What Is a Disregarded Entity?

A disregarded entity is a business structure separate from its owner for legal purposes but not recognized as distinct for tax purposes. 

This classification is commonly used in the U.S. for single-member Limited Liability Companies (LLCs). Per the Internal Revenue Service (IRS), this type of LLC is not treated as a separate entity for federal income tax purposes—the income, deductions, credits, and liabilities associated with the business are treated as those of the owner.

For this reason, the owner reports the LLC's income and expenses on their personal tax return using Schedule C (for sole proprietorships) or Schedule E (for rental real estate activities).

Other examples of disregarded entities include certain qualified subchapter S subsidiaries (QSubs) and certain grantor trusts.

While the entity is disregarded for federal income tax purposes, it may still be recognized as separate from other tax obligations, such as excise or payroll taxes. Disregarded entities are considered legally separate from the owner for liability protection and contractual obligations.

For international businesses, disregarded entities can apply to foreign-owned, single-member LLCs operating in the U.S. or U.S.-owned entities operating abroad.

What is the purpose of a disregarded entity?

The primary purpose of a disregarded entity is to simplify tax reporting while maintaining legal protection for business owners. This structure offers several key advantages, including simplified tax filing, pass-through taxation, liability protection, and flexibility in ownership and management compared to other business structures. 

What are the pros and cons of a disregarded entity?

Business owners must weigh advantages against drawbacks when deciding whether to become a disregarded entity.

Pros of a disregarded entity

Disregarded entity status affords several business benefits:

• Tax simplification: Disregarded entities allow business owners to report their income and expenses on their personal tax returns, eliminating the need for separate business tax filings. One-time filing streamlines the tax process, simplifies compliance, and can potentially reduce accounting costs.
• Liability protection: Despite being "disregarded" for tax purposes, these entities (particularly single-member LLCs) still provide legal separation between personal and business assets, similar to corporations. This crucial feature protects the owner's personal assets from business liabilities and debts, limiting the owner's liability exposure to the LLC’s assets.
• Flexibility: Disregarded entities offer flexibility regarding management structure and profit distribution. This can be particularly advantageous for small businesses, entrepreneurs, and startups that need adaptability during the early stages.
• Pass-through taxation: As a disregarded entity, the business's income "passes through" to the owner's tax return, similar to partnerships and S corporations. This means the company is taxed at the owner's individual tax rate. Thus, the business avoids double taxation that can occur with traditional C corporations.
• Ease of formation and maintenance: Single-member LLCs, the most common type of disregarded entity, are generally easy to form and maintain, with fewer formal and administrative requirements than corporations.

Cons of a disregarded entity

While becoming a disregarded entity can offer certain benefits, downsides may keep a business from scaling and require extra resources—these include:

• Investor hesitancy: Disregarded entities are often viewed as less credible than corporations. Many investors prefer to invest in C-corporations for the clear ownership and management frameworks, as well as the ability to issue different classes of stock.
• Self-employment taxes: Being a disregarded entity does not exempt business owners from self-employment taxes. These are additional taxes paid on top of income taxes.
• Restricted growth potential: The disregarded entity structure may not be suitable for businesses desiring significant growth or seeking outside investment.
• Credibility issues: Some clients or partners may perceive disregarded entities, especially single-member LLCs, as less established or professional compared to corporations—a belief that can negatively impact business relationships and opportunities for growth.
• State-level variations: While disregarded for federal income tax purposes, these entities may still owe other taxes, depending on the state, such as employment tax, franchise tax, sales tax, or excise tax. 
• Limitations on liability: Liability protection for single-member LLCs isn’t always absolute. Courts may hold an owner personally liable for an LLC's debts and obligations, provided evidence confirms an owner's wrongdoings.
• Potential complexities: Disregarded entities can become complex in cases of multiple owners or owners who pursue specific investment types or international opportunities. Further, an LLC is not entirely disregarded for tax purposes if the owner isn’t a U.S. citizen.

What qualifies as a disregarded entity?

A disregarded entity is a business entity not recognized as separate from its owner for federal income tax purposes. To qualify as a disregarded entity, a business must meet the following criteria:

• Single owner: The entity must have only one owner. This can be an individual, corporation, or another business entity. 
• Not organized as a corporation: The entity cannot be structured as a corporation under state law. 
• No election for separate entity treatment: The entity must not have elected to be treated as a separate entity for federal tax purposes.

The most common types of disregarded entities are single-member LLCs, Qualified Subchapter S Subsidiaries, and Qualified Real Estate Investment Trust (REIT) Subsidiaries.

While sole proprietorships and S corporations share some similarities with disregarded entities regarding tax treatment, they are not technically considered disregarded entities.

Is an LLC owned by another LLC a disregarded entity?

An LLC owned by another LLC is not automatically a disregarded entity. The classification

depends on several factors:

1. Single-member LLC: If another single LLC wholly owns the LLC, it can be treated as a disregarded entity for federal income tax purposes.
2. Multi-member LLC: If the LLC has more than one member (owner), it is not considered a disregarded entity. Instead, it is typically classified as a partnership for federal income tax purposes unless it elects to be taxed as a corporation.
3. Election for separate entity treatment: Even if another LLC wholly owns an LLC, it can elect to be treated as a separate entity by filing Form 8832 (Entity Classification Election) with the IRS.
4. State-level considerations: While an entity may be disregarded for federal income tax purposes, it's important to note that state-level tax treatment may differ—Wisconsin’s provisions are a good example. 
5. Foreign disregarded entities: In cases where a U.S. LLC owns a foreign LLC, the foreign LLC may be treated as a foreign disregarded entity, depending on the specific circumstances and elections made.

How do I know if my entity is disregarded?

To determine if an entity is disregarded, consider the following criteria:

1. Single owner: If an LLC has only one owner, it's likely a disregarded entity.
2. Default classification: The IRS automatically considers a single-member LLC a disregarded entity for federal income tax purposes. 
3. No corporate status: Under state law, the entity must not be organized as a corporation.
4. No separate entity election: The entity must not have elected to be treated as a separate entity for federal tax purposes. If a business filed Form 8832 to be taxed as a corporation, that entity is not disregarded.
5. Tax filing method: The entity is likely disregarded if an owner reports business income and expenses on a personal tax return.
6. State recognition: While an entity may be disregarded for federal income tax purposes, some states may treat the entity differently for state tax purposes.
7. Exceptional cases: In community property states, an LLC owned by a married couple can sometimes qualify as a disregarded entity.

When should I consider setting up a disregarded entity?

Setting up a disregarded entity, typically a single-member LLC, could be advantageous if a business is seeking liability protection or wants to simplify tax reporting. Those looking to avoid double taxation or leverage state-specific benefits may also consider forming a disregarded entity. 

Independent consultants, freelancers, and solo business owners who want liability protection without tax complications might choose to set up a disregarded entity. The same goes for those managing real estate investments or exploring global business expansion—specifically companies setting up a foreign U.S. corporation branch that wants simplified tax treatment.

While disregarded entities can be a suitable choice for many small businesses due to their simplicity and flexibility, owners must weigh the pros and cons, as well as consider their specific needs and circumstances. Consulting with a qualified legal or tax professional can help business owners considering this option to make an informed decision.

Disclaimer: The intent of this document is solely to provide general and preliminary information for private use. Do not rely on it as an alternative to legal, financial, taxation, or accountancy advice from an appropriately qualified professional. © 2024 Velocity Global, LLC. All rights reserved.