What Is a Disregarded Entity LLC?

A disregarded entity limited liability company (LLC) is a unique type of business structure that combines elements of both corporation and partnership tax statuses. A disregarded entity is a type of business entity that is separate from the business owner. Even though this separation exists, the Internal Revenue Service (IRS) disregards the separation for tax purposes.

There are a few business types that the IRS may recognize as disregarded entities. Still, the most common example of a disregarded entity is a single-member limited liability company (single-member LLC). This guide will explain what a disregarded entity LLC is, how it works in terms of taxes and liability, and the pros and cons of choosing this structure for your business.

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What Is a Disregarded Entity LLC?

Many entrepreneurs are attracted to one popular business structure: the LLC. LLCs are attractive because owners have flexibility and risk protection. Limited liability means that the owners of the business have protection for their personal assets. Someone who sues the company can't reach an LLC owner's personal assets, such as a car or bank account. This is because an LLC is a separate entity. 

Sole proprietors, for example, do not have this separation. The owner of a sole proprietorship could be personally liable for business debts.

A disregarded entity LLC is a limited liability company that is not separate from its owner for federal income tax purposes. It's a popular choice for single owners, allowing them to benefit from limited liability protection while avoiding the complexity of corporate tax. This means the LLC itself doesn't pay taxes. Instead, taxes are passed through to the owner's personal income tax return. LLCs are called "pass-through entities" for this reason.

These LLCs are disregarded for tax purposes, meaning they do not file a separate business tax return. Instead, the owner files a Schedule C with their personal income tax return. While state law governs the formation of LLCs, tax law dictates their tax status. Importantly, these entities will provide legal protections and liability protection like a corporation.

Single-Member LLCs and Taxes

For a single-member LLC (SMLLC), the owner reports all business income and losses on their personal income tax return. This includes self-employment taxes for Social Security and Medicare. Although there's no corporate tax, the owner may opt for S corp status. This can offer savings on self-employment taxes.

By default, the IRS recognizes single-member LLCs as disregarded entities. A single-member LLC qualifies as a disregarded entity because only one member owns it, and the member has not chosen a different tax classification. If the owner of an LLC chooses a different federal tax classification and files tax form 8832, they may be taxed as an S corporation or C corporation. A single-member LLC will no longer be disregarded if the owner chooses corporate taxation.

If the owner of an LLC does not choose corporate taxation, then the LLC will be taxed like a sole proprietorship. This means that business income and expenses are reported on the business owner's personal tax return. This is called pass-through taxation. When LLC owners file their individual income tax returns, they will be responsible for employment taxes and excise taxes.

Choosing to be taxed as a corporation rather than a sole proprietorship means that the LLC is no longer a disregarded entity. This is because the IRS taxes the corporation itself. A disregarded entity is separate from the owner for liability purposes but not for federal tax purposes.

Benefits of Disregarded Entity LLCs

The primary benefit of a disregarded entity LLC is the simplicity of tax filing. Pass-through taxation is a benefit of disregarded entity LLCs. Filing taxes for a disregarded entity LLC is a more straightforward process than handling taxes for a corporation.

Owners of corporations have to file a separate return for the corporation in addition to their tax return. Corporations also have to deal with double taxation. Owners avoid the complexity of corporate tax filing but still enjoy limited liability protection. 

Limited liability is an advantage that disregarded entity LLCs have over sole proprietorships. It could be important, though, to keep up with all requirements to ensure that the LLC continues to be recognized as separate from the owner. A creditor could attempt to pierce the veil of a disregarded entity LLC so that they could reach the owner's personal assets.

Disregarded entity LLCs are especially beneficial in community property states, where spouses can have a multi-member LLC treated as a disregarded entity. Plus, these LLCs can have a real statement trust or qualified subchapter S subsidiary as owners.

Drawbacks of Disregarded Entity LLCs

The main drawback is self-employment tax liability. Owners of a single-member LLC pay these taxes on all business income. Additionally, if the LLC is not a qualified subchapter S subsidiary, it can't become an S corp to save on these taxes. This structure might not be ideal for businesses with high payroll taxes or those needing a separate entity classification election.

Seeking Assistance With Disregarded Entity LLCs

Setting up and managing a disregarded entity LLC involves understanding both state law and tax law. Tax liability and legal protections can be complex. It's advisable to seek legal and tax advice to ensure compliance. They can also help optimize your tax situation.

Contact a local small business attorney today.