When an individual wishes to start a business, there are indeed many kinds of considerations to check and decide on, so, for the ones who don’t have any experience, such decisions may turn out to be quite a daunting task. Out of the many options available, a few business formats tend to easily qualify for limited liability coverage and ease up the reporting of taxes.
Entrepreneurs and small business owners often face a complexity v/s control struggle, and when they comprehend what different structures can do, it makes a world of difference!
This article will focus on explaining one such business structure in detail, its main features, and how it can assist in broader areas of management for the business owner, legal and financial.
What is a Disregarded Entity?
A disregarded entity is a type of business entity that is legally distinct from its owner but for federal income tax law, it is not considered to be a separate entity.
Such status allows the business to leverage the benefits of legal cover while eliminating the complexities of tax compliance. Losses, incomes, and tax credits all go through the proprietor’s tax return or the business’s tax return because the IRS chooses to ignore the entity for taxation.
The expression is mostly associated with the single-member limited liability company (SMLLC) but other entities like select types of trusts and qualified subsidiaries may also fall under this category.
The idea appeals to individuals who wish to start a business or a small company as well as multinational companies due to its flexibility, protection from liabilities, and the easing of the burden of tax filing.
Key Characteristics of a Disregarded Entity
1. Tax Treatment
Disregarded entities can in a way contribute towards the simplification of federal income tax purposes by eliminating the need to file for different tax returns. Instead:
- Individual Owners: File their business losses and profits within their tax forms usually on form 1040’s schedule C or E or F.
- Corporate Owners: Combine the financial activities of the disregarded entities with their corporate tax returns.
This system allows the problem of double taxation which is regularly experienced by Corporations, where the profits are taxed at both the company and the shareholder level, to be resolved.
2. Legal Separation
Although these types of entities are disregarded for tax purposes, they are still regarded as separate legal entities according to state laws. This means that:
The owner does not have any personal responsibility and the owner can limit the amount that they can lose if the business is sued or goes into debt.
The entity can have its own real estate, sign documents, and function without the constraints of the owner.
Still, liability protection may be defeated if the owner does not observe the proper business and personal asset separation or legal compliance requirements.
3. Employment and sales taxes
Though disregarded entities have an easier time with their income tax reporting, they are liable for other sorts of taxes and these include:
- Payroll Taxes: For any employees in the organization, one should fill out federal and state employment tax forms.
- Sales Taxes: The organization may be required to register and remit sales tax depending on the goods or services it sells and the state.
- Excise Taxes: These may apply to some industries including transportation and manufacturing as they may need additional tax filings.
In most cases, disregarded entities are required to get an Employer Identification Number (EIN) to meet these requirements.
4. State tax variations
Tax treatment of disregarded entities at the state level may deviate from the federal level. In as much as a great number of states conform to the IRS classifications, others may introduce their additional tax provisions such as franchise tax or gross receipts tax. For instance:
- As for California, disregarded entities should not ignore the LLC annual tax and fee, although the entity is disregarded in terms of federal authorities.
- Along with that, New York may require additional forms to be filed to reflect income and activity in New York State.
Owners should be aware of the state requirements to make sure they do not breach them.
What Types of Businesses Can Be a Disregarded Entity?
Disregarded entities can come in a variety of forms with the most common being a single-member limited liability company also known as an (SMLLC). Many sole proprietors and limited business owners prefer using SMLLCs as it offers them protection from liability while also allowing them to declare their business income in their returns. This arrangement reduces the burden of administration while at the same time enhancing financial management. Additionally, the tax filing process becomes seamless.
Further, there are qualified subchapter S subsidiaries (QSubs) that undergo classification as disregarded entities. Primarily those that are wholly owned by S-Corporation. For federal tax purposes, these corporations are considered to be a single entity with the parent company. So all of the QSub’s exemptions from filing tax returns are valid and only the parent company does so.
Another category involves businesses that are owned by trusts for example a grantor trust, where the income and expenses of the trust are reported on the personal return of the grantor. Most of the time this category is used when planning an estate where the trust is used for a single beneficiary.
Corporate-owned LLCs can also be used as disregarded entities when they are intended to operate specific assets and operations. For example, a corporation may create an LLC that deals with real estate or intellectual property while maintaining a separate primary business.
Lastly, the US LLCs that are owned by foreign nationals are also commonly reported as disregarded entities. These entities allow the owners who do not reside in the US to create a business in the US and reduce the extent of their tax requirements. Nevertheless, in the case of foreign-owned disregarded entities, certain compliance measures such as filling Form 5472 for acquisitions with related personas become mandatory.
Real-World Example of a Disregarded Entity
Scenario: Emily, a freelance graphic designer, establishes a single-member LLC called ‘Emily Designs, LLC’, to separate her business and personal risks.
