If you are self-employed, you may have heard the term “disregarded entity.” It may sound mysterious and complicated, but in reality it’s a simple concept. A disregarded entity is a business entity with 1 owner; the IRS does not recognize that business as separate from its owner. To be clear: the business, even if it is “disregarded,” is still actually separate from its owner for liability purposes. But the owner does not file a separate tax return for the business.
What are some examples of disregarded entities?
A disregarded entity can be 1 of 2 things: a single member limited liability company (SMLLC) or an S corporation (S corp).
A limited liability company, or LLC, is a small, closely held company, usually owned by 1 or 2 people. The LLC designation allows the owners to separate their business’s liability from their own personal liability. SMLLC simply means that the LLC has a single member. In other words, the company has only 1 owner. For example, a self-employed entrepreneur— like a photographer or a freelance journalist — might choose to register their “business” as a single member limited liability company (SMLLC). They’ve now structured their work under the mantle of a company, thereby separating their liability. So if a SMLLC business gets sued, the owner might lose the money they’ve invested in the business, but they can’t lose personal property such as their home. But when tax time rolls around, that company is disregarded, and all of the income it generates is considered the income of the owner. For this reason, the SMLLC does not file a separate tax return. Instead, the owner reports all of the company’s income and loss on their own income tax return.
An S corp is a closely held corporation that chooses to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. This means that they pass on all of their income and losses to their shareholders, and have no income or losses themselves. If the S Corp has only 1 shareholder, then it can be a disregarded entity. Here are the requirements for S Corp status:
- The company has to be a domestic corporation (based in the United States).
- The shareholders have to meet certain guidelines:
- They can be individuals, certain trusts, and estates
- They cannot be partnerships, corporations, or non-resident alien shareholders
- If the S Corp is to be a disregarded entity, it has to have only 1 shareholder
- For S Corp status alone, without disregarded entity, they can have up to 100 shareholders
- They can only have 1 class of stock
- Certain types of corporations are not allowed, like financial institutions, insurance companies, and domestic international sales corporations
What do the tax returns look like for the owner of a disregarded entity?
SMLLCs and S Corps get to choose whether or not they want to file as a disregarded entity. They can choose to file in another way as well. But for our purposes, we’re going to focus on filing as a disregarded entity.
If you as an individual person own an SMLLC, then you essentially file taxes in the same way you would do for a sole proprietorship. You report the SMLLC’s income and loss on your Form 1040, U.S. Individual Income Tax Return. The only difference is that you would have to report those numbers using Schedule C and attach it to your return. However, if a corporation owns the SMLLC, then that corporation would report the SMLLC’s income and loss on their Form 1120, U.S. Corporation Income Tax Return. It’s a lot like filing taxes for a corporate branch or division.
If you own an S Corp, then the process for filing taxes is also similar to filing for a branch or division of your company. The only difference is in the form you use. In this case, it’s Form 1120S. Simply put, for federal tax purposes, the SMLLC or the S Corp does not exist. The IRS treats all of the assets, income, losses, and liabilities as if they belong to the owner of the disregarded entity. However, it’s important to remember that even though a disregarded entity doesn’t “exist” to the IRS, it doesn’t work that way with other state and federal laws. For example, if you have employees, you still have to follow employment laws and withhold income and payroll taxes. We hope this clears up some of the confusion surrounding disregarded entities. Do you have other questions? Just ask! We might address them in a future blog post.