What is a Disregarded Entity: Pros and Cons of being a Disregarded Entity

In cases where an entity is titled as a disregarded entity, the US IRS system will not count it as a tax-paying entity that is separate from a business. Even though not only a separate entity but the IRS recognizes a few other businesses as disregarded entities. One of the most common examples of a disregarded entity is a single-member limited liability company. The article will briefly discuss the benefits of a disregarded entity and how the title would impact its mergers and acquisitions.

What is a disregarded entity?

The term disregarded entity mentions a business entity with a single owner which does not fall under the tax terms set by IRS and is separate from its owner. A disregarded entity, as a result, does not file tax returns separately as it is termed as SMLLC – Single-member limited liability Company.  Rather, the loss and profit it owes are filed in Form 1040.

  • If an individual is a sole owner, the income and loss of an SMLLC will be reported in the Form US 1040 US individual Income Tax Return. It is a much similar method followed by a sole proprietorship.
  • On the other hand, if the owner is a corporation, the loss and profit of an SMLLC will be reported in Form 1120, US. Corporation Income Tax Returns. In the case of S corporation, Form 1120S will be used. The process is similar to the tax filing of a division or a corporate branch.

In simpler words, a single-member LLC is a business entity that is owned by a single member with limited liability.

What is a disregarded entity
source: taxslayerpro.com

Understanding disregarded entity LLCs

LLC is an attractive business structure for many entrepreneurs because, in LLC, there’s much flexibility, risk protection, and less liability.

Less or limited liability means that the owners will have their personal assets protected. This particularly means that in case someone sues an LLC company for any violation, the lawsuit wouldn’t reach the owner’s personal assets like a business account or car.

This is because the LLC is a separate identity unlike a Sole proprietor for instance they do not have such separation. This is because a Sole proprietor would be liable for his business debts and profits.

Single-Member LLC and Taxes

As said, the IRS recognizes the SMLLC as a disregarded entity. A single-member LLC is not regarded as a taxpayer because the LLC is handled by one member and any other tax classification is not determined.

In situations where the owner of the LLC opts for different federal classification and files taxes through form 8832, they would be then taxed as a c corporation or S corporation. If the owner chooses the corporation tax classification, then an SMLLC will not be taken as a disregarded entity.

If corporate taxation is not chosen by the LLC owner, then the LLC will be taxed according to the terms of taxes used for the sole proprietor. This particularly means that any expanse or business income will be reported on the LLC owner’s personal tax returns. The process is called pass-through taxation. When there’s an individual income tax return filing, the owner of the LLC is responsible for paying excise taxes and employment taxes.

An LLC would no longer be a disregarded entity if the LLC owner chose to file income tax returns as a corporation rather than a sole proprietor. This may be the reason because the IRS itself implied taxes on corporations. In addition to that, it is important to understand that a disregarded entity title separates its owner from the liability purpose, not from the federal tax purpose.

Advantages and Disadvantages of a Disregarded Entity?

There are a number of advantages and disadvantages of a disregarded entity. Here are some for your understanding.

advantages and disadvantages of a disregarded entity
source: asenaadvisor.com

Advantages of Disregarded Entity

The commonly obtained advantages include;

Pass-through taxation – In pass-through taxation, the expenses and the income from the company pass directly to you. This means if you are a taxpayer, then you will file your taxes as an individual. On the other hand, income and expenses for SMLLC registered as a corporation would be taxed under corporation tax returns.

Liability – The title of a disregarded entity applies to the federal level rather than the state level. This benefits an LLC in retaining all the liability advantages and the LLC assets are protected from creditors’ claim or any other legal liability.

Simple tax filing – Another benefit that a disregarded entity title will provide is the simple tax filing option. As business owners are taxed by pass-through taxation with this, the owner of the business will be taxed on the income and expense of an individual, not the business. The process ultimately saves time and expense that you may bear in filing separate taxes for LLC.

Disadvantages of a Disregarded Entity

While having an LLC status for your company can be an overwhelming situation. But here are some disadvantages that you should consider.

Excise and employment taxes – As a disregarded entity, an LLC will be recognized for the federal taxes only. This means that you will still be responsible for paying excise and employment taxes. Of course, the employment tax will only be applied if you hire employees. Otherwise, you’ll be liable for the excise taxes only. For this, you have to use either your employer identification number (EIN) or the Social Security Card number (SSN) while filing your excise or employment taxes. You should use your EIN whenever there’s an employment tax involved. 

Self-employment taxes – As a disregarded entity the owner does not get freed from the self-employment taxes. They may become an addition to your income taxes, but the amount you pay up to a maximum cap likely becomes deductible.

Investor hesitancy – Another disadvantage of having a disregarded entity title is that the investors may likely avoid investing in them. Plus, the disregarded entities are assumed to be less credible than a corporation. Many investors wish to work with a c corporation due to the reason that they are able to provide a different classification of stocks.

This could be the main disadvantage for SMLLC that they don’t get big investors like any other business structure due to hesitancy. This is why you should understand your business needs and look for the structure that benefits those needs.

How can a tax classification be changed from a disregarded entity to another entity?

If following a tax classification with an LLC isn’t working for you, then you can easily request a tax classification change with the help of Form 2553 or Form 8832. Both Forms have different tax requirements. This is why you should choose the form according to how you want to be taxed.

To change your LLC taxation process to a corporation or partnership, choose Form 8832 Entity Classification Election. To be taxed as an S corporation, fill out Form 2553, Election By a Small Business Corporation.

Understanding disregarded entity LLCs
source: sftaxcounsel.com

Can you change the classification back to a disregarded entity?

Changing your tax classification from a corporation back to a disregarded entity is possible. But there are some caveats from the IRS that you should consider.

Before you wish to switch your tax classification either from LLC to a corporation or vice versa, keep in mind that you can change your tax classification only once in the period of five years. The exceptions are:

  • You selected the tax election status when you filled the entity form
  • More than fifty percent of business owners have changed.

If you get eligible to switch your classification use Form 8832 to request a change.

Similar rules will be applied if you are switching from an S corporation to a sole proprietor. But for S corporation, you will use Form 2553.

Clear your confusion about Form 2553 and Form 8832

In determining what form to use is a bit tricky for you, then adhering to the following chart will come in handy.

Current Tax Status

Switching to

Form Type

Disregarded Entity

Corporation

8832

Disregarded Entity

S Corporation

2553

Corporation

Disregarded Entity

8832

S Corporation

Disregarded Entity

8832

What should you do if you want to be a Disregarded Entity?

If your business is a single-member LLC, you don’t need to do anything to be a disregarded entity. An LLC already has a disregarded entity status so you can easily file your income tax returns as an individual.

On the other hand, if you are not, you have to switch your tax classification to have a disregarded title. Otherwise, you can’t be a disregarded entity.

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