Legal Protections: Let’s say Emily’s home and car are personal holdings. The LLC helps protect consumers against the owner’s liabilities by protecting Emily’s assets against any debts of the business or lawsuits.
Tax Simplification: The IRS “disregards” Emily’s LLC for tax purposes, allowing her to declare all her business earnings and expenses on Schedule C of her tax return. On the other hand, this means that Emily does not need to submit a business tax return in the sole proprietorship scenario, helping ease her administrative obligations.
Advantages of Operating as a Disregarded Entity
✅ Reduced Tax Reporting Obligations
Owners do not need to submit a separate return for their business and at the same time, they pass through all the profit and expenses in their return thereby decreasing administrative costs.
✅ Limited Liability of Owners
The owner and the entity are legally separate and as a result, owners are shielded against business loss as long as business customs are complied with.
✅ Avoiding Multiple Taxation.
While a regular business structure gets taxed on both the company’s profit and the dividend issuance, disregarded entities only get taxed once at the shareholder’s level.
✅ Management Requirements
Because these entities do not require as many formalities as boards of directors or holders of shares, they are less complicated than corporations.
✅ Change Taxation Election
Depending on the owner’s objective, the owner can choose to ignore the default disregarded classification or evaluate the entity as a corporation or S-corporation for taxation purposes.
Disadvantages of Being a Disregarded Entity
✅ State Tax Differentiation.
Federal taxes are not the only ones to consider, some states expect the company to comply with their network of imposed taxes or filing duties which complicates the understanding of the easiness of federal taxation.
✅ Low Investor Base.
Disregarded entities do not offer a substantial investor base due to the reason that issuing shares easily and raising equity is a problem for them.
✅ Too Risky.
Using business funds for personal expenses will leave a lot of risk because it will lead to businesses arguing that liability coverage does not apply.
✅ Taxes.
The selling or employing taxes is an obligation that the owner has to handle while stressing the maintenance of other tax obligations, which in turn increases the administration burden.
Who Should Consider Forming a Disregarded Entity?
Entrepreneurs and Freelancers: Sole proprietors wishing to protect their assets, without the formalities of a corporation
Small Business Owners: Those who want easy tax filing without compromising on their legal shield.
Corporate Organizations: Businesses with holding companies or subsidiaries held under LLCs to reduce cost and ease the burden of financial statements.
Foreign Investors: Non-residents who want to set up a business in the USA with reduced taxation compliance.
Conclusion
In all such cases, Disregarded entities manage to generate a perfect blend of taxation relief and asset protection and therefore end up being the favorite of all entrepreneurs, small businesses, and even large multinational companies.
Competitively, the structure allows for minimal tax filing obligations coupled with greater operational flexibility. However, one has to comprehend the additional responsibilities that accompany such benefits namely, compliance at the state level for example, and appropriate control over finances.
A call to an experienced tax consultant or legal professional ensures the best business structure is recommended in terms of the objectives, hence eliminating risks while creating possibilities to the greatest extent possible.
FAQs About Disregarded Entities
What is the primary benefit of a disregarded entity?
It is the reporting and compliance burden that a disregarded incorporation carries that is the biggest advantage for its owner. This is because owners of this entity are only required to include the revenue, expenses, and deductions of the entity as part of their tax returns as opposed to the entity requiring a separate tax return filed. This also stipulation allows corporate veil for liability purposes by providing shelter for personal liabilities concerning assets of the business.
Can a disregarded entity hire employees?
A disregarded company can employ people. In such cases, however, the company or the owner still has to meet employee tax requirements, including payroll tax withholding maintaining payroll tax forms, filing, and requesting an Employer Identification Number. In this case, even if such business is disregarded for income tax reporting, the entity is considered a distinct entity for employment and excise taxes.
Is it possible for a U.S. LLC wholly owned by foreigners to qualify as a disregarded entity?
Yes. For federal tax purposes, foreign-owned U.S. LLCs may be treated as disregarded entities but there are further compliance somewhat burdensome requirements like the obligation to file Form 5472 to report transactions involving related parties. Those requirements ensure compliance with U.S. tax laws and reporting policies and are meant to guarantee a transparent business process.
Is it essential for a disregarded entity to have an EIN?
A disregarded entity has to have an EIN if it has employees or if it has to complete and submit specific required forms such as employment tax returns or excise tax paybacks. However, for single-member LLCs without employees, their owners’ Social Security Number (SSN) is quite adequate to meet federal tax obligations regarding income.
Can a disregarded entity decide to change the tax classification that they operate under?
Yes, a disregarded entity is allowed to file the IRS Form 8832 which is the Entity Classification Election enabling the entity to change the tax classification under which it operates. For instance, a single-member LLC may request to be taxed like a corporation or an S-Corporation if that is what the owner prefers. This way, over some time, disregarded entities can grow and specialize in multiple services as per the requirements of the future business.
Nabin Adhikari
