What is a disregarded entity?
US tax and compliance regulations are notoriously complicated and full of obscure terms. "Disregarded entity" is no different. While you might have heard this phrase before, you may not understand what it meansor why it matters for your business.
In this article, we'll explain what disregarded entities are and which kinds of businesses this classification applies to. We'll also go over other business types to give you a complete picture of your options as a founder.
What is a disregarded entity?
A disregarded entity (DE) is a tax/accounting term used to denote a business that is “disregarded” by the IRS for tax purposes. Rather than being subject to corporate tax, business income will be taxed as the owner’s personal income.
In other words, disregarded entities are taxed as if you hadn’t incorporated a business at all. There are multiple types of disregarded entities to choose from when filing your taxes. Here are some of the most common.
Single member LLC (SMLLC)
The most common disregarded entity is a single-member LLC. This structure is automatically taxed as a disregarded entity by the IRS, without the need to file Form 8832.
Note that even though income tax only applies to the owner, the LLC will still be taxed as a separate entity for employment and certain excise taxes, where applicable.
Jointly owned LLC
While this is less common, an LLC owned by two spouses may be considered a disregarded entity if it exists in a state with community property laws. The IRS notes three conditions that need to be met for an entity to qualify for this tax status:
- The business entity is entirely owned by a husband and wife as community property under state laws.
- No one else other than each spouse would be considered an owner for tax reasons.
- The entity is not treated as a corporation pursuant to IRC §301.7701-2.
Technically not considered disregarded entities by the IRS, business structures that have their revenue directly passed to the owners achieve the same effect. By having the company’s revenue attributed to the owners alone, these entities won’t be taxed themselves — just the owners.
Below is a list of the most well-known structures.
- Sole proprietorship
What are the benefits?
Choosing a business model that can be taxed as a disregarded entity confers many advantages that otherwise might not be available. These are three of the most substantial benefits.
No double taxation
With some corporate structures, the owner and the entity are taxed separately. This leads to double taxation — paying corporate tax on business income plus personal income tax on salaries. In the case of a disregarded entity (or other pass-through entity), only the owner is taxed.
LLCs allow the owner to obtain limited liability protection, unlike sole proprietorships for example. Practically speaking, this limits courts, creditors, and other adverse parties from claiming assets from the owner of the business. This is assuming no personal guarantees have been put in place, which would hold the owner personally liable.
Interested in learning more about LLCs and sole proprietorships? Check out our guide.
Easier tax filing
With income passing through to the owner for tax purposes, only one tax return needs to be filed each year. If you file their own taxes, this means less paperwork and more time making your business profitable. If you outsource their taxes, you will likely pay fewer fees than those with multiple returns.
What about other business structures?
We’ve covered the different disregarded entities and their benefits, but what about other business structures? How are they taxed?
LLCs that contain more than one member cannot be treated as a disregarded entity, but they still have some flexibility during tax season. A multi-member LLC will be taxed as a partnership unless it files Form 8832 and elects to be taxed as a corporation.
C-Corps have to file taxes as corporations, so they don’t have the same flexibility as LLCs. This leads to double taxation since the corporation itself is taxed along with any individual shareholders that received dividends.
Choosing a business structure that is treated as a disregarded entity allows for strategic tax planning and can help you save money as a business owner. With inflation and interest rates continuing to rise, it's beyond prudent to make the most of your dollars.
Incorporating an LLC gives you critical liability protections while allowing you to file taxes as a disregarded entity. If you’re ready to incorporate your business, hit the link below to create your LLC or C-Corp in a matter of minutes.