Exploring Wealth Strategies: What is a Disregarded Entity?

By Edward E. Fernandez | June 24, 2024

If your business is a disregarded entity, you can leverage asset protection and simplified tax filing. Plus, you can maximize tax efficiencies in both your business and investments.

Let’s explore the concept of a disregarded entity, its forms and intricacies, and the advantages and disadvantages it brings to your business structure. Start reaping the benefits from your business today. 

 

What Is a Disregarded Entity? 

The Internal Revenue Service (IRS) uses “disregarded entity” in the context of how they treat your taxes based on how you operate the business. It “disregards” a single-owner business entity for tax purposes—hence the term.

Here’s how the IRS describes the term “disregarded entity”:

A disregarded entity LLC with only one member is considered separate from its owner unless the owner treats the business as a corporation by filing Form 8832

A DE operates as a separate entity for legal purposes but not for tax purposes. While it remains distinct from its owner for employment tax and certain excise taxes, DEs do not file separate income tax returns. Instead, tax liabilities are reported on the owner’s federal income tax return.

The IRS disregards certain entities by default based on how taxes are treated and how the business operates. There are two components here:

  1. The entity of your business or how you operate it
  2. The tax implications

 

Business Types Considered Disregarded Entities

Let’s dive deep into the various types of businesses and why they fall under the “disregarded entities” category. You’ll find that the common thread among the business entities below is that they are all under a sole proprietor.

Single-Member Limited Liability Company (SMLLC)

SMLLCs are the most commonly disregarded entity for federal income tax purposes. As described above, SMLLCs are disregarded entities by default unless elected otherwise.

The IRS views SMLLCs as entities separate from their owners.

SMLLCs pay business taxes through the owner’s personal income tax return. This means the owner reports the business income and expenses on their federal income tax return through Schedule C. There are no separate returns between the owner and their business.

A disregarded entity is typically used to protect the personal assets of the owner of a single-member LLC while simplifying tax filings.

C Corporation

Typically, corporations and multi-member LLCs are not disregarded entities. However, exceptions exist.

If the corporation has a sole owner, it may be taxed as a separate legal entity. Hence, the owner may pay taxes through their personal income tax return or be taxed as a C corporation.

S Corporation

If the corporation satisfies specific requirements, it can also be taxed as an S corporation. S corps are recognized as pass-through entities, with the corporation’s taxable income, deductions, credits, and losses passing through individual shareholders’ personal tax returns.

S-Corp differs from C-Corps in that the latter are typically large companies and the former a sole proprietorship or small business.

Qualified Subchapter S Subsidiary

Qualified Subchapters (or QSubs) are subsidiary corporations wholly owned and successfully elected QSub status by an S corporation. A parent S corporation uses Form 8869 to elect one or more of its eligible subsidiaries to be treated as a QSub. 

As a QSub’s separate existence is disregarded, transactions between the S corporation parent and the QSub are disregarded. The subsidiary’s accumulated earnings and profits, passive investment income, and built-in gains are then treated as items of the parent corporation.

The QSub election effectively dissolves the QSub’s previous status as a distinct entity for federal tax purposes. Because of this, a final income tax return must be submitted. This typically encompasses the deemed liquidation transaction.

The IRS typically considers a QSub a disregarded entity. Refer to Secs. 1361(b)(3)(A)(i) and (ii). However, it is also authorized to treat it as a separate entity for certain purposes, such as the following:

  • Employment taxes
  • Certain federal liabilities, refunds, and credits of federal tax
  • Certain excise taxes

 

Why Disregarded Entities Matter

Many business owners leverage the concept of disregarded entity because of three things:

Asset Protection

Disregarded entities separate personal assets from business liabilities. This provides a layer of protection and shields an owner’s personal assets, such as property or savings, from liability and legal claims.

For instance, if someone sues a business or the company is liable for business debts, an LLC owner’s personal assets—their real estate properties, bank accounts, or car—are untouchable.

