The term “disregarded entity” may sound like a negative thing, but it has the potential to be a positive thing for independent businesspeople when tax time rolls around. If you’re a single-person business and you’re attempting to determine the most advantageous way to file your taxes, here’s what you should know about the pros and cons of utilizing a disregarded entity when you file your return.
What Is a Disregarded Entity?
A disregarded entity is a business entity that the IRS can ignore on your tax returns. The IRS requires all businesses to report their income, but the situation is slightly different when a business only consists of one person. All profits generated through that business can be assumed to be a single person’s income because there are no other members or employees to share it with.
In essence, a disregarded entity is when you become your business for tax purposes. There is no separation between yourself and your business entity, and therefore no need to file two separate returns to report the same information. Both returns will run concurrently as a single personal income tax return if you choose to utilize this method of reporting your taxes to the IRS.
How Does a Business Become a Disregarded Entity?
A business can become a disregarded entity simply by filing a single tax return if it meets the criteria necessary for a disregarded entity. Disregarded entities can only be single-person businesses with no other employees, although they are allowed to utilize external professional services or independent contractors.
The IRS will regard businesses registered as single-member LLCs as disregarded entities by default. This means you don’t choose to become a disregarded entity. You would have to make a choice to be regarded as something other than a disregarded entity if you wanted to opt out in favor of a different tax filing method.
What Types of Businesses Can Be Classified as Disregarded Entities?
Disregarded entity status can only be utilized in a handful of tax situations. With the exception of single-member limited liability companies, there may be some scenarios where disregarded entity status isn’t available to these types of businesses. It’s best to consult with a tax professional about tax responsibilities unique to your business type.
Single-Member Limited Liability Companies (LLCs)
Single-member limited liability companies (SMLLCs) or limited liability companies that only have one owner are already disregarded entities by default. If you fall into this category, you would need to choose to be taxed as any other LLC by filing form 8832 for your business. If you want to remain a disregarded entity, you don’t need to take any additional steps.
Qualified Subchapter S Subsidiary (QSubs)
Qualified subchapter S subsidiary companies are exclusively owned by their parent company and, therefore, not considered to be separate. Taxation for QSubs is rolled directly into taxation of the parent company, and the QSub itself can be disregarded. It makes no difference in terms of reporting because everything is ultimately accounted for.
Depending on the circumstances, some QSubs may be required to file separate tax paperwork to report on things like employment taxes. QSubs may also have separate filing requirements for state tax purposes if their parent company is located in a different state.
Domestic Branches of Foreign Corporations
A domestic branch of a foreign corporation can become a disregarded entity as it is assessed differently for tax purposes. There are often conflicts with tax laws between the United States and other countries. Utilizing the disregarded entity method in these cases can sometimes become complicated. This is best attempted with the assistance of a qualified tax professional with experience in international taxation matters.
What Are the Advantages of Being a Disregarded Entity?
Many single-member LLCs (SMLLCs) and LLCs with a single member allow the IRS to regard their business as a disregarded entity because they appreciate the simplicity and freedom that comes with using the default option made available to them. There may be some cases where independent professionals feel as though it’s the most advantageous method of filing their taxes.
Simplified Tax Reporting
When you file as a disregarded entity, you don’t need to file two separate tax returns. Some people have special reasons or unique circumstances that may make it more worthwhile for them to file separate tax paperwork for their business entity, but those who don’t would often prefer to save the effort. “This can also save money on fees paid to an accountant or CPA to prepare the taxes by creating less work for them,” highlights Taylor Fike, Partner at Fike Advisors and Expert Contributor for Mosey.
Limited Liability Protection
When you are a sole proprietor, your sole proprietorship is responsible for everything you do. As a qualified LLC, you are only recognized as a disregarded entity for the purposes of filing your taxes. Your entity still exists just like any other LLC when it comes to practical applications in the real world.
You’ll still be able to enjoy the protections that come with forming an LLC. The LLC will be regarded as a separate entity for the purposes of debts, legal responsibilities, and other liabilities. Your LLC serves as a barrier between your personal finances and your business finances, helping to insulate you from most types of business-related harm. “Be aware,” says Fike, “This does not limit your liability in any criminal actions or tax fraud. If you are reporting your business tax information on your personal tax return, it is important to be accurate to the best of your knowledge regardless of your limited liability.”
Flexibility in Business Operations
Forming a single-member LLC affords you with more options, flexibility, and privacy. You don’t need to consult with anyone when you make business decisions, but you’ll still have the same options and protections that you would if your LLC was owned by a partner or a team. An LLC is offered plenty of choices, and those choices are exclusively yours to make.
What Are the Disadvantages of Being a Disregarded Entity?
That said, being a disregarded entity can have certain downsides as well — and staying aware of these potential pitfalls can help you make the best choice for your business.
Hinders Business Growth and Expansion
One person is only capable of completing so much work and earning so much income without the assistance of other people. The advantage of having a multiple-member LLC or a partnership is that someone else is there to share responsibility and divide the workload.
Becoming a single-member LLC may hinder your potential to grow or expand your business. This may not be an issue if you’re content with keeping things smaller in scale and assuming all of the responsibilities that come with running a single-member business. If your sights are set higher, you may want to consider possible limits to your growth you may encounter by choosing to operate as a solo venture.
Personal Liability for Business Debts
It’s very rare that the owner of a single-member LLC can be held personally liable for business debts, but it’s still possible. A creditor or petitioner can bring a debt case or lawsuit into court and argue for “piercing the corporate veil,” which means they feel it’s legally necessary to reach through the protections of an LLC and into its owner’s bank account.
In order to successfully seize your assets or finances in court, a plaintiff must demonstrate that your personal self and your LLC entity are one and the same. Alternatively, they would need to prove that you’re using your LLC to commit fraud or otherwise do harm to the public or to creditors.
General guidelines suggest that keeping LLC funds separate from personal funds by opening a business bank account is an efficient way to promote the idea of separation between an LLC and an individual. Compliance with local annual filing requirements may also help to demonstrate that you treat your SMLLC as a separate entity from yourself.
Difficulty Raising Capital
Many LLCs have trouble raising capital due to their smaller size and liability protections. It’s usually much easier for corporations to obtain loans or credit, especially if they’re larger and have a history of significant revenue. LLCs may have to turn to private investors who share their vision or want to invest in their community, and suitable investors can sometimes be difficult to find.
Potential for Self-Employment Taxes
Sole proprietorships and independent contractors are responsible for paying their own taxes. Even if you’re a disregarded entity, you may still have to pay self-employment taxes on income you earn as your only employee.
Navigate Compliance as a Disregarded Entity
As a disregarded entity, you’re solely responsible for the upkeep of your LLC. It’s important to run your single-member LLC the same way you would run an LLC with multiple members so that you can continue to enjoy the protections and opportunities provided by an LLC. Compliance is key to success.
Mosey’s business compliance platform makes it easy for businesses to keep track of important compliance issues, like taxes, licenses, and filing requirements. You have your hands full running your own solo business. Let Mosey’s automations work in the background to help you manage your compliance. Schedule a demo with Mosey to learn how we can help you help yourself.
