A disregarded entity is a single-owner business entity that the Internal Revenue Service (IRS) “disregarded” for tax reasons. So in case, you are still wondering what is a disregarded entity or sole proprietorship, its advantages, and disadvantages
This article discusses the tax choices available to sole proprietorships, the benefits, and the drawbacks of being a disregarded entity.
Definition: what Is a Disregarded Entity?
A business with a single owner treated as one entity for federal income tax purposes is disregarded.
This indicates that the owner’s income tax return will include payment of the taxes that comes from his business.
What Kinds of Businesses Fall into Disregarded Entities?
A person or a business can be the only owner of a limited liability corporation. The single-member limited liability corporation (SMLLC) is the most commonly “disregarded entity”.
SMLLCs are automatically disregarded entities according to IRS, but the owner can request a different classification if their business qualifies.
Aside from SMLLCs, two other types of corporations can become disregarded entities. They are qualified REIT subsidiaries and qualified subchapter S subsidiaries.
Taxation of a Single-Owner Business
A single person who owns a business has a few options on how to own and operate the business.
A single person can create a sole proprietorship, a single-member LLC, or a solely-owned company.
Self-employed individuals, on the other hand, are not required to pay state unemployment taxes because they cannot receive unemployment benefits in the event of a job loss.
Because there is no separate company in the case of a sole proprietorship, the business income is the individual owner’s income and is reported on Schedule C.
Limited Liability Company (LLC)
A single-member LLC’s owner has a choice. The IRS will automatically designate the LLC as a disregarded entity. In other words, the IRS regards the LLC similarly as a sole proprietorship for the purposes of federal income tax.
However, if the owner elects to have the LLC taxed as a corporation, the LLC is not a disregarded entity
Consider the following advantages and disadvantages, as well as the laws and requirements if you have an interest in establishing a single-member LLC that will be a disregarded entity for income tax reasons.
We’ll also look at what it takes to set up an SMLLC that will be treated as a disregarded company.
A corporation with a single owner that is taxed as a C-corporation is regarded as a distinct entity.
As a result, the corporation will pay taxes on its income, and the sole owner will record and pay taxes on any compensation they get.
Determining disregarded entity status
The single-member LLC (SMLLC) is the most typical kind of disregarded entity; however, qualified subchapter S subsidiaries (QSub subsidiaries) and real estate investment trusts (REITs) are the other two kinds of businesses that are classified as ignored entities.
Disregarded entities include even single-member LLCs held by S corporations.
By default, all single-member LLCs get treated as disregarded entities. This implies that when it comes to income taxes, the IRS does not view you, the LLC’s owner, as a different legal person from your LLC.
Advantages of a disregarded entity
Being a disregarded entity has a number of benefits, including the following:
Easy tax filing
Pass-through taxation only taxes the business owner, not the company as a whole. As a result, you only need to file one tax return, saving you the time and money of having to file a separate return for your LLC.
The position of disregarded entity applies solely at the federal level, not at the state level, where it remains a separate entity with all of the liability advantages of an LLC.
This implies that the income and costs of your LLC pass from the firm to you as an individual. Then, the law permits you to declare them on your personal tax return.
The income and costs of an SMLLC held by a corporation or partnership are reported on the corporation’s or partnership’s tax return as a division of the corporation.
Disadvantages of Being a Disregarded Entity
Excise and employment taxes
Because the LLC is a disregarded company, it is only recognized for federal tax purposes.
This is to say, it may still be liable to employment and excise taxes.
However, this is only significant if you have employees other than yourself or if your LLC is subject to excise tax.
While you can file your LLC’s federal taxes using either your Social Security number or an employer identification number (EIN), if your LLC is subject to excise or employment taxes, you must use an EIN to report and pay such taxes.
The proprietor of a single-member LLC is nonetheless liable for self-employment taxes, even though the LLC is a disregarded company. These are in addition to your income taxes, although you can deduct the amount you pay up to a certain limit.
When forming your LLC or later, after weighing the pros and cons, you can choose whether you wish to keep your disregarded entity status or want to have it taxed as a corporation.
