Understanding Disregarded Entities
A disregarded entity is a business that’s treated as a separate entity for tax purposes but isn’t an independent taxpayer. It’s a single-owner business entity that the Internal Revenue Service (IRS) “disregards” for tax purposes, having that business owner file their taxes on their personal returns instead of a separate business return.
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.
Single-Member LLCs as Disregarded Entities
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.
Tax Implications for Disregarded Entities
The term disregarded entity refers to a business entity that’s a separate entity from its owner, but that is considered to be one in the same as the owner for federal tax purposes.
What does it mean to be a Disregarded Entity? A disregarded entity for federal income tax purposes, is a business with a single owner that is not separate from the owner. This means that the owner’s income tax return includes the payment of the business’s taxes.
Eligibility and Characteristics
A Disregarded Entity refers to a business entity owned by one person but is separate from its owner for liability purposes. Sole proprietorships and partnerships are not disregarded entities because the business does not exist as a separate entity from the owner.
What is a Disregarded Entity for Tax Purposes? A disregarded entity (DRE) is characterized by three main elements:
- It has a single owner.
- It is not constructed as a corporation.
- The owner hasn’t chosen to be taxed separately.
As the central aspect of a DRE, the IRS ignores the legal separation for federal tax reasons. This may seem like a “best of both worlds” scenario for owners of disregarded entities as they enjoy the liability protections associated with incorporation, while avoiding double-taxation.
Common Types and Comparisons
The most common disregarded entity is a single member LLC. An LLC provides liability protection and flexibility, but with one owner the IRS does not see it as a separate business for taxes.
A sole proprietorship is similar as there is no legal separation between business and owner. The owner reports business income on their personal return and is personally liable for debts.
An S corporation and sole proprietorship "pass through" income to owners who pay taxes on their shares of earnings. But an LLC taxed as a corporation must file a separate return and pay applicable corporate taxes before profits reach owners.
The default tax status for single-member LLCs is as disregarded entities. The IRS treats the LLC and owner as one for income taxes, but legally the LLC still provides owner liability protection.