What Is a Disregarded Entity LLC? (Benefits & Downsides)
A business structure with one owner is interchangeably referred to as a sole proprietorship, single-member LLC, or a disregarded entity.
If you run a business by yourself, it would be important to know the distinction, since it has implications on liability protection and tax classification.
As a Mergers and Acquisitions specialist and a Master's Degree holder in tax law, I help business owners understand the different business structures, as well as their tax classifications.
Together with our team of legal professionals, we'll talk about what company structure you should adapt for your business.
Quick Summary:
- A “disregarded entity” is a tax designation given by the IRS to single-member LLCs and sole proprietorships.
- A single-member LLC and a sole proprietorship is a business structure owned by one individual that has advantages and disadvantages.
- The income taxes are based on the owner's individual tax rate, which could be as high as 37% if they're in the highest tax bracket, according to the IRS.
- I advise owners of sole proprietorships to convert their business structure into a single-member LLC in order to benefit from limited liability protection.
What is a Disregarded Entity?
A disregarded entity is a tax designation where the business and its owner are treated as a single unit.
The structure of a limited liability company separates the business entity from its owners, to benefit from limited liability protection.
Essentially, when an LLC is taxed as a disregarded entity, the IRS disregards the separation and considers the business and owner as one entity, but only for federal income tax purposes.
I inform clients that in strict legal business terms, only a single-member LLC may be considered as a true “disregarded entity”, and that a sole proprietorship is merely taxed as one [1].
The Benefits of a Disregarded Entity
Here are the benefits of a single-member LLC and sole proprietorship:
1. Single-Member LLC
A single-member LLC, taxed as a disregarded entity, benefits in several ways and is an excellent option to structure an individually-owned business.
According to the U.S. Small Business Administration, over 70% of businesses are operated as sole proprietorships or single-member LLCs due to the tax benefits and ease of administration.
Pass-through taxation
Business income, losses, deductions, and credit are passed-through, filed and paid on the sole members’ personal tax return. It avoids double-taxation and simplifies the filing process.
Liability protection
Since the LLC is regarded as a separate entity, the personal assets of the owner are protected from any legal action taken against the business.
Personal property may not be sought to settle debts and other legal obligations related to the business.
Although this is true, I ensure that my clients open a business bank account to maintain separation of company finances and personal assets.
Organization and structure
Once the LLC has been formed, there are minimal compliance requirements needed to maintain the business in order to remain in good standing with the state.
A colleague of mine only had to file annual reports, maintain a registered agent, and pay franchise taxes to meet the basic requirements of the state.
2. Sole-proprietorship
A sole-proprietorship is the simplest way to launch and operate a business, since it is not an official entity subject to federal or state regulations.
Ease of formation
A sole proprietorship is not required to incorporate with the state. Instead, the owner only registers a business name and obtains the necessary license or permit to operate.
Pass-through taxation
The business and the owner are treated as one entity, as such, sole proprietors are not subject to double taxation. The company itself is not levied at the corporate level, but the owner is taxed on their personal returns.
Control
Being the sole owner of a business once, I had complete control on how to run the entity. Unlike regular employees, you have a flexible working schedule.
The Downsides of a Disregarded Entity
There are a few setbacks that may be associated with the specific business structure and tax classification.
1. Single-Member LLC
Limited growth
In my experience, solely-owned business entities may find it difficult to attract equity investors or partners, since profit potential is relatively limited.
Single-member LLCs would have to rely on small-business loans and financing for capital and growth.
Self-employment taxes
Any single-owned business is required to pay self-employment taxes that would reflect all income generated from the LLC, since the IRS assumes the earnings are collected by the owner.
"As a disregarded entity, an LLC's earnings are reported on the owners' personal tax returns using Schedule C of Form 1040, avoiding the need for a separate corporate tax return but requiring payment of self-employment tax on business income."
- Jon Morgan, CEO, Co-Founder & Editor-in-Chief of Venture Smarter
See More: What Tax Form Does an LLC File
2. Sole Proprietorship
No limited liability protection
A sole proprietorship is not treated separately from its owner, as such, the owner is personally liable for any legal action, obligations, or debts incurred by the business.
Difficult to secure loans or obtain financing
Banks and other lending companies give preference to established companies because they have corporate assets and credit history.
Owners of a sole proprietorship may find difficulty obtaining finances from banks and other financial institutions and have to rely on small business loans.
FAQs
Is a DBA the Same as a Disregarded Entity?
A DBA is not the same as a disregarded entity. A Doing Business As or DBA allows your company to operate under a different name and has no effect on its tax classification.
Does a Disregarded Entity Need a Tax ID Number?
A disregarded entity needs a tax ID number for opening a business bank account, obtaining loans, or hiring employees.
References:
- https://www.irs.gov/businesses/small-businesses-self-employed/single-member-limited-liability-companies
