What is a Disregarded Entity? What You Need to Know
If you’re a busy solopreneur, you may have defaulted to a sole proprietor for your business structure. Operating as a sole proprietor is not ideal, however, because your personal assets could be lost if anything goes wrong with the company. Incorporating your company brings liability protection, but also complications like corporate formalities (board members, annual board meetings, etc).
You can’t form a traditional LLC with only one business owner, but there is another LLC option.
A single-member LLC is simpler and offers liability protection; however, as a disregarded entity, it’s taxed like a sole proprietorship. So what’s a disregarded entity exactly? Let’s find out.
What is a disregarded entity?
According to the IRS, a disregarded entity is “part of the owner’s tax return.” Does that sound like the best of both worlds? It may be for some businesses, especially at the start, and it’s a very common choice.
As long as LLCs are permitted in the state it’s operating in, the LLC stands as its own legal entity for the purposes of owning property, making contracts and potentially getting sued. For federal filing purposes, however, the LLC is disregarded.
Individual real estate investors can also opt to file as a disregarded entity LLC for their rental properties. In states with community property laws in place (Louisiana, Arizona, California, Texas, Washington, Idaho, Nevada, New Mexico, Wisconsin), a married couple owning a rental property jointly may also file as a single-member LLC. Those same community property laws also allow married couples operating a business to be considered a disregarded entity.
If you’ve got a rental property you can put it in a LLC, but it might be better to get more liability on your insurance policy, which will effectively do the same thing,” Stoner said. “If you carry a lot of insurance, it will be moot and you should carry insurance anyway with a rental property.”
How to become a disregarded entity
To become a single-member LLC (SMLLC), you will need to do the following:
- File with the office of the secretary of state in your home state by filling out forms (including Articles of Organization or a Certificate of Organization)
- Register a business name (which no other business in the state can use)
- Pay a one-time filing fee. When you file, you can choose to be taxed as a corporation. If not, you become a disregarded entity, and no separate tax return is required for your LLC.
After that, depending on the state where you filed, you may have to pay annual LLC tax fees or, in some cases, the fees are paid every two years. You will then need to sign business agreements as your LLC. Owners of SMLLCs don’t take a salary, and they use their own funds to fund the business.
Once the SMLLC is formed, you should draw up an operating agreement to clarify the business’ terms, structure and decision-making policies. If not, your LLC agrees to comply with the default rules of your state.
Is a single member LLC right for your business?
While going the disregarded entity route works for many beginner businesses, it is not going to be the best move for everyone. “In California, a lot of people become S or C corps instead,” said Brian Stoner, a CPA in Burbank. He also noted that in California, S or C corporations’ liability protections are a little better, but annual dues in Calif. are $800.
Becoming an S or C corporation may be more expensive, but it works out better with liability, and business owners can offset the cost by structuring their taxes in different ways.
One comprehensive analysis by the American Bar Association found that the liability protection afforded by the SMLLC is by no means ironclad. “Practitioners must take great care when working with an SMLLC because how separate an SMLLC is from its owner depends on how one looks at the situation. Depending on which legal regime applies, the SMLLC may be as visible and substantial as a stone wall or as diaphanous and prone to disappearance as the Cheshire Cat.”
A persuasive consideration in its favor is that a SMLLC is considered a pass-through entity, so if the business is eligible, it may reap the benefits of up to 20% to pass-through businesses per the Tax Cuts and Jobs Act.
What entities can be disregarded?
A disregarded entity can refer to one of the following:
- A single-member LLC
- Qualified real estate investment owners
- Community property states (SMLLC)
- Qualified real estate venture owned by a married couple
Finally, there are also irrevocable grantor trusts and qualified subchapter S subsidiaries (qSubs). An irrevocable grantor trust is a type of living trust that’s taxed as a disregarded entity. qSubs are not treated as separate from their parent S corporations, and is considered a disregarded entity.
Can a disregarded entity have an EIN?
“If you’re getting a single-person LLC, you should get a Federal ID [EIN] for your LLC, just like any LLC,” Stoner says. It doesn’t matter if your business is just one person.
It is possible to use your own Social Security number on tax forms with a single-member LLC, but it makes sense to get a Federal ID. For example, Stoner said if you live in California and use your Social Security number to e-file and have more than one LLC, it creates a transmission error.
It’s important to get an EIN, too, because banks typically require one to open a business account, and it’s already required if you have any employees. An EIN is also needed if the LLC is required to file any excise tax forms. Business owners can easily apply for a federal ID online on the IRS website.
Taxes and disregarded entities
Come tax time, not a whole lot is going to change. “If you were a sole proprietor and you become a single person LLC, you’re still a sole proprietor effectively,” Stoner said. “You don’t file anything differently.”
“You’ve got a sole proprietorship or rental just like you always did. The business is the business, you just have to continue filing the way you did if you had the business before you got the LLC.”
If you were a business before and you filed your self-employed income on a Schedule C, you’re going to file it exactly the same way. If you own a rental property as a single person LLC, you’re going to file a Schedule E.
“For federal [taxes], nothing really changes,” Stoner says. “You put down the name of the LLC as opposed to you being a sole proprietor. With rentals, I usually put down the LLC name in the field boxes talking about the rental.”
SMLLCs owned by an individual will file a 1040. If owned by a corporation, the corporation uses a form 1120 to report income and deductions.
Businesses filing as a SMLLC will have to pay self-employment taxes (Medicare and Social Security) on the business’ net income, and if you opted to be taxed as a corporation, you might not have to pay as much in taxes. If your SMLLC has employees, you will also have to pay employment taxes.
Opting to file as a disregarded entity is a common one, especially with new small businesses, and just might be the answer to your business needs. However, it’s not necessarily the best solution for everyone, particularly for a rapidly expanding business. Be sure to discuss your business’ unique situation with a tax professional.