The term "disregarded entity" refers to how a single-member limited liability company (LLC) may be taxed by the Internal Revenue Service (IRS). If your LLC is deemed a disregarded entity, it simply means that, in the eyes of the IRS, your LLC is not taxed as an entity separate from you, the owner.
Determining disregarded entity status
While there are two other types of entities that are considered disregarded entities—a qualified subchapter S subsidiary (QSub subsidiary) and a real estate investment trust (REIT)—the most common type of disregarded entity is the single-member LLC (SMLLC). Even those single-member LLCs owned by S corporations qualify as disregarded entities.
All single-member LLCs are by default considered disregarded entities. This means that the IRS does not treat your LLC as an entity separate from you, its owner, when it comes to income taxes.
An exception is made if you file Entity Classification Election (Form 8832), which allows you to elect that your LLC is treated as a corporation.
Since they have more than one member, LLCs opened by two spouses are usually taxed as a partnership. However, in states with community property laws, the IRS may permit such LLCs to instead be treated as disregarded entities.
In order to retain a disregarded entity classification, you must take care not to lose your SMLLC status, either by not meeting your state's LLC requirements or by adding an additional member or members to your LLC.
Advantages of a disregarded entity
There are many benefits for a single-member LLC to be deemed a disregarded entity. The most common include:
- Pass-through taxation. This means your LLC's income and expenses pass through the company to you as an individual, which means they are required to be reported on your individual tax return. Income and expenses of an SMLLC owned by a corporation or partnership are reflected as a division of the corporation's or partnership's tax return.
- Simpler tax filing. With pass-through taxation, only the business owner is taxed, not the business, which means you have to file only one tax return, saving you the time and expense of filing a separate return for your LLC.
- Liability. The status of disregarded entity only applies at the federal level, not the state level, where it remains a separate entity and thus retains all the liability advantages of an LLC. This means that assets owned by the LLC are protected from any claims a creditor may have on the property of the LLC's owner.
Disadvantages of a disregarded entity
Although being a disregarded entity has its perks, there are some reasons an LLC owner may choose otherwise.
- Employment and excise taxes. Being a disregarded entity is recognized only for the purposes of federal taxes, meaning the LLC may still be liable for employment and excise taxes. However, this is relevant only if you have employees other than yourself or if your LLC has any excise tax liability. While you use either your Social Security number or employer identification number (EIN) when filing your LLC's federal taxes, if your LLC has liability for either excise or employment tax, you must use an EIN to report and pay such taxes.
- Self-employment taxes. Being a disregarded entity does not release the owner of a single-member LLC from the responsibility of self-employment taxes. These are in addition to your income taxes, but the amount you pay is also deductible, up to a maximum cap.
Once you've weighed the pros and cons, you can decide whether you want to maintain your disregarded entity status or elect to have it taxed as a corporation, either when you first form your LLC or later down the road.