Starting a business involves making many decisions, including choosing the legal structure. One option is a disregarded entity, which isn’t recognized for corparate tax purposes. This means the owner reports the business’s income and expenses on their personal tax return, like a sole proprietorship.

What is a Pass-Through Entity?

A pass-through entity is a business entity that does not pay taxes on its income. Instead, the income “passes through” the business to its owners, who report it on their personal tax returns. Examples of pass-through entities include partnerships, LLCs, and S corporations.

What is the Difference Between a Pass-Through Entity and Disregarded Entity?

Even that pass-through entities and disregarded entities are both classified as flow-through entities for tax purposes. There are some key differences between the two:

A pass-through entity is a business entity that does not pay income taxes at the entity level. Instead, the income, deductions, and credits of the business are passed through to the owners, who report them on their individual tax returns. Examples of pass-through entities include partnerships, S corporations, and certain types of LLCs.

On the other hand, a disregarded entity is a business entity that is not recognized as a separate legal entity from its owner for tax purposes. Instead, the business’s income, deductions, and credits are reported on the owner’s individual tax return. The most common type of disregarded entity is a single-member LLC.

What are the Pros of Disregarded Entity?

There are several pros of being a disregarded entity:

Simple Tax Filing

One of the most significant benefits of being a disregarded entity is simple tax filing. As mentioned before, the owner can report the business’s income and expenses on their personal tax return. This eliminates the need for a separate tax return for the business, saving time and money.

Flow-Through Taxation

As a pass-through entity, disregarded entities offers flow-through taxation. This means that the business’s income and losses are passed through to the owner. This can result in a lower overall tax burden. Because the owner only pays taxes on the net income of the business rather than on both the business’s income and their personal income.

What are the Cons of Disregarded Entity?

While there are many pros of disregarded entities, there are also some cons to consider:

No Partners

A con of disregarded entities is that it cannot have partners. If the owner wants to bring in new investors or partners, they must change the structure of the company.

Harder to Keep Track of Multiple Businesses

Another disadvantage of being a disregarded entity is that tax filing can become complicated if the owner has multiple businesses. Since all of the owner’s businesses are reported on their personal tax return, it can be challenging to keep track of everything and ensure that all income and expenses are properly reported.

Which Business Can Be A Disregarded Entity?

Not all businesses can be disregarded entities. Only certain types of business entities can elect to be disregarded for tax purposes, for example:

Single-Member LLCs: A single-member LLC is a business entity with one owner. It offers the same limited liability protection as a regular LLC. However, for tax purposes, the business is disregarded. The owner reports the business’s income and expenses on their personal tax return.

What is the Difference Between a Disregarded Entity and Sole Proprietorship?

A sole proprietorship is a business owned and operated by one person. Like a disregarded entity, the business is not recognized as a separate legal entity from the owner for tax purposes. However, there are some key differences:

    • Limited Liability Protection: While a disregarded entity offers limited liability protection, a sole proprietorship does not. This means that the owner’s personal assets are at risk if the business incurs debts or is sued.

    • Self-Employment Tax: Unlike a disregarded entity, a sole proprietorship is subject to self-employment tax on its net income. This can result in a higher overall tax burden for the owner.

    • Business Structure: A sole proprietorship is not a separate legal entity from its owner. In contrast, a disregarded entity is a separate legal entity that is disregarded for tax purposes.

How Does Disregarded Entity Tax Work?

Disregarded entity tax is a little different than a other business tax procedures. A disregarded entity does not pay taxes on its income. Instead, the owner reports the business’s income and expenses on their personal tax return using Schedule C (Form 1040). The net income from the business is then subject to self-employment tax and income tax.

If the owner has employees, the business will still need to pay payroll taxes and file employment tax returns. Disregarded entity owner should also file and pay state taxes depending on the their state.

Can Non Residents Have Disregarded Entities?

Yes, non-residents can have a disregarded entity in the United States. However, there are some additional considerations for non-resident owners:

    • EIN : Non residents will need to apply for an Employer Identification Number (EIN) from the IRS before they can start their business.

    • Disregarded Entity Tax Obligations: Non residents will still need to comply with all U.S. tax laws, including paying self-employment tax and filing tax returns.

    • Business Licenses and Permits: Non residents may need to obtain business licenses and permits in state and federal levels if their industry requires them to do so.

Does a Disregarded Entity Need an EIN?

EIN stands for employer identification number. A disregarded entity is not required to have its own EIN unless it has employees or meets other specific requirements. Instead, the owner can use their personal Social Security Number (SSN) for tax purposes. However, there are some situations where a disregarded entity may need to obtain its own EIN, such as:

    • Opening a Bank Account: Many banks require businesses to have an EIN before they can open a business bank account.

    • Business License or Permit: Some states require businesses to have an EIN before they can obtain certain licenses or permits.

How to Become a Disregarded Entity?

To become a disregarded entity, a business owner must choose a business structure that is eligible for the status. Single member LLC is the most popular choice for the disregarded entities. Then, the owner make the business be treated as a disregarded entity by filing Form 8832 with the IRS.

You should fill the Form 8832 within 75 days of the business’s formation or within 75 days of the start of the new tax year. Once the election is made, it will remain in effect until the owner chooses to change the business’s tax classification.

If you need help with filing Form 8832 feel free to contact us. Our representatives are here for you!

Afterglow’s Final Word About Disregarded Entities

Not all businesses can be disregarded entities, and the requirements may vary depending on the business structure and industry. Additionally, non-resident owners may have additional considerations and requirements when creating a disregarded entity in the United States.

If you are considering forming your company and opting as a disregarded entity, it is important to consult with a tax professional or a business lawyer. This will ensure that you understand all of the benefits, risks, and compliance requirements associated with this business structure.