When you’re a disregarded entity, it doesn’t mean you’re disregarded in a bad way. It just refers to how you get treated for federal income tax purposes.
What are disregarded entities?
A disregarded entity is an entity that the Internal Revenue Service ignores for federal tax purposes. In other words, you don’t report your business income as a separate entity. Instead, you report your business income on your personal tax return.
That usually means adding a Schedule C statement of profit and loss to your Form 1040 personal tax return.
The most common disregarded entity is a sole proprietorship followed by a single-member limited liability company (single-member LLC).
To be a disregarded entity, you have to meet three requirements.
Requirement 1: One Owner
A disregarded entity can generally only have one owner.
If you have multiple owners and didn’t create a formal business structure, you’re generally still a partnership in the eyes of the IRS. That means that you’ll usually need to file a Form 1065 partnership tax return.
There are some situations where two spouses who are the only two owners in the business can remain a disregarded entity through the qualified joint venture rules.
Requirement 2: Not a Corporation
If you create a C-corporation or S-corporation through your state, that corporation is now a separate entity for federal income tax purposes. It doesn’t matter if there’s still only one business owner or multiple shareholders.
You’ll need to file either a Form 1120 corporation tax return or Form 1120-S S-corporation tax return. You’ll also owe personal income taxes based on how you paid yourself (e.g., salary, dividends, or retained earnings in an S-corp).
Requirement 3: Did Not Elect to Be Taxed as a Separate Entity
The final requirement usually applies to a single-member limited liability company (LLC).
By default, a single-member LLC automatically gets taxed as a disregarded sole proprietorship. A multiple-member (owner) LLC automatically gets taxed as a corporation.
A disregarded entity LLC also has the option to get taxed as either a C-corporation (not common) or an S-corporation (fairly common). Once you choose that option, you generally need to file a corporate tax return similarly to how you would if you had incorporated instead of forming an LLC.
What are the pros and cons of remaining a disregarded business entity?
There are several reasons that you may or may not want to remain a disregarded entity.
Pro of Being a Disregarded Entity: Easier Taxes
With a disregarded entity, you file and pay taxes as an individual. You can take all of the usual business deductions and subtract them from your business income. You pay personal income taxes and self-employment taxes on your net profits.
While you have to add a few forms to your tax return, you don’t have to file an entirely separate tax return. Partnership, corporation, and S-corporation tax returns can be much more complicated and more expensive than individual tax returns.
When you pay yourself through a corporation, you also often need to file payroll taxes even if you’re the only employee.
Con of Being a Disregarded Entity: Possibility of Paying Higher Taxes
Changing from a disregarded entity to a corporation or S-corporation can potentially lower your taxes.
You may be able to have some of your income treated as dividends. That means potentially reducing your self-employment taxes. You could also qualify to pay the lower qualified dividends tax rate on some of your income instead of the higher personal income tax rate.
The potential tax savings depend on the type of work that you do. Before you use any of those tax moves, you first have to take a reasonable salary subject to income taxes and self-employment tax or FICA tax.
Additionally, the possible tax savings may not offset the annual filing fees for your corporation or LLC, possible legal fees, and added tax filing and accounting costs. So before deciding this is a reason to not remain a disregarded entity, talk to your tax advisor and work through all of the numbers.
Mixed: Legal Protections
In terms of legal protections, LLCs and corporations usually work similarly for things like the protection of the owner’s personal assets. So it may not matter if you’re a disregarded single-member LLC or a corporation.
On the other hand, some states have small nuances in their law where it may be better to be either a corporation or LLC in very particular situations. In addition, if you ever have to do something like take a client to small claims court for non-payment, some states require that either an LLC or corporation (or both) have to be represented by a licensed attorney.
Finally, if you’re currently just a sole proprietorship with no LLC, you may be able to get insurance that covers your potential risks for cheaper than forming an LLC or corporation.
Not Really a Con of Being a Disregarded Entity: Needing a Separate Business Bank Account
If you have a corporation or LLC, you often need to have a separate business bank account by law. The reason is that even if you’re the only owner, it’s an entity separate from yourself that needs its own account. You also don’t want to lose the legal protections of your LLC or corporation because you mixed personal and business funds.
Of course, it’s good accounting practice to have a separate business account even if you’re an informal sole proprietorship. It makes your accounting easier and can help make IRS audits go more smoothly.
The only slight negative for creating an LLC or corporation here is that it might be harder to find a free business checking account. More banks offer free business checking accounts to sole proprietors, and many sole proprietorships just use a separate personal checking account.
Con of Being a Disregarded Entity: Harder to Deal with Some Larger Corporations
When you’re a disregarded entity, it can be harder to deal with some larger companies. They may only want to work with LLCs or corporations or could have a lot of extra paperwork and bureaucracy for a sole proprietorship.
What they’re usually worried about is a contractor trying to claim that he’s misclassified as an independent contractor and should receive employee benefits. While having a corporation or LLC isn’t the 100% determining factor, it’s safer for big companies to only work with formally registered businesses.
So even if so far you’re leaning towards an LLC not being worth it, having an LLC can actually increase your income in some situations by helping you get more and bigger clients.
Conclusion
Like anything with taxes and law (and especially things that touch on both), there are no clear answers on whether it’s better to be a disregarded entity for federal income tax purposes. It depends on several factors and can also change over time as your business changes.
Talk to your advisor to get help figuring out what you should do.
