A disregarded entity is a legal entity that is overlooked for federal and specific state income tax purposes. For a single-member limited liability company (LLCs) that does not elect to be taxed as a corporation, the IRS uses the disregarded entity designation. It also treats S corp subsidiaries (QSubs) as disregarded entities.
Discussing A Disregarded Entity in Detail
A disregarded entity is a corporate structure that is not a corporation and hasn’t elected to be considered as such for federal tax purposes and has only one owner. The IRS considers a disregarded entity to be a part of the owner’s tax return.
For example, even though a sole proprietorship has only one owner, it is not considered a disregarded entity since it is not a legal entity independent of its owner. A sole proprietorship may operate under a trading name, but it is conducted legally and for tax purposes under the same umbrella as its owner.
It is the same case with an S corporation: it can’t be treated as a disregarded entity as it is a type of corporation. S companies assess their profits, deductions, and credits – which they refer to as “tax attributes” – and then assign them to their shareholders or sole owners. Allocations are rendered in proportion to the number of shares owned.
A disregarded entity is not recognized by the Internal Revenue Code (IRC) as a distinct business formation.
How Do You Know If You Have A Disregarded Entity?
The type of corporate structure you use will decide whether or not your company is a disregarded entity or not. Partnerships, Sole proprietorships, companies, and LLCs of more than one owner are not considered disregarded entities, whereas single-member LLCs are considered disregarded entities.
For federal income tax purposes, you and your company are considered one, and you will pay taxes on your business’ income on your tax return. However, unlike an LLC or corporation, your assets are not covered under a sole proprietorship and can be seized if your company is sued or has debts it cannot pay out of its assets.
Similarly, a partnership is considered an extension of its co-owners, and its revenues are passed through to every partner’s individual income tax return.
The business is a different entity from the owners if you act as a corporation or LLC with several owners, but it is not considered a disregarded entity. A company, like an LLC, is an independent body that protects the owner’s assets and properties and covers its liabilities.
The income earned by a company and the income earned by its members are taxable. Like a sole proprietorship or partnership, an LLC’s income is passed on to the owner, though an LLC may be taxed as a partnership or as an S corporation.
In the eyes of IRS, the most common disregarded entity – LLCs with single members does not exist. Instead, the company’s assets and liabilities are treated as those of the owner, who is then taxed accordingly.
A qualified subchapter S subsidiary and a qualified REIT subsidiary are two other disregarded entities, but we won’t go over them here.
Ways A Disregarded Entity Works
Apart from the points discussed above, another significant aspect that comes into play with disregarded entities is company debts and litigation. Liability is usually determined by a business entity’s legal status, which is determined by the given state’s business law.
LLCs are legal organizations that can be established in any jurisdiction. A limited liability company (LLC) is a legal entity that can own property, sue, be sued under its name, and enter into contracts. The LLC’s owner or owners are only responsible for the LLC’s operations up to the sum of their investment.
The Internal Revenue Code (IRC) determines how you are taxed in the United States of America. The IRC ignores a single-member LLC’s legal presence and considers its actions as those of its owner.
Most states that have an income tax obey the IRC and treat single-member LLCs as disregarded entities for state income tax purposes while acknowledging their presence for other non-tax purposes. However, it is essential to note that a single-member LLC is still considered a separate business entity for employment taxes and some other excise taxes.
An otherwise disregarded entity (a single-member LLC) can elect to be taxed as a regular corporation or an S corporation under the federal tax code. Still, the entity will no longer be disregarded if it chooses this way.
A qualified subchapter S subsidiary (QSub) can also be considered a disregarded entity if its parent S corp elects to treat it this way. The QSub must also be owned entirely by the S corporation to be treated as a disregarded entity.
- TAX IDs and Single-Member LLCs
Suppose a single-member LLC wants to be categorized as a disregarded entity for its tax-related purposes. In that case, it must use its employer identification number (EIN) or the owner’s Social Security number on all tax documents. The LLC’s EIN is also required for particular employment and excise tax purposes.
- Process of Paying Income Taxes as a Disregarded Entity
A disregarded entity’s tax liability is reported explicitly on Schedule C of the individual’s income tax return. Each S corporation owner receives a Schedule K-1 from the corporation and records their allocation on Schedule E of their income tax return.
Final Words & FAQ’s
If you operate a single-member LLC, being classified as a disregarded entity will simplify the process of taxation, and it will shield your assets from liability.
If you’ve already completed the paperwork to form an LLC and it is a single-member LLC, there’s nothing else that you need to do. If you’re a sole proprietorship and want to become a disregarded entity, you’ll need to form a single-member LLC. For further guidance on this matter, visit the Secretary of State’s website in your state.
- Is an LLC owned by another LLC a disregarded entity?
Yes, as far as the IRS is concerned, it is a disregarded entity If the ownership is 100%. The owned LLC is part of the LLC that owns it in every legal way – other than a business liability.
- Is a husband and wife LLC a disregarded entity?
The IRS has a special rule applicable to such LLCs that are owned by married couples. Under this rule, the married couple that owns the LLC can treat their jointly owned business entity as a disregarded entity for tax purposes if their jointly-owned business is not otherwise listed as a corporation under federal law.