What is a Disregarded Entity? Understanding How They Affect Your Taxes

If you've been researching business structures or preparing your taxes as a single-member LLC owner, you've likely come across the term "disregarded entity", a specific type of business entity. While it might sound complex, this tax classification is actually one of the simpler concepts in business taxation.

In this guide, we'll break down exactly what a disregarded entity is, how it affects your taxes, and whether it's the right choice for your business.

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What is a disregarded entity?

A disregarded entity is a business that the IRS “disregards” or ignores for federal tax purposes. It most commonly applies to single-member LLCs (limited liability companies) and sole proprietorships. 

While these businesses exist as separate legal entities—including having liability protection and other benefits—the IRS treats them as extensions of their owners for tax purposes. For federal income tax purposes, a single-member LLC is not recognized as an entity separate from its owner.

This means all business profits, losses, deductions, and credits flow directly to the owner's personal tax return rather than being reported on a separate business return. For most small business owners, this income is reported on Schedule C of Form 1040, simplifying the tax filing process while getting to keep the legal protection that of an LLC.

Can an LLC be a disregarded entity?

Yes, an LLC can be a disregarded entity. In fact, all single-member LLCs automatically become disregarded entities unless they elect a different tax status with the IRS. But this only applies to LLCs with one owner. Multi-member LLCs cannot be disregarded entities and instead get taxed as partnerships.

Single-member LLC owners can choose to change their tax status if it makes financial sense for their business. This process is known as an entity classification election, which involves filing Form 8832 with the IRS. 

For example, some owners elect to have their LLC taxed as an S corporation to potentially reduce their self-employment tax burden once their business reaches a certain income level. However, business owners should make this decision carefully. An S corporation status comes with additional paperwork and compliance requirements.

How to elect disregarded entity status with the IRS

The good news is that single-member LLCs don’t need to do anything special to become disregarded entities. It happens automatically. 

When you form your single-member LLC, the IRS automatically classifies it as a disregarded entity by default. The Internal Revenue Service (IRS) does this to simplify the tax reporting process for single-member LLCs. There’s no extra paperwork or election process required.

However, if your business is currently taxed as a corporation or partnership and you want to change to disregarded entity status, you’ll need to file IRS Form 8832. This form allows you to change your business’s tax classification. 

Keep in mind that certain restrictions and waiting periods may apply when changing your tax status, so you should check with a tax professional before making this decision.

How does a disregarded entity affect self-employment tax?

When you operate as a disregarded entity, you’re considered self-employed in the eyes of the IRS. For income tax purposes, all your business income and expenses are reported on your personal tax return. This means you’ll need to pay self-employment tax (a combined rate of 15.3% that covers both Social Security and Medicare).

Unlike employees who split this tax with their employers, you’ll be responsible for the full amount since you’re essentially both the employer and employee. Many business owners choose to set aside a portion of their income throughout the year to cover these taxes because they can be a big expense that catches new entrepreneurs off-guard.

What is the difference between a sole proprietorship and a disregarded entity?

While sole proprietorships and disregarded entities are treated the same way for tax purposes—both pay the same self-employment tax and report business income on their personal tax returns—they have key legal differences.

A sole proprietorship offers no legal separation between you and your business, meaning your personal assets could be at risk if your business faces legal issues. 

A disregarded entity that’s structured as a single-member LLC, however, gives you liability protection by legally separating your personal assets from your business. This means the LLC is treated as a separate legal entity, providing a layer of protection for your personal assets.

Another important difference is flexibility. While sole proprietorships are stuck with their tax classification, single-member LLCs can elect to be treated as an S corporation or C corporation for tax purposes if it’s a benefit to the business as it grows. 

Both of these differences make disregarded entity LLCs a popular choice for small business owners who want basic liability protection with simple tax filing.

How does a disregarded entity file taxes?

Filing taxes as a disregarded entity is pretty simple. You don’t need to deal with a separate business tax return. Instead, you’ll report all your business income and expenses right on Schedule C of your personal tax return (Form 1040).

You might be wondering about an Employer Identification Number (EIN). If you’re running your business solo with no employees, you can usually just use your Social Security number. But you’ll need an EIN if you’re hiring employees, forming an LLC, or want to open a business bank account (most banks require one). 

Additionally, an EIN is required if your LLC has an excise tax liability or needs to file excise tax returns. You can get an EIN quickly and free through the IRS website.

