A disregarded entity is used by the Internal Revenue Service (IRS) for a specific set of single-member limited liability companies (LLCs) that don’t enjoy the benefits of being taxed as an entity separate from the owner. This taxation term is usually applied to an LLC with only one owner. The IRS essentially ignores or “disregards” the entity for income tax purposes.
If you are a new business owner, you should consult with an experienced business law attorney to understand the various ways in which a disregarded entity can impact your taxes.
How Does the IRS Determine Disregarded Entity Status?
A disregarded entity LLC is basically a separate entity whose status is ignored by the IRS for taxation purposes during a given tax year. LLCs in Alabama are usually created as separate entities at the state level. Based on this, the business is disregarded as being separate at both state and federal levels for the purpose of taxation. This makes the owner solely responsible for the taxes.
Single-member LLC (SMLLC) taxes are usually the same as what the sole proprietor would report on their personal income return. Real estate investment trusts (REIT) and qualified subchapter S subsidiaries (QSub subsidiary) are usually considered disregarded entities. S-corporation-owned single-member LLCs may also be qualified as disregarded entities.
You can make an exception by filing Entity Classification Election (Form 8832) to elect your LLC to be treated as a corporation. In relation to this, it’s in your best interests that you don’t lose your SMLCC status. This can happen if you don’t meet Alabama’s LLC requirements or include additional members to the LLC.
Pros of a Disregarded Entity
There are several benefits to getting classified as a disregarded entity by the IRS. These include:
In pass-through taxation, the income and expenses of your LLC will pass through the company and to you as the sole proprietor. You will be required to report on your individual tax return. Income and expenses of an SMLLC when owned by a partnership or a corporation will be reflected as a division of the partnership or corporation’s tax return.
LLC members are not considered employees. They don’t need to pay employment taxes on their paycheck. Instead, you will need to pay employment taxes on your business income. You should get disregarded entity 1099 (1099-NEC) when you provide a W-9 to any of your clients.
LLCs considered disregarded entities don’t need to file a separate tax return for the entity. Instead, owners file Schedule C with Form 1040 to report taxable income on their individual tax returns. You will need to pay self-employment tax on all your business earnings for the year. Pertaining to this, you won’t need to file a corporate income tax return. This will allow you to save on the time and expense of filing a separate return for your LLC.
LLC is considered one of the better options for small businesses since it allows liability protection to the owners. An LLC is a legal entity. Owners are shielded from personal liability for any business obligations and debts. Personal liability protects your personal assets by keeping them separate from the business.
When you are the sole member of your LLC, it gets treated as a disregarded entity for taxation purposes. This means that you get to enjoy personal liability protection while benefiting from tax advantages. You can maintain an unincorporated business as a single owner. With a disregarded entity, you also get to enjoy liability protection.
Cons of a Disregarded Entity
While a disregarded entity has its advantages, there are a few reasons why owners don’t generally prefer this classification:
Excise and employment taxes
Disregarded entities are only recognized for the purpose of federal taxes. This means you will still be responsible for excise and employment taxes. This becomes relevant if your LLC has excise tax liability or you have other employees. You can file your LLC’s federal taxes by using the employer identification number (EIN) or the Social Security number. However, when you need to file the excise or employment tax, you can only use the EIN.
Single-member owners of a disregarded entity are not released from the burden of paying their self-employment taxes. These taxes are in addition to income taxes. The amount paid is deductible up to the maximum cap. You will be considered self-employed since your compensation is through a share of profits from the LLC.
Self-employment taxes can be as high as 15.3%. This is more than you would have paid if you were working for someone else since your employer will pay a part of them. You can decide whether to maintain your disregarded status or have it taxed as a corporation at the time of forming the LLC or later down the road.
Choose a Dedicated Business Formation Attorney to Maximize Your Competitive Advantage
The seasoned business formation attorneys at the BHM Law Group can help you navigate the numerous complications and challenges of starting a business. Our attorneys will explain the comprehensive impact of a disregarded entity on your business and advise you on whether it is the right choice for you or not.
To schedule your free consultation, call us at (205) 964-9764 or fill out thi