information and help you determine if a disregarded entity is a good option for your business—or if your tax burden will be lower using a different tax status.
For example, a single-member LLC can reduce self-employment taxes while keeping pass-through taxation by choosing the S-corporation tax status.
As a single-member LLC owner classified as an S-corporation, you are not considered a self-employed individual. Thus, you are not subject to the self-employment tax.
The Benefit of Dividends
Medicare and Social Security taxes will be withdrawn from your salary by your LLC, but all other company profits can be disbursed to you as a dividend. And here’s the key: You’ll avoid employment taxes on the money you receive from the company in the form of a dividend.
John formed a consulting firm 5 years ago as a disregarded entity. Last year his business did quite well and he had a net income of $120,000. To save on self-employment tax, he elected to have his LLC taxed as an S-corporation. He paid himself $72,000 and had his LLC deduct the appropriate employment taxes for Social Security and Medicare. John took the remaining $48,000 as a dividend. This amount was not subject to employment tax.
It’s important to note that the IRS prohibits the disbursement of all company profits as a dividend. You must pay yourself a salary that the IRS deems “reasonable.” To avoid IRS scrutiny, some accountants apply a 60/40 approach, where at least 60% of profit is taken as salary and the rest as a dividend. You can also reference sources such as the U.S. Bureau of Labor statistics to determine the average salary of individuals in your field.
How to Become a Disregarded Entity
If you determine that a disregarded entity tax status is the right choice for your single-member LLC, the good news is you don’t need to take additional action.
Because a disregarded entity is the IRS’s default single-member LLC tax status, you have to make an election only if you don’t want your business to be a disregarded entity.
To have the IRS treat your business as a corporation, file Form 2553. The election must be made no more than 2 months and 15 days after the beginning of the tax year when the election is to go into effect.