Pros and cons of a disregarded entity

Need to know more before you decide if being a disregarded entity is for you? We asked real small business owners about their experience running a disregarded entity. Here's what they had to say about the good and not-so-good parts:

Pros of being a disregarded entity

Starting and running a business comes with enough challenges already. Let's look at what makes this business structure worth considering, according to entrepreneurs who've made it work.

Simple tax reporting

When you run a disregarded entity, you can say goodbye to complex business tax returns. Everything from your business income to expenses flows directly into your personal tax return through Schedule C. 

This gets rid of the need for separate business filings and reduces the time you spend organizing tax documents every year.

Rob Gold, VP of Marketing Communications at Intermedia Cloud Communications, has helped small businesses with their financial operations. 

He's particularly enthusiastic about this aspect of disregarded entities. "I've seen small business owners stress over separate tax returns, drowning in paperwork,” Rob says. “With this setup, all business income just flows through to their personal return, cutting down on extra filings."

Lower administrative burden

Running a disregarded entity means you can focus more on growing your business and less on paperwork. Unlike corporations, you won't need to hold annual meetings, keep extensive meeting notes, or deal with complicated corporate governance requirements. 

This saves you valuable time and energy that's better spent on your actual business operations.

Flexibility

One of the most valuable features of a disregarded entity LLC is that it can grow with your business. If your company becomes more profitable or your tax needs change, you're not locked into your current tax status. 

You can elect to have your LLC taxed as an S corporation or C corporation later on, giving you the freedom to adapt as your business evolves.

Mark Pierce has spent decades helping businesses navigate their legal structures as the founder of Wyoming Trust & LLC Attorney. He sees this flexibility as a crucial advantage. 

"Starting as a disregarded entity gives you room to grow," he notes. "When your business reaches a certain income level, you can switch to S corporation status to potentially save on self-employment taxes, without having to completely restructure your business."

Cons of being a disregarded entity

While the simplicity of a disregarded entity is appealing, it's not all smooth sailing. Here are some challenges you'll want to consider before making your decision.

Higher self-employment taxes

As the owner of a disregarded entity, you'll pay self-employment tax on all your business profits. It’s a hefty 15.3% that covers both the employer and employee portions of Social Security and Medicare taxes. 

Unlike corporation owners who can potentially reduce this tax burden through salary and distribution strategies, disregarded entity owners pay these taxes on their full business income.

Edward White, Head of Growth at beehiiv, often discusses this tax impact with business owners. "The biggest downside? Higher self-employment taxes," he explains. "It's something that catches many new business owners by surprise when they're doing their taxes for the first time."

Maintaining proper financial separation

While the IRS might treat your business and personal finances as one, you absolutely can't. Mixing personal and business funds—like using your business account for personal expenses or vice versa—can result in "piercing the corporate veil." 

This legal term means you could lose your liability protection and put your personal assets at risk if your business faces legal troubles.

Rob has seen this mistake trip up too many business owners. "Just because the IRS ignores the entity for tax purposes doesn't mean legal protections disappear," the VP of Marketing Communications at Intermedia Cloud Communications warns. "If the business is structured properly, liability protection stays intact. If not? That's when personal assets can be at risk."

Some states impose additional LLC fees

Just because the IRS disregards your entity doesn't mean your state will do the same. Some states charge annual franchise fees or impose extra taxes on LLCs, regardless of their federal tax treatment. 

For example, California charges LLCs an annual fee of $800, plus additional fees based on your gross income. These are costs that can significantly impact your bottom line depending on where you operate.

Leon Turkin, a financial expert at Turkin Mortgage who helps businesses navigate these state-specific challenges, emphasizes this point. 

"You need to look beyond federal tax treatment when choosing your business structure," he advises. "Different states have their own rules, and some will impose fees or taxes on LLCs regardless of how the IRS treats them. These costs can really add up, especially in states with higher fee structures."

Is a disregarded entity right for your business?

The answer to this question really depends on your priorities and business goals. If you’re looking for a simple way to run your business with basic liability protection and straightforward tax filing, a disregarded entity could be your best bet. A single member limited liability company (SMLLC) offers these advantages while simplifying the tax process. 

However, if minimizing self-employment taxes is a major concern, or you’re planning to bring on partners soon, you might want to consider other options like an S corporation.

Rob puts it well: “For anyone who values simplicity but still wants some protection, a disregarded entity makes sense. It’s a middle ground that lets business owners keep more control over their finances without getting bogged down in extra tax or legal requirements.” 

Before making your final decision, consider consulting with a tax professional who can look at your specific circumstances.

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