Is a single-member LLC automatically a disregarded entity?
The IRS automatically classifies a single-member LLC as a disregarded entity.
However, the LLC has the option to request that the IRS treat it as a different company by submitting Form 8832 (company classification election).
Does a disregarded entity need an EIN?
If a single-member LLC has no workers and no excise tax liabilities and is a disregarded entity, it does not require an Employer Identification Number, or EIN.
The member should use their name and tax identification number for federal tax purposes. The company has the option to get an EIN.
Be aware that opening a business bank account can necessitate having an EIN.
Can a multi-member LLC be a disregarded entity?
An LLC with multiple members is not a disregarded entity.
An LLC with at least two members is treated as a partnership for federal income tax purposes unless it files Form 8832 (Entity Classification Election) and elects to be taxed as a corporation.
However, if a married couple co-owns the LLC and lives in a state that recognizes community property, they can treat their jointly-owned company as a disregarded entity for federal tax purposes if they meet the following criteria:
- Each couple owns the LLC entirely as common property under state law.
- On federal tax returns, there is no mention of other owners of the LLC.
- According to federal legislation, the company is not a corporation.
How your single-member LLC can be disregarded
A single-member LLC is immediately considered a disregarded entity by the IRS. As a result, no action is required to have your LLC categorized as a disregarded entity for income tax purposes.
When it comes to other taxes, the IRS will not consider your LLC to be a separate company from you.
What is the difference between a sole proprietor and a disregarded entity?
Although taxes are recorded and paid on an individual basis for both a sole proprietorship and a single-member LLC, a sole proprietorship is not a disregarded business.
A sole proprietorship, unlike an LLC, does not provide liability protection. If this troubles you, you can convert your sole proprietorship to an LLC after it is formed.
How Much Does It Cost To Start An LLC?
A limited liability company (LLC) is one of the most effective instruments for entrepreneurs. It shields them from commercial liabilities, allowing them to avoid personal liability, and it provides tax flexibility.
And, for all of its power, the expenses of forming an LLC are rather low when compared to other investments you’ll make in your business.
LLC costs are classified into two types: LLC startup costs and LLC maintenance expenditures.
There are also continuing charges to keep your LLC running. Here’s what you should know.
Startup Costs for an LLC
There are a number of costs related to the preparation and filing of legal documents to incorporate your LLC.
In addition, there are additional ancillary charges associated with registering your LLC with state and local authorities. For example, you should ensure that you have all of the necessary permits, licenses, and certificates required by the local, state, and federal governments.
Typical fees range from $50 (for lawyer services) to $800 (for filing fees), depending on the state.
The majority of entrepreneurs’ LLC startup expenditures will come from filing fees.
You don’t need a lawyer to file articles of organization to form an LLC, but it doesn’t hurt to employ an LLC filing service, especially given the minimal expenses involved.
Several service providers may register your LLC for less than $50, plus the state fee.
The cost of hiring a legal services provider is well worth it. It can lessen the danger of filing documents incorrectly, which can result in additional fees to revise the application or reapply, not to mention wasted time.
Typical prices range from $0 to $200.
It is an internal contract that describes the management of your LLC, the obligations and contributions of the owners (members), and process for reaching decisions.
Anyone can make their own operating agreement for free.
However, when it comes to splitting earnings and losses among owners, you need to enlist the help of professionals to ensure that everything is done appropriately.
Legal service companies can complete the work for $50 to $200, or you can employ a local lawyer. It’s a small price to pay to ensure that everyone is on the same page and to avoid future disagreements.
Typical costs: vary depending on state and local newspaper rates.
Entrepreneurs in New York, Nebraska, and Arizona must pay additional LLC fees for publication.
A business owned by one person is treated as a single entity for federal income tax purposes and is referred to as a disregarded entity.
Additionally, qualified REIT subsidiaries and qualified subchapter S subsidiaries are corporate entities that are not subject to the same rules.
A sole proprietorship, a single-member LLC, or a solely-owned corporation are all taxation alternatives for a single-owner business.
Payroll taxes, but not state unemployment taxes, are due by self-employed people who run a disregarded organization.