Disregarded entity – clearing up the confusion year 6 electricity unit

An LLC can elect to be treated as a corporation for income tax purposes. If your SMLLC has elected to be taxed as a corporation or S corporation, it is not considered a disregarded entity for income tax purposes. To make this election, the SMLLC must file Form 8832 – Entity Classification Election (PDF). Read more about filing an entity election for an LLC. Are These Other Business Types Disregarded Entities?

Businesses are set up under state regulations, through the secretary of state for each state, and no state recognizes a "disregarded entity" as a business type. Look at each of the legal types of business to see how it compares to the requirements for a disregarded entity:

• Sole proprietorship,in which you and the business are the same entity. The sole prop is taxed on Schedule C, but there is no separate business entity to provide liability protection for you if the business can’t pay its bills or gets sued.

• A partnership, as noted above, is not a disregarded entity (including a limited partnership or limited liability partnership) because partnership taxes are not figured on Schedule C. (Read more about partnership taxes on How a Partnership Pays Income Tax.)

The IRS says, "If a “disregarded entity” is owned by an individual, it is treated as a sole proprietor. If the “disregarded entity” is owned any any other entity, it is treated as a branch or division of its owner." Some Background on the Disregarded Entity

The Internal Revenue Code (the regulations governing federal taxes) states that a business entity is a corporation by default. If the entity is not a corporation it is an "eligible entity," and it can elect its classification for federal tax purposes.

The Code says, "an eligible entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner." The only business type that fits all the qualifications to be a disregarded entity is a single-member LLC. (SMLLC). LLC Not Electing to Be a Corporation

The IRS says, "An SMLLC that does not elect to be a corporation will be classified by the existing federal guidance as a "disregarded entity" which is taxed as a sole proprietor for income tax purposes." An LLC can file an election to be taxed as a corporation.

So, basically, any SMLLC that is not taxed as a corporation is a disregarded entity for tax purposes. That is, the SMLLC is taxed as a sole proprietor. But here’s where the confusion comes in: A sole proprietor is NOT a disregarded entity because the company is not separate from the owner.

The relevant term in the previous paragraph is "taxed as." A sole proprietor files business taxes using Schedule C, and the profit/loss from the Schedule C is included with the individual income tax return. So a Single-Member LLC "taxed as" a sole proprietorship file a Schedule C.

A Single-Member LLC doesn’t need to do anything to "elect" to be a disregarded entity, even though it does sound like that. The SMLLC needs to file its business taxes on Schedule C. The alternative, which is for the SMLLC to be considered an association and taxed as a corporation, is that the SMLLC must file Form 8832 – Entity Classification Election (PDF). Read more about filing an entity election for an LLC. Liability Issues for a Disregarded Entity

A disregarded entity is considered the same entity as the owner for tax purposes, but not for liability purposes. For more information on this subject, read this article in which attorney Robert Warwick discusses disregarded entity tax and liability issues.

The disregarded entity status of a single-member LLC does not apply to employment taxes. The business has several options for which employer ID number to use when filing unemployment taxes. Read more about these options for filing employment taxes. For More Information

Disclaimer: The author is not a CPA or tax attorney and does not intend to give tax or legal advice. If you are wondering if you qualify as a disregarded entity or how that designation might affect your business taxes, check with your attorney and tax professional.