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A disregarded entity is an LLC with only one owner (single-member LLC or SMLLC).  The SMLLC still provides liability protection through the separation of personal assets from the business’s assets, but the IRS treats the LLC like a sole proprietorship for tax purposes. 

How does an LLC become a disregarded entity?

When forming an LLC with only one owner, the IRS automatically classifies the entity as a sole proprietorship, so there is nothing the owner has to do.  By being a disregarded entity, unless the LLC has employees, the entity doesn’t even need an EIN (Employer Identification Number) and will instead use the owner’s Social Security Number for tax purposes.   

How does a disregarded LLC file taxes?

As a disregarded entity, the LLC is taxed like a sole proprietorship and the LLC does not file a separate income tax return.  The entity is taxed as a “pass-through” entity and files IRS Schedule C with the sole owner’s personal income tax return, which is how a sole proprietorship would file.

Being taxed as a sole proprietor has nothing to do with the lack of liability protection of the sole proprietorship.  It only refers to how the entity is taxed.

Why use a disregarded entity?

Having an LLC be a disregarded entity makes year end taxes less complex since there isn’t a separate entity tax filing.    Additionally, the owner of an LLC taxed as a corporation must report and pay unemployment insurance on themselves.

When it is better for an LLC to be taxed as a corporation?

For most people, being taxed as a corporation doesn’t make sense until it is making a decent profit.  The owner of a Limited Liability Company taxed as a corporation becomes an employee of the business in addition to being an owner.  When this happens, the sole owner has to submit quarterly payroll taxes and pay unemployment insurance on themselves.  The benefit of being taxed as a corporation is that after the owner takes a “reasonable salary”, any additional profits can be distributed as dividends.  As a disregarded entity, those profits would have been subject to self-employment taxes of 15.3%.  A reasonable salary varies by the type of work being performed and the amount of time the owner spends working in the business. 

What if you want the LLC taxed differently?

One of the benefits of the LLC is that the members can change how it is taxed.  There are some limits on when and how often it can be changed, but is a useful option as the business grows.  The owner could elect to have the LLC taxed as a corporation by filing IRS Form 8832; Entity Classification Election.   

Remember that everyone’s personal situation and business needs will be different, so be sure to talk with a professional before making a decision!

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