What Is a Disregarded Entity? Pros & Cons for Entrepreneurs

As a small business owner, you've probably heard terms like LLC, S-Corp, and sole proprietorship. But there's another tax term that might be less familiar YET incredibly important for your business strategy: disregarded entity.

So, what IS a disregarded entity? You'll learn everything you need to know about this important classification and what it means for your federal income tax purposes in this article. Grab your favorite beverage, and let's dive in! ☕

What Is a Disregarded Entity for Tax Purposes?

A disregarded entity is a business that the IRS chooses to "disregard" as separate from its owner for federal tax purposes. Despite being a legally registered business entity at the state level (like an LLC), the IRS treats it as an extension of the owner for taxes.

The most common example is a single-member LLC.

Your LLC provides you with liability protection under the state law, but the IRS ignores this separation for tax purposes. This means all business income and expenses flow directly to your personal tax return – you don't need to file a separate business tax return!

Examples of a disregarded entity for tax purposes include:

• Single-owner LLCs that haven't elected corporate tax treatment

• Qualified subchapter S subsidiaries (QSubs)

• Certain wholly-owned subsidiaries of corporations

With a disregarded entity, you report business income and expenses on Schedule C of your personal tax return (Form 1040) if you're an individual owner.

Learn more about small business taxes for dummies!

What Is an Example of a Disregarded Entity?

The most common example of a disregarded entity is a single-member limited liability company (LLC). Here's a hypothetical example to explain how it works.

Sarah is a graphic designer who forms an LLC called "Sarah's Designs, LLC" in her state. She's the only owner of this business. Her LLC is a separate entity that protects her personal assets from business liabilities, but the internal revenue service (IRS) treats it differently for tax purposes.

The IRS "disregards" Sarah's LLC as separate from herself. This means Sarah doesn't file a separate tax return for her business.

Instead, she reports all her business income and expenses on Schedule C of her personal Form 1040 tax return, just as if she were a sole proprietor.

Is a Disregarded Entity Good or Bad?

Whether a disregarded entity is good or bad for your business depends on what your business is and your goals. There's no one answer that fits all entrepreneurs. Disregarded entities offer some advantages, but they also come with limitations that might not work for every small business owner.

Pros of a Disregarded Entity

Running your business as a disregarded entity can work really well for some people. Here are the main reasons why.

• Simplified Tax Filing: One of the biggest advantages of a disregarded entity is tax simplicity. Instead of filing a separate business tax return, you report all business income and expenses on your personal tax return. Easy-peasy.

• Pass-Through Taxation: Business losses can offset other income on your personal tax return (subject to certain limitations).

• No Double Taxation: Unlike C corporations, disregarded entities avoid double taxation. Income is taxed only once at your personal tax rate, not at both the business and personal levels.

• Business Expense Deductions: You can still deduct legitimate business expenses just as you would with any other business structure.

So, for some entrepreneurs, a disregarded entity might be all you need!

Cons of a Disregarded Entity

Disregarded entities also have their fair share of cons. Here's what they are.

• Self-Employment Taxes: As a disregarded entity, all your business profits are subject to self-employment taxes (currently 15.3% for Social Security and Medicare). You can potentially lower these payments with other tax structures like an S-Corp.

• Limited Tax Planning Strategies: Disregarded entities have fewer options for advanced tax planning compared to S or C Corporations. If your business brings in a high income, this could mean missing out on potential tax savings.

Also, keep in mind that some states may treat disregarded entities differently than the IRS, so always check your local laws.

So, Why Set Up a Disregarded Entity?

A disregarded entity can be the perfect combination of legal protection and tax simplicity for many small business owners. It can work particularly well for:

• New businesses

• Solo entrepreneurs

• Side hustles

• Service-based businesses (freelancers, consultants, etc.)

• Businesses with moderate profits

As your business grows and evolves, you can always change your tax classification to an S-Corp, which can potentially help you save on self-employment taxes once you reach a certain level of income.

Learn more about our tax services to start saving money as a small business owner!

FAQs

What Is the Difference Between a Sole Proprietorship and a Disregarded Entity?

The main difference between a sole proprietorship and a disregarded entity is legal protection. A sole proprietorship offers no separation between you and your business, and your personal assets are at risk for business debts and lawsuits. A disregarded entity (typically a single-member LLC) provides personal liability protection under state law while being treated the same as a sole proprietorship for federal tax purposes.

What Is a Disregarded Entity for EIN?

A disregarded entity can still get its own Employer Identification Number (EIN). Single-member LLCs aren't required to have an EIN if they don't have employees, but many still get one to open business bank accounts or establish business credit. Having an EIN doesn't change the disregarded status.

Is an S-Corp a Disregarded Entity?

No, an S-Corporation is not a disregarded entity. An S-Corp is a separate tax entity that files its own tax return (Form 1120-S) and issues K-1 forms to shareholders. Both S-Corps and disregarded entities use pass-through taxation, but S-Corps have a separate tax identity. This allows S-Corp shareholders to potentially save on self-employment taxes - something disregarded entities can't do.

Get Ready for Tax Season with Desi Tax Service®

Understanding disregarded entities is just one piece of the tax puzzle for entrepreneurs. At Desi Tax Service®, we help small business owners find clarity in tax season and start saving money you didn't even know you had.

Whether you're running your business as a disregarded entity or are thinking of switching to another tax structure, such as an S-Corp, learn more about our tax services and how we can help you make tax season easy (and even FUN!).