Simplified Tax Reporting and Compliance

Disregarded entities allow investors to streamline their tax filings. Business owners must only report their income, deductions, credits, and expenses under their personal tax returns.

Compare this to partnerships and corporations. Both involve separate tax returns and more paperwork.

Avoiding Double Taxation

A corporation is taxed on profits, and its shareholders are taxed on dividends received. A disregarded entity enables business profits and losses to flow through to shareholders’ individual tax returns, avoiding the need for separate business tax filings and the risk of double taxation. The latter avoids filing separate business tax returns and the risk of double taxation.

 

The Implications of Disregarded Entities 

Disregarded entities bring many benefits to the business and your investments. But it’s also vital to know their negative and positive implications for taxes, assets, and the business in general.

Tax Implications

  • Pass-through taxation. As mentioned earlier, a disregarded entity’s income and losses are reported on the owner’s personal tax return. This simplifies the tax obligations and avoids double taxation.
  • Treatment of income and losses. Investors can offset other income with losses from the disregarded entity, potentially reducing overall taxable income.
  • Employment and excise taxes. Owners of disregarded entities are subject to self-employment taxes on all income earned from the business. This necessitates payment of employee and employer portions of Medicare and Social Security taxes and payroll taxes. LLCs must also pay excise taxes. These can add up quickly and bring more complexities and obligations.  It’s advisable to seek advice from a tax professional to cover all aspects comprehensively.

Assets

  • Liability protection. Disregarded entities safeguard personal wealth from business-related liabilities by legally segregating business assets from personal ones.
  • Asset management. Effective utilization of disregarded entities facilitates improved asset management and protection, ensuring that real estate investments are insulated from personal financial risks.
  • Estate planning. Older investors can use disregarded entities to streamline estate planning. They can better facilitate asset transitions to heirs and avoid the complexities of probate.

Business and Planning

  • Structuring property investments. Disregarded entities provide a flexible framework for structuring real estate investments. It makes property management and planning for future growth or transitions easier.
  • Flexibility. Disregarded entities offer flexibility in ownership structure and tax filing options, making them a favored choice for small businesses and startups that may require restructuring in the future.
  • Limited options for expansion. A disregarded entity may not be the best option if business growth and expansion are your priorities. It can limit your ability to raise capital through issuing stock or taking on investors, which corporations can do. LLCs often encounter difficulties in capital-raising due to reliance on personal funds or member loans. Unless they have several sources of wealth, aggressive growth and expansion are harder to come by.

 

Key Considerations for Seasoned Investors

Seasoned investors contemplating the use of disregarded entities must consider the following:

Choosing the Appropriate Entity Structure

Assess your investment objectives and financial circumstances. Determine whether a single-member LLC or another disregarded entity suits your needs.

Consider the level of liability protection vis-a-vis your assets and real estate investments.

Understanding Tax Implications

Acquaint yourself with the tax implications. Understand how income, liabilities, credits, and losses will be treated. Review applicable state laws for your business.

Gauge the potential benefits of pass-through taxation and if it matches your circumstances. Stay informed about state-specific regulations and their potential impact on your tax responsibilities.

Seeking Professional Advice

Consult tax advisors and legal professionals to ensure compliance with federal tax filings and state tax laws. Remember to discuss how you can optimize the tax efficiency for your business and investments during this consultation.

 

Boost Investment Success with 1031 Crowdfunding

By understanding how disregarded entities simplify tax reporting, provide asset protection, and offer flexibility in ownership structures, entrepreneurs can strategize business structures that suit  their investment goals. 

To leverage these benefits, consider exploring disregarded entities for your LLC or small business. At 1031 Crowdfunding, we’ve assisted numerous business owners who are also investors in navigating disregarded entities, offering personalized guidance tailored to their needs. 

Elevate your investment success and financial security with 1031 Crowdfunding. Register for an account today and discover how we can support your journey.

 

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