When you’re rushed off your feet running a small business, navigating tax can feel like yet another drain on your time. But it’s a bit simpler if your business is classified as a disregarded entity.
Disregarded entities are an important aspect of tax law, and luckily they’re pretty straightforward to understand. Knowing how they work could have a big impact on how you report your business income and expenses.
In this article, we’ll drill down into disregarded entities and their tax implications — to see if you can simplify your tax reporting and potentially even save money.
What is a disregarded entity?
A disregarded entity is a business structure that’s effectively ignored by the IRS. That doesn’t mean your business doesn’t pay tax at all, but the IRS treats you and your business as a single entity for the purpose of tax reporting.
When operating a disregarded entity, you’d report your businesses’ income on your personal tax return. This classification simplifies tax filing but also has implications that we’ll discuss later.
Only non-corporation businesses with a single owner can be disregarded entities. There’s no registration process to be classified as one (it happens automatically), but it’s wise to make sure your business is formed and registered according to state laws.
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Types of disregarded entities
Unless you elect to be treated as a corporation, your limited liability company (LLC) will automatically be considered a disregarded entity for federal tax purposes.
Here are a few types of businesses that are classified as disregarded entities:
- Single-member LLCs: In this case, the company is legally distinct from the owner, which offers liability protection. But, for tax purposes, it’s treated as an extension of the owner. This is the most common type of disregarded entity.
- Qualified Subchapter S Subsidiaries (QSubs): QSubs are S corporations that are owned by other S corporations. While an S corporation itself cannot be a disregarded entity, as soon as it makes the QSub election, it stops being treated as a separate corporation.
- Other Entities with a Single Owner: Certain trusts, sole proprietorships, and partnerships with a single member can be considered disregarded entities — even though they all have different characteristics.
Perks of classifying as a disregarded entity
If your business fits the criteria for classification, there are a few benefits you might experience:
- Simplified tax reporting: Reporting everything under your personal taxes will save you loads of time when it comes to preparing and filing your tax return. If you outsource your reporting to an accountant, your accounting costs will be lower since they’ll only be filing one return on your behalf.
- No need for double taxation: Most corporations get taxed at both the corporate level and on dividends to shareholders. This is called double taxation. With a disregarded entity, you’re only taxed once at the individual level, which could reduce your tax burden.
- More flexible reporting: With a disregarded entity, you have more flexibility in the way you manage your income and deductions. You can directly offset personal income with business expenses, allowing for more strategic management of your finances. This could lower your tax liability.
As you can see, it’s possible that you could get a better tax rate overall as a disregarded entity. The rate for sole proprietors tends to fall around 13%, while small partnerships and S-corporations pay nearly 24% and 27%. However, it all depends on factors such as the income level of your business and the nature of its expenses.
What are the tax implications of disregarded entities?
In this section, we’ll discuss some of the tax implications of operating a disregarded entity.
When your business is classified as a disregarded entity, you can report all income and expenses on your personal tax return. For example, if you run a single member LLC, you’d typically use a Schedule C to report your business’s financial activities.
Classifying as a disregarded entity is simpler if you don’t have employees, as it only applies to federal taxes. You’ll still have to file payroll taxes under a separate Employer Identification Number (EIN).
Employer identification number (EIN)
For the reasons above, obtaining an EIN is a good idea. It’s useful for banking and administrative purposes, as well as tax compliance, and helps maintain the necessary separation between your personal and business finances.
Assets and liabilities
For tax purposes, the assets and liabilities of your business are considered yours. You’d report these on your personal tax return. That said, should your business incur debts or face lawsuits, your personal assets will be protected because, in the eyes of the law, your business maintains its status as a separate entity.
Each state requires different sales tax obligations, so it’s important to understand these in order to remain compliant. Sales tax is considered at state rather than federal level, which means your business may be required to operate with its own sales tax ID, even as a disregarded entity.
How Homebase helps small businesses
Filing taxes doesn’t have to be complicated. Homebase makes it simple by calculating wages and taxes and sending correct payments to employees, the state, and the IRS.
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Before we sign off
The main benefit of operating a disregarded entity is how much it simplifies your tax reporting. But it’s important to understand the tax implications it could have for you and your business. When dealing with tax, it’s always a good idea to consult with a tax professional. This will help keep you compliant while making the best decisions for your business.
Frequently asked questions about disregarded entities
How do I know if I am a disregarded entity?
It’s easy to know if your business is a disregarded entity because classification happens automatically if your business meets any of the following criteria:
- Your business is a single-member LLC (or similar structure)
- Your business income and expenses are reported on your personal tax return
- You haven’t elected to be treated as a corporation by filing the IRS form 8832
However, if you need advice, it’s worth consulting a tax professional or the IRS directly.
Is a disregarded entity the same as a DBA?
No, a disregarded entity isn’t the same as a Doing Business As (DBA). When a business registers a DBA, it means that it’s operating under a different name to its legal, registered one. Meanwhile, a disregarded entity is a classification that applies when a business owner reports their business taxes on their personal tax return.
Do disregarded entities need an EIN?
Yes, in many cases it’s still important to have an Employer Identification Number (EIN), even if your business is a disregarded entity. An EIN is required for opening business bank accounts, filing payroll tax, and managing other financial activities for your business.