Which Business Legal Type is a Disregarded Entity?
Defining "Disregarded Entity"
A disregarded entity is a business type that is separate from the owner for liability purposes, but it is the same as the owner for tax purposes. Actually, the way the IRS describes this entity is that the business is separate from its owner but it 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.
There are two pieces to the disregarded entity puzzle, both of which must be present for the business to be a disregarded entity:
- The business type is separate from the individual for liability purposes, and
- The business is taxed through the individual's personal tax return, based on its net income on Schedule C.
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.
The one business entity that is not separate from the business owner is a sole proprietorship.
The sole proprietorship tax form (Schedule C) is part of the owner's personal tax form.
So, the disregarded entity question is all about taxes - how a business files its business tax return.
So a Single-Member LLC "taxed as" a sole proprietorship files a Schedule C. 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 Only Disregarded Entity: A Single-Member LLC
The IRS says that "an LLC with only one member is treated as an entity disregarded as separate from its owner for income tax purposes,...unless it...affirmatively elects to be treated as a corporation.."
An LLC can elect to be treated as a corporation for income tax purposes. If your SMLLC has elected to be taxed as a corporation or S corporation, it is not considered a disregarded entity for income tax purposes. To make this election, the SMLLC must file Form 8832 - Entity Classification Election (PDF). Read more about filing an entity election for an LLC.
Are These Other Business Types Disregarded Entities?
Businesses are set up under state regulations, through the secretary of state for each state, and no state recognizes a "disregarded entity" as a business type. Look at each of the legal types of business to see how it compares to the requirements for a disregarded entity:
- Sole proprietorship, in which you and the business are the same entity. The sole prop is taxed on Schedule C, but there is no separate business entity to provide liability protection for you if the business can't pay its bills or gets sued.
- A multiple-member LLC is registered with the state and this business type provides liability protection, but this entity pays income taxes as a partnership.
- A partnership, as noted above, is not a disregarded entity (including a limited partnership or limited liability partnership) because partnership taxes are not figured on Schedule C. (Read more about partnership taxes on How a Partnership Pays Income Tax.)
- A corporation is a separate business entity from the owners, providing liability protection, and it pays taxes on Form 1120.
- A subchapter s corporation (s corporation), on the other hand, provides liability protection and it files an information return on Form 1120-S. The owners are taxed on their personal income tax return, but not on Schedule C.
How Does My Business Become a Disregarded Entity?
If you own a single-member LLC, you don'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.
How Does a Disregarded Entity File a Tax Return?
To pay its business income tax, a single-member LLC completes a Schedule C to report the profit or loss from the business, and this report is included in the owner's personal tax return.
What's the EIN for a Disregarded Entity?
You may be asked to report a taxpayer ID number for your single-member LLC on a W-9 form or other form that relates to federal income taxes. Just to confuse the issue, if you own a single-member LLC, the IRS says,
For federal income tax purposes, a single-member LLC classified as a disregarded entity generally must use the owner's social security number (SSN) or EIN for all information returns and reporting related to income tax.
What about Employment Taxes for a Disregarded Entity?
The disregarded entity status of a single-member LLC does not apply to employment taxes (federal income tax, FICA taxes, and unemployment 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.