Disregarded Entity - Clearing up the Confusion
What is a Disregarded Entity?
A disregarded entity is a business entity that is separate from its owner but which elects to be disregarded as separate from the business owner for federal tax purposes. That is, it's an entity that doesn't want to be a separate entity from the business owner. If this sounds like a double negative, it is.
To explain it simply (as much as possible:
A business is typically a separate entity from the business owner.
That separation is good for the owner, because it also separates the liability of the owner and the liability of the business for things like debts and lawsuits. Corporations, partnerships, and limited liability companies are separate entities from their owners. These entities are also taxed separately from the owner, on different tax forms.
So, the disregarded entity question is all about taxes - how a business files its business tax return.
Which Business Type is a Disregarded Entity?
The only type of business that is a disregarded entity is a single-member (owner) LLC. LLC's are typically taxed as partnerships, which is a separate tax return from your personal tax return. But if you have a one-member LLC, you report your business taxes with your personal tax return, using Schedule C.
You don't have to do anything to become a disregarded entity. There is no form to file to elect disregarded entity status. You just file your single-member LLC income tax return using Schedule C.
Of course, it's much more complicated than that. Here's more detail:
Disregarded Entity on Business Tax Forms
You may have seen the term "disregarded entity" on a tax form.
For example, it might be included in a discussion of the single-member LLC business entity.
You may also have seen this term when you are applying for a tax ID number (an Employer ID Number) for your business.
The IRS says,
"If a “disregarded entity” is owned by an individual, it is treated as a sole proprietor. If the “disregarded entity” is owned any any other entity, it is treated as a branch or division of its owner."
Some background on the Disregarded Entity
The Internal Revenue Code (the regulations governing federal taxes) states that a business entity is a corporation by default. If the entity is not a corporation it is an "eligible entity" and it can elect its classification for federal tax purposes.
The Code says, "an eligible entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner." The only business type that fits all the qualifications to be a disregarded entity is a single-member LLC. (SMLLC).
Read more about business types and the disregarded entity, to understand why the single-member LLC is the only disregarded entity.
A sole proprietorship is not a disregarded entity because the business is not separate from the owner in any case.
LLC Not Electing to be a Corporation
The IRS says, "An SMLLC that does not elect to be a corporation will be classified by the existing federal guidance as a "disregarded entity" which is taxed as a sole proprietor for income tax purposes." An LLC can file an election to be taxed as a corporation.
So, basically, any SMLLC that is not taxed as a corporation is a disregarded entity for tax purposes. That is, the SMLLC is taxed as a sole proprietor. But here's where the confusion comes in: A sole proprietor is NOT a disregarded entity because the company is not separate from the owner.
The relevant term in the previous paragraph is "taxed as." A sole proprietor files business taxes using Schedule C, and the profit/loss from the Schedule C is included with the individual income tax return. So a Single-Member LLC "taxed as" a sole proprietorship files a Schedule C.
A Single-Member LLC doesn't need to do anything to "elect" to be a disregarded entity, even though it does sound like that. The SMLLC just needs to file its business taxes on Schedule C. The alternative, which is for the SMLLC to be considered an association and taxed as a corporation, is that the SMLLC must file Form 8832 - Entity Classification Election (PDF). Read more about filing an entity election for an LLC.
Liability Issues for a Disregarded Entity
A disregarded entity is considered the same entity as the owner for tax purposes, but not for liability purposes. For more information on this subject, read this article in which attorney Robert Warwick discusses disregarded entity tax and liability issues.
Examples: A single-member LLC may decide to use the "disregarded entity" designation when the LLC files its Application for Employer Identification Number (EIN) on Form SS-4.
Disregarded Entity and Employment Tax
The disregarded entity status of a single-member LLC does not apply to employment taxes. The business has several options for which employer ID number to use when filing unemployment taxes. Read more about these options for filing employment taxes.
For more information
If you would like more information on how and why the disregarded entity was created, this article from the American Bar Association might be helpful.
Disclaimer: The author is not a CPA or tax attorney and does not intend to give tax or legal advice. If you are wondering if you qualify as a disregarded entity or how that designation might affect your business taxes, check with with your attorney and tax professional.