There are plenty of things to do before you open your new business. One of the most important tasks is choosing a small business structure. If your business is a single-member limited liability company (LLC), you may have heard the term disregarded entity. If you haven’t, don’t worry! A disregarded entity isn’t bad news. So, what is a disregarded entity?
Read on to learn the meaning of disregarded entity, what disregarded entity means for tax purposes, and more.
What is a disregarded entity?
To put it simply: A disregarded entity is a tax term that describes how the IRS treats a single-member LLC. Generally, an LLC is a separate entity from the owners where business and personal taxes are kept separate. But if an LLC has only one member, the IRS no longer treats it as separate from its owner and combines business and personal taxes.
What does this look like in action? Let’s look at an example. Imagine that you are the sole owner of an LLC. The IRS automatically treats your LLC as a disregarded entity and combines your personal and business taxes for income tax purposes. This means you don’t have to file a separate income tax return. All you have to do is file business taxes on Schedule C (Form 1040), Profit or Loss from Business (Sole Proprietorship).
An LLC is a disregarded entity for tax purposes only. So, disregarded entities still enjoy the limited liability an LLC offers.
Disregarded entity for tax purposes
Again, a single-member LLC is a disregarded entity only for income tax purposes. When it comes to other taxes, a single-member LLC operates as usual (e.g., separate from the business owner).
Disregarded entities remain separate from the owner when paying:
- Employment taxes
- Excise taxes
A little confused? Let’s break this down into an easy-to-understand chart:
| Separate Entities | Disregarded Entities |
|---|---|
| What taxes should I worry about? Employment taxes Excise taxes | What taxes should I worry about? Business tax Income tax |
| What IRS forms should I know about? Forms 720, 730, 2290, 11-C and 8849 | What IRS forms should I know about? Schedule C to report business income, expenses, and profits Form 1040 to report your individual taxes |
Community property states and disregarded entities
There’s one exception to the rule that only single-member LLCs can be disregarded entities: community property states.
Spouses share all assets and debts acquired during a marriage in states that allow for community property between spouses. When it comes to an LLC in a community property state, a married couple can own the LLC together and still treat it as a disregarded entity for federal tax purposes.
The spouses must file a joint tax return and include Schedule C (Form 1040) and any other schedules relevant to their business.
There are nine community property states:
- Arizona
- California
- Idaho
- Louisiana
- Nevada
- New Mexico
- Texas
- Washington
- Wisconsin
If an LLC owned by spouses is in a state that isn’t a community property state, the general rule still applies (e.g., the LLC is multi-member and is not a disregarded entity).
Businesses that can’t be disregarded entities
Not all businesses can be disregarded entities. Generally, only single-member LLCs qualify. For example, if you have a multi-member LLC, your business can’t be a disregarded entity.
Business structures that cannot be disregarded entities include:
- Sole proprietors
- Partnerships
- Corporations
- Multi-member LLCs
But, what happens if a multi-member LLC loses members until there’s just one owner left? In that case, the business is a single-member LLC, and the IRS would automatically consider it a disregarded entity. Likewise, if a business is single-member and adds new members, it is no longer a disregarded entity.
How to become a disregarded entity
You don’t have to do anything special to become a disregarded entity. If you own a single-member LLC, the IRS automatically considers your business a disregarded entity. But if you want the IRS to tax your LLC as a corporation, you can file Form 8832, Entity Classification Election.
Key takeaway: Your single-member LLC is automatically a disregarded entity for tax purposes unless you file a Form 8832. Once you file Form 8832, the IRS taxes your business as a corporation.
Advantages to being a disregarded entity
You may be wondering, Are there any advantages to being a disregarded entity? Luckily, there are. So, what are the benefits?
One of the main benefits of a disregarded entity is that taxes are easier. Instead of handling multiple tax returns, the owner of a disregarded entity only has to worry about one. If you are the owner of a single-member LLC, claim all business income and expenses on Schedule C.
Along with tax time being easier, you also still get to keep the perks of an LLC, like limited liability protection.
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This article is updated from its original publication date of December 21, 2015.
This is not intended as legal advice; for more information, please click here.