A disregarded entity is a one-person business structure that’s taxed separately from its owner.
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That means the business is not required to file its own tax return, and instead, the owner reports their business profits on their personal return. This is because the IRS “disregards” that the owner and business are separate from each other.
While legally the business entity and owner are separate (and the owner has some liability protection), the business’s profits pass through to the owner’s tax return. So if your profits are $50,000, you, the owner, are taxed on $50,000 through your personal tax return.
Which business entities are considered disregarded entities?
Only one type of business. When you form a single-member LLC, you default to being a disregarded entity.
Don’t let the word “default” scare you. A disregarded entity is simply a tax classification, not an official business entity structure, and you can request to change your classification without changing your legal structure. (More on that later.)
You may see this term appear when you’re completing documentation for the IRS, like when you fill out an application for an Employer Identification Number (EIN).
You’ve probably noticed that we’ve been using fancy language to talk about a pretty simple concept:
Single-member LLCs are considered disregarded entities unless they request to be taxed differently.
But, what about sole proprietors?
Even though sole proprietors also have their business profits passed through to their personal tax return, they aren’t classified as disregarded entities because they don’t register as a separate entity with their state.
And multiple-member LLCs?
Multi-member LLCs are also not recognized as taxable entities by the IRS, but their default tax classification is a partnership, not a disregarded entity.
So, while the IRS doesn’t accept any form of LLC as a taxable entity, it treats single-member and multi-member tax classifications differently.
Why is the IRS biased when it comes to LLCs? Because an LLC is not a tax structure, it’s a legal structure. While taxes and legal protection seem like they go hand in hand, they are actually two separate things. The legal protection you receive from an LLC is based on your state’s rules about LLCs, while your tax treatment is based on the IRS’s tax classifications.
Since an LLC is not a tax classification, the IRS has to give you a default tax classification.
How are disregarded entities taxed?
Disregarded entities are taxed the same way as sole proprietors.
If you’re a single-member LLC who hasn’t changed your tax classification since forming your company, you’re paying taxes the same way as a sole proprietor.
Sole proprietors are pass-through entities and taxed on their taxable business profits. Taxable profits are what’s left after you subtract your tax deductions from your total income.
There are two taxes disregarded entities (and sole proprietors) pay:
- Self-employment tax, which is 15.3 percent
- Income tax, which varies based on your tax bracket
As a disregarded entity, you report your total business income, expenses, and profits on the Schedule C, which you file with your Form 1040: U.S. Individual Income Tax Return. The information from the Schedule C is added to line 12 of Schedule 1: Additional Income and Adjustments to Income. This information is then reported on your 1040 tax return.
Even if you don’t use the business profits personally, you’re still taxed on the total profits because they are automatically “passed through” to you, the owner.
Learn more about the ins and outs of small business taxes here.
What are the pros of being a disregarded entity?
1. Filing taxes is easier
Since you and your business are taxed together, you only file one tax return, saving you time and money.
2. You have legal protection
Another benefit is that you have some legal protection between your personal assets and your business assets. If someone sues your business or you have unpaid debts, in many cases, creditors and claimants can only go after your business assets.
3. You’re not subject to double taxation
Finally, unlike a corporation, disregarded entities aren’t subject to double taxation.
When you’re a corporation, you pay taxes twice. First, the business pays taxes on its profits at the corporate tax rate of 21 percent. Then, the owners pay taxes on the dividends they receive.
What are the cons of being a disregarded entity?
1. The self-employment tax
Many consider the self-employment tax to be the biggest con of being a disregarded entity. Since you pay self-employment tax on top of income tax, it can seriously increase your overall tax liability.
2. It can be harder to raise money
Another con is that it can be more challenging to raise money from investors as a disregarded entity. Some investors prefer C corporations because they can issue different types of stocks. It’s also easier for them to receive dividend payouts.
How do I become a disregarded entity?
If you’re a single-member LLC, you’re automatically a disregarded entity and you can just file your taxes as usual.
If you’re not a single-member LLC, then you can’t become a disregarded entity. It’s as simple as that.
How do I change my tax classification from a disregarded entity to another entity?
If you want your LLC to be taxed as a corporation or partnership, you’ll use Form 8832: Entity Classification Election. If you want to be taxed as an S corp, you’ll use Form 2553: Election by a Small Business Corporation.
Keep in mind that you’ll only complete one of these forms to change your tax classification, not both. Both forms are pretty painless to fill out. You can even get a line-by-line walkthrough of Form 8832 right here.
Can I change my tax classification back to a disregarded entity?
Yes! But, the IRS doesn’t want you changing your tax classification all willy nilly, so there are a few caveats.
If you’re switching your tax classification from a corporation back to being taxed as a sole proprietor, in most cases, you can only change your tax classification once every five years.
The exceptions are:
- You selected your tax election status when you formed your entity
- Fifty percent or more of your business’s owners have changed
If you’re eligible to change your status, then you’ll use Form 8832.
If you’re switching from an S corp back to being taxed as a sole proprietor, the same rules apply. You can only change your classification once every five years, unless you made your tax election when you formed your entity. If you qualify to change, you’ll use Form 2553.
I’m still confused about the difference between Form 8832 and Form 2553
It is confusing. So we made this handy chart for you.
|Current Tax Status||Switching To||Form|
|Disregarded entity (taxed as a sole proprietor)||Corporation||Form 8832|
|Disregarded entity (taxed as a sole proprietor)||S Corp||Form 2553|
|Corporation||Disregarded entity (taxed as a sole proprietor)||Form 8832|
|S Corp||Disregarded entity (taxed as a sole proprietor)||Form 8832|
Now you know a good amount about this complex (but crucial) IRS term. And you can finally decide if being a disregarded entity is right for your business—or if it’s time to make a change.