Definition: Disregarded EntityThe term “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. Rather, the company’s income, expenses, losses, gains, deductions and credits are reported on the owner’s personal income tax return. Treatment by the IRS as a disregarded entity has no impact on the limited liability protection of an LLC.
Structuring your business as a limited liability company (LLC) has many benefits—the most obvious of which is the liability protection it affords. Another, and equally beneficial, quality is tax flexibility.
Because the IRS does not consider an LLC to be a distinctly separate entity for tax purposes, members of an LLC choose how they want to be taxed.
The default classification for single-member LLCs is as a disregarded entity and is taxed like a sole proprietorship. The LLC’s profits and losses are not taxed directly but passed through to the owner’s personal federal tax return.
In the right business setting, this can equate to sizable tax savings.
To help you determine if a disregarded entity is the most advantageous tax classification for your single-member LLC, we’ll:
- Define what a disregarded entity is
- Explore how it’s taxed
- Describe the advantages and disadvantages of this tax structure
- And indicate when a corporate tax classification may be the better choice for your small business
What is a Disregarded Entity?
When LLCs were introduced as new business structures in the 1980s, they were not given their own federal income tax classification. Instead, the IRS applied its existing tax statuses for businesses: sole proprietorship, partnership and corporation.
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.
As a disregarded entity, these are the tax considerations you need to know:
- 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 will 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 percent 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 will need to obtain an EIN number for your LLC and use this number to report and pay for employment and excise taxes.
- Changing Tax Status: As we now know, a disregarded entity is the default tax status for single-member LLCs. You can, however, elect to change this tax classification and be treated as a corporation even if your business structure stays the same. We’ll discuss why this may be advantageous for single-member LLCs later on in this post. The addition of LLC members will also result in a change of your tax status—from sole proprietorship to partnership.
Pros and Cons of Disregarded Entities
Now that we’ve defined what a disregarded entity is, let’s examine how it can benefit or hinder your business.
Pros of a Disregarded Entity
- Simple Tax Filings
As we’ve covered, a single-member LLC is taxed as a sole proprietorship. As such, you do not 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. By avoiding the complexity of filing a corporate return, you’ll save the time and expense of tax preparation efforts.
- Avoid Double Taxation
As a disregarded entity, you only pay taxes 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
As we already mentioned, 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 LLC’s classified as S-corporations only pay employment taxes on salary, but 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 easily claim and divest their ownership.
Electing S-Corporation Status for a Single-Member LLC
Given the tax consequences of a disregarded entity, we recommend you consult with a CPA or other tax professional. They can examine your financials 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 the owner of a single-member LLC 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 point: you’ll avoid employment taxes on money you receive from the company in the form of a dividend.
To illustrate how this works, let’s look at an example.
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 a salary of $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 the scrutiny of the IRS, some accountants apply a 60/40 rule, 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 like 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 any additional action.
As we mentioned earlier on in this post, disregarded entity is the default single-member LLC tax status. You simply need to file your business taxes on Form 1040, Schedule C.
You only have to make an election 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 two months and 15 days after the beginning of the tax year when the election is to go into effect.
The Bottom Line
There’s no one best tax status for all small businesses, but there is a best option for your small business right now. And it may be that a disregarded entity with its favorable tax treatment is that option.
As we just covered, there’s a lot to consider. So before you make a final decision, it’s in your best interest to consult with an experienced tax professional to thoroughly examine the pros and cons of each tax position.