Advantages and Disadvantages of Being a Disregarded Entity

October 21, 2021
disregarded entity

If you’re unsure if you should be a disregarded entity, we’re here to help you decide. This article will define what it means to be a disregarded entity and share the advantages and disadvantages of being one.

Read on to learn more about disregarded entities to make your decision easier.

What Is a Disregarded Entity?

An entity is something that is separate or distinct. There are many types of business entities such as corporations, S-corporations, partnerships, limited liability companies, and more. These different business entities have different tax implications and pros and cons.

The most common type of disregarded entity is a single-member LLC (SMLLC). A disregarded entity is a business (with a sole owner) that is not separate from the owner for tax purposes. This means that the owner will pay the business taxes as a part of their personal income taxes. The IRS and states ignore disregarded entities for tax purposes even though it is separate from the owner. 

This results in business taxes being passed through to be filed with the owner’s income taxes. 

How To Start a Disregarded Entity

So, how do you set up a disregarded entity? There are no forms required to be considered a disregarded entity by the IRS. If you set up your single-member LLC, the IRS automatically sees you as a disregarded entity. 

You will need to set up an LLC following your state’s guidelines and pay any necessary fees. This may mean you need to draft articles of organization or an operating agreement depending on the state guidelines. To keep your limited liability protection, you need to have separate bank accounts for business and personal and keep finances distinct from one another.

Now that you understand what a disregarded entity is, we will discuss the pros and cons of this business structure and its tax implications.

Advantages of Being a Disregarded Entity

There are several advantages of being a disregarded entity that make it worthwhile for some business owners. Take a look at the pros below to see if you think it’s the right move for your business. 

Pass-Through Taxation

As a disregarded entity, your business’ taxes will pass through to your personal taxes. They will be reported on your personal tax return. This allows business owners to avoid double taxation. As a disregarded entity, business earnings are only taxed once. 

Simplified Tax Filing

One benefit of being a disregarded entity is the simplification of filing taxes. The state and IRS will ignore the business entity and look to the owner for taxation. This allows disregarded entities to skip over additional paperwork other business entities may have to file with their taxes.

A single-member disregarded entity LLC can claim business income on their personal taxes but still receive liability protection.

Limited Liability Protection

Another benefit of being a disregarded entity LLC is that the business owner gets limited liability protection. This means that, unlike sole proprietorships, disregarded entities have some liability protection. It limits the ability of courts and lawyers to go after the business owner’s assets. 

Single-member LLCs can be disregarded for tax purposes while maintaining liability protection. However, there are legalities that need to be met for liability protection. The requirements may depend on your state, but you must show your business is separate from personal assets. 

Disadvantages of Being a Disregarded Entity

Along with the advantages of being a disregarded entity come disadvantages. Here are some cons of disregarded entities below. 

Investor Hesitancy

One disadvantage of disregarded entities is that investors may be hesitant to invest in them. Disregarded entities are often viewed as less credible than corporations. Many investors prefer to only invest in C-corporations because they are able to issue different classes of stock. Single-member LLCs are not always able to get investors like other business structures do because of this hesitancy. Consider your business needs, and if investors are an important part of your business plan, you may want to consider another structure.

Self-Employment Taxes

Being a disregarded entity does not exempt business owners from self-employment taxes. Self-employment taxes are additional taxes paid on top of income taxes. The amount paid is deductible up to a maximum cap. 

We hope this guide has helped you understand what a disregarded entity is and whether or not it is the right fit for your business. We are not tax professionals. Speak to a tax professional for more information and insight before deciding on your business.

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