Disregarded Entity

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Disregarded Entity

What is a Disregarded Entity?

A disregarded entity, as defined by the Internal Revenue Service (IRS), is a business entity that is not recognized for tax purposes.

Instead, all of the entity's income, deductions, and credits are reported on the personal tax return of the single owner. Common disregarded entities include single-member Limited Liability Companies (LLCs) and sole proprietorships.

Types of Businesses That Can Be a Disregarded Entity

Single-Member Limited Liability Companies (LLCs)

A single-member LLCs is perhaps the most common type of disregarded entity. As the name suggests, a single-member LLC is an LLC with just one member or owner. By default, the IRS considers Limited Liability Company LLCs as disregarded entities for tax purposes.

Thus, the member is personally liable for the taxes on the LLC's profits, which they report on their personal income tax return. If the owner is an individual, the IRS treats the LLC as a sole proprietorship, while if the owner is another entity, the LLC is treated as a branch or division of the owning entity.

Qualified Real Estate Investment Trust (REIT) Subsidiaries

A qualified REIT subsidiary can also be a disregarded entity. A REIT is a company that owns or finances income-producing real estate. If a REIT owns all of the stock of a corporation, that corporation can qualify as a disregarded entity. This means that the IRS does not consider the subsidiary separate from the REIT for income tax purposes.

Certain Trusts

In some cases, trusts can also be considered disregarded entities. A grantor trust, wherein the grantor retains certain powers or ownership benefits, can be considered a disregarded entity. The IRS treats the assets and income of the trust as owned directly by the grantor.

Owned Entities in Community Property States

In some community property states, a business entity that is solely owned by a married person can be considered a disregarded entity if the income is treated as community income.

While these are common examples, it's important to note that the rules regarding disregarded entities can be complex. Always consult with a tax professional or legal counsel to understand the implications of your specific situation.

How to Set Up a Disregarded Entity

Creating a disregarded entity usually involves forming a single-member LLC under state law. The specific requirements can vary from state to state, but generally, this involves choosing a unique business name, appointing a registered agent, and filing articles of organization with the relevant state agency. It's also advisable to create an operating agreement, even though this is not typically a state requirement.

Once the LLC is established, the owner must obtain an Employer Identification Number (EIN) from the IRS. Even though a disregarded entity does not file separate taxes, it still needs an EIN for banking and identity purposes.

Tax Treatment for a Disregarded Entity

From a tax perspective, a disregarded entity is treated as a sole proprietorship. The income and expenses of the business are reported on Schedule C of the owner's personal tax return (Form 1040). Despite being disregarded for income tax purposes, these entities are still considered separate from their owners for employment tax and certain excise taxes.

Advantages and Disadvantages of a Disregarded Entity

One of the main advantages of a disregarded entity is the simplicity of its tax treatment. Because it's taxed as a sole proprietorship, there's no need for the entity to file a separate tax return. This can simplify tax preparation and reduce accounting costs.

However, a major disadvantage is that the owner of a disregarded entity is personally responsible for all the entity's debts and liabilities. This differs from an entity taxed as a corporation, where the owners are generally not personally liable.

Disregarded Entity vs. Pass-Through Entity

The terms "disregarded entity" and "pass-through entity" often get used interchangeably, but there are key differences. While both avoid double taxation, a disregarded entity is ignored for tax purposes, and all activity is reported on the owner's personal tax return. In contrast, a pass-through entity, such as an S corporation or a multi-member LLC, is recognized by the IRS, and while the profits pass through to the owners' personal tax returns, the entity itself must still file its own tax return.

Can a Disregarded Entity Have Employees?

Yes, a disregarded entity can have employees. However, for the purposes of employment taxes, the IRS does not disregard the entity. The entity, rather than the owner, is considered the responsible party for reporting and paying employment taxes.

Impact of a Disregarded Entity on Self-Employment Taxes

The profits of a disregarded entity are subject to self-employment taxes, which consist of Social Security and Medicare taxes. The owner must report the business's earnings as self-employment income and calculate the self-employment tax on Schedule SE of their personal tax return. This is an essential consideration for any owner of a single-member LLC or other disregarded entities, as self-employment taxes can significantly impact their tax liability.

How to Convert a Disregarded Entity to a Taxed Entity

A disregarded entity can be converted to a taxed entity through a process known as "electing corporation status". For a Limited Liability Company (LLC), this involves filing Form 8832, Entity Classification Election, with the Internal Revenue Service (IRS).

  1. Obtain Form 8832: Download Form 8832 from the IRS's website.
  2. Complete the Form: Fill in the required information, including the name of the business, its address, and the Employer Identification Number (EIN). You will also need to specify the type of entity you wish your business to be classified as. For instance, if you want your LLC to be taxed as a corporation, you would select that option.
  3. Sign and Date the Form: The owner or an authorized representative must sign and date the form.
  4. File the Form with the IRS: Mail the completed form to the appropriate IRS address listed in the form's instructions. You should retain a copy for your records.
  5. Wait for Confirmation: The IRS will send a letter confirming the receipt of the form and the approval of the election.
  6. Start Filing as the New Entity Type: Once the IRS has approved your election, you can begin filing taxes under the new entity classification.

Remember, converting your disregarded entity to a taxed entity may have significant tax implications. Therefore, it's advisable to consult with a tax professional or attorney before making this decision.

Different entity types have different tax structures, liability implications, and reporting requirements, so it's crucial to understand these aspects thoroughly before making any changes.

Do disregarded entities issue 1099?

A disregarded entity, such as a single-member LLC, does not typically issue a 1099 form under its own name or Employer Identification Number (EIN). Because it is considered the same as its owner for tax purposes, the owner is generally the one responsible for tax filings, including issuing any necessary 1099 forms.

However, if the disregarded entity has employees, it uses its own EIN for reporting and payment of employment taxes, even though it does not for income tax purposes. The IRS treats the entity as a separate entity for purposes of employment taxes and certain excise taxes.

As always, tax law can be complex, and the specifics can vary depending on the situation. It is always advisable to consult with a tax professional or legal counsel for advice tailored to your circumstances.