Are you thinking about starting a business or forming an LLC? There are so many questions to ask and specific details to consider: What are the tax benefits? What is the right choice for your business, and how will you be affected?
In this article, I am going to be discussing what a Disregarded Entity is, and how it affects a business.
First, let take a moment to look at the definition of a Disregarded Entity. A Disregarded Entity refers to a business entity with one owner that is not recognized for tax purposes as an entity separate from its owner. A single-member LLC ( “SMLLC” ), for example, is considered to be a disregarded entity.
Now, let’s take a look at what a disregarded entity is for tax purposes.
Disregarded by IRS
The IRS classifies a single-member LLC by default as a disregarded entity and treats the business as a sole proprietorship for income tax purposes. The IRS disregards the company as being separate from its owner. The company’s income, expenses, losses, gains, deductions and credits are reported on the owner’s income tax return.
If the LLC owner is an individual, he would report income and expenses on Schedule C, Profit and Loss for Business; or Schedule E, Supplemental Profit and Loss; or Schedule F, Profit or Loss from Farming. The owner, however, can also be a business owner, including another LLC.
An individual owner of an LLC classified as a disregarded entity is not an employee of the company. Rather, the owner is subject to self-employment tax on the earnings from the LLC. The self-employment tax is in addition to income tax, though 50 percent of the self-employment tax is deductible.
LLC’s With Employees
If a single-member LLC has employees, the IRS treats the company as a separate entity when it comes to employment tax and certain excise taxes. Since 2009, a single-member LLC must use its name and Employer Identification Number to report and pay employment taxes. The LLC must use its name and EIN as well if it needs to register for excise tax activities, and report and pay excise taxes. Though the IRS does not require an LLC to have an EIN unless it has employees or pays excise tax, the company may still need an EIN to open a bank account or meet state regulations. An LLC owner can apply for an EIN online at the IRS website. The online application is free, and the LLC receives the EIN immediately.
Taxpayer Identification Number
When filing for income tax, the owner of a single-member LLC treated as a disregarded entity must use the owner’s Social Security number, or if she has one, the owner’s separate EIN, on all returns and forms related to income tax., even if the LLC has its own EIN.
Liability Protection Unaffected
Treatment by the IRS as a disregarded entity has no impact on the limited liability protection offered by an LLC. The LLC protects the owner’s personal assets from the debts and obligations of the company as long as the owner maintains an account of business income and expenses separate from personal accounts. Any personal assets used as collateral for business loans are not protected.
Changing Tax Status
A single-member LLC can elect to change its tax classification to be treated as a corporation, even if the actual business structure remains the same. The addition of another member for the LLC will also result in changing the tax treatment from sole proprietorship to partnership. Tax repercussions from changing the tax status can be complicated, depending on the company’s specific situation, making the advice of an accountant highly valuable.