If you’ve been told that your limited liability company is a “disregarded entity,” you might think you’ve been penalized for doing something wrong. But a disregarded entity isn’t a bad thing—it’s just one of the ways the Internal Revenue Service can tax a single member limited liability company.
Disregarded Entity Explained
Unlike corporations, LLCs do not have their own federal income tax classification. LLCs can be taxed as though they were sole proprietorships, partnerships or corporations.
The IRS automatically taxes single member LLCs as though they were sole proprietorships. From a legal standpoint, businesses that operate as sole proprietorships don’t exist separately from their owners. Therefore, a sole proprietor includes business income and expenses on his or her personal tax return.
When an LLC is taxed like a sole proprietorship, the LLC’s income and expenses are reported on the owner’s personal tax return rather than an LLC tax return, and the IRS ignores the LLC’s status as a business entity. Because of this, LLCs that are taxed like sole proprietorships are known as “disregarded entities.”
It’s important to note that a single member LLC’s status as a disregarded entity refers only to the way it’s taxed—the LLC still has an identity that’s separate from its owner for purposes of employment taxes and liability.
Other Ways That LLCs Can Be Taxed
If you form a single member LLC and do not file additional paperwork with the IRS, your LLC will automatically be taxed as a disregarded entity. A multiple-member LLC will be taxed like a partnership.
However, you can choose to have your LLC taxed as a corporation by filing a form with the IRS. Corporations are taxed as either S corporations or C corporations. An S corporation is a pass-through entity that does not pay taxes at the corporate level. However, shareholders pay taxes on their salaries and any company profit. C corporations pay federal income taxes at the corporate level, and owners are also taxed on any salary or dividends they receive.
Why Choose Disregarded Entity Status?
Having your LLC taxed as a disregarded entity is less complex than being taxed as a corporation. You don’t need to file any additional forms with the IRS, and you can report all of your business income and expenses on your personal return, rather than having to file a corporate tax return.
However, if you are an LLC disregarded entity, you will pay Medicare and Social Security taxes—known as self-employment taxes—on all of your LLC’s net income. If your LLC elects to be taxed as a corporation, you may be able to avoid some of those taxes. You must pay yourself a reasonable salary, and you’ll pay Social Security and Medicare taxes on that salary. But you won’t owe those taxes on the remainder of your company’s profit.
If your LLC’s net income significantly exceeds your salary, you may save money by being taxed as a corporation, though you will also have to contend with the additional administrative cost of managing payroll and withholding taxes.
Having your LLC taxed as a disregarded entity can be the smartest choice for a business that’s just starting out. As your business grows and becomes more successful, however, it’s a good idea to consult with a tax professional to determine whether taxation as a disregarded entity LLC is still the best option.
This portion of the site is for informational purposes only. The content is not legal advice. The statements and opinions are the expression of author, not LegalZoom, and have not been evaluated by LegalZoom for accuracy, completeness, or changes in the law.