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Understanding Tax Impacts of Disregarded Entities for Business Owners
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Workforce Management

Understanding Disregarded Entities for Business Owners

One Minute Takeaway

  • Determining a business entity can be daunting as there are many choices.
  • Disregarded entities offer several tax advantages over their counterparts.
  • The main difference between disregarded entities and other business entities is that the owner and business are considered one and the same.

When you start a business, one of the most significant choices you’ll make is determining your company’s business entity. This decision affects the legal protections for your business and can also affect the size of your tax bill when it comes time to file your small business taxes. The most common forms of business are sole proprietorship, partnership, corporation, S corporation, and limited liability company (LLC).

What Is a Disregarded Entity for Tax Purposes?

A disregarded entity is a single-owner business that the IRS directly ties to its owner for federal income tax purposes, as well as certain states’ income tax. Rather than filing separate business and personal forms, the owner pays any business taxes owed as part of their personal tax return. They can also claim business losses on their personal return.

The business is called a disregarded entity because the IRS doesn’t consider the company and owner separate.

What Types of Businesses Can Be a Disregarded Entity?

The most common business the IRS classifies as a disregarded entity is the single-member LLC. In a “limited liability” company, the owner’s personal assets are protected, meaning if the owner is sued, the person suing them can’t come after the owner’s home, car, or bank accounts. The IRS automatically categorizes single-member LLCs as disregarded entities, but the business owner is free to select a different classification as long as their business qualifies. To have the business treated as a corporation, the business owner must file IRS Form 8832, Entity Classification Election.

LLCs that are operated by spouses are generally classified and taxed as a partnership, but in states with community property laws the IRS might be more flexible and allow those businesses to be classified as a disregarded entity.

The IRS also classifies two other less common types of corporations as disregarded entities: a qualified real estate investment trust (QREIT) subsidiary and a qualified subchapter S subsidiary.

Does a Disregarded Entity Have to File Tax Returns?

The business owner is responsible for paying a disregarded entity’s federal taxes on their personal tax return, so a disregarded entity doesn’t have to file a separate federal income tax return for the business itself. State tax laws likely have different requirements, so as a business owner it’s up to you to refer to your state’s tax or revenue office to understand what is required in your area.

NOTE: It’s important to keep in mind that if the business has employees, a disregarded entity is still responsible for payroll and excise taxes if they are required. And the owner is also still responsible for paying self-employment taxes. Being a disregarded entity also does not release the owner of a single-member LLC from the responsibility of self-employment taxes. These taxes are paid in addition to your income taxes, but the amount you pay is also deductible, up to a maximum cap.

What Are the Advantages of a Disregarded Entity?

A disregarded entity has several benefits when compared to a typical corporation, including:

  • Fewer taxes (aka pass-through taxation) – A business owner with a disregarded entity will realize significant tax advantages over their corporation-owning counterparts. Corporations pay taxes on their profits, and the profits are taxed a second time when the owners receive dividends. Disregarded entities aren’t subject to that type of double taxation.
  • Simplicity – The process is also much easier for a disregarded entity when it comes to federal income taxes, because there’s just a single return to be filed (again, it’s important to keep state laws in mind here).
  • Security – Finally, a disregarded entity offers some legal protection for both the business owner and the single-member LLC, meaning legal action against the business is less likely to affect the owner’s personal assets and vice versa.

What Are the Disadvantages of a Disregarded Entity?

A disregarded entity might not be the perfect choice when deciding how to classify your business. It can have a couple of distinct disadvantages including:

  • Difficulty raising capital – If you decide to grow the business, it’s harder to raise money through investors as a disregarded entity. Most investors would rather invest in corporations, which offer stock that protects the investors stake in the company.
  • Possible additional taxes – As mentioned previously, business owners are responsible for paying self-employment taxes but also FICA and FUTA taxes (payroll taxes) for any employees, and any excise taxes on goods and services such as fuel, alcohol, tobacco, and indoor tanning.

As you can see, laws that affect disregarded entities can be complicated. Talk with your accountant or attorney for specific advice pertaining to your situation.