After knowing what is an LLC, you might come across the term "disregarded entity LLC." This refers to a type of LLC not recognized as a separate legal entity for federal tax purposes by the Internal Revenue Service (IRS). Instead, all income and losses are passed through to the owner(s), who is responsible for reporting these items on their tax return.
In this article, I will dive deep into disregarded entity LLCs, explaining what they are, the benefits of forming one, and the circumstances under which you might choose to elect not to go for a disregarded entity.
Let's dive deep into this topic.
What Does LLC Disregarded Entity Mean?
LLC disregarded entity means that the LLC is not considered a separate entity for tax purposes. This means that all profits and losses of the LLC will be reported on its owner's tax returns.
LLC disregarded entities can provide many benefits, including simplicity and cost savings when compared to incorporating flexibility in choosing a business structure and the ability to pass through profits and losses to the owners. However, owners need to be aware of the potential risks associated with this type of entity before deciding if it is the right choice for their business.
Ultimately, each individual's situation should be evaluated on its own merits when choosing whether or not an LLC disregarded entity is suitable. Professional legal and tax advice can also help ensure that all necessary steps are taken when forming an LLC disregarded entity.
Is An LLC A Disregarded Entity By Default?
Knowing how to tell if an LLC is a disregarded entity is important.
By default, an LLC is a disregarded entity, meaning it does not have to file separate federal tax returns (outside informational filings for the IRS). However, if desired, an LLC can elect to be treated as a Corporation by filing Form 8832 with the IRS.
As part of learning how to start an LLC, you should understand the difference between a disregarded entity and a Corporation, as this will determine how you are taxed. With an LLC treated as a disregarded entity, there is no double taxation like with a Corporation. The profits of the LLC get "passed through" to the owners, known as "members," and they pay taxes on their respective shares of the earnings on their tax returns (Form 1040).
In contrast, if an LLC elects to be taxed as a Corporation, it must file its separate federal return and pay any applicable taxes. This means that not only would the owners need to file Form 1040 for their tax returns, but the LLC would also need to file Form 1120 and pay taxes on its profits. This type of tax treatment is called "double taxation" and can result in more complicated and costly filing requirements. Therefore, most LLCs opt to keep their disregarded entity status. This status applies for federal tax purposes.
State laws may also vary about how an LLC is treated and taxed. Depending on where your business is formed, you may be required to register your LLC with the state and file additional paperwork or pay specific fees. Additionally, suppose you will be doing business in multiple states. In that case, you should contact each state directly to determine what type of registration or paperwork must be filed there.
Single Member LLC Disregarded Entity: Pros And Cons
Let's explore the pros and cons of a disregarded LLC,
Let’s start with the good stuff.
The first significant pro of operating as a disregarded LLC is pass-through taxation. This means that all profits and losses are "passed through" the business to the owners of the LLC, who then report them on their tax returns. This can be incredibly beneficial for some businesses since it avoids having to pay taxes twice: once at the company level and again at the individual level.
Simpler Tax Filing
Another major pro is more straightforward tax filing. Since all income and expenses flow directly through to its owners, disregarded LLCs don't need to file separate corporate tax returns; instead, they only need to file an informational return with the IRS each year. This makes filing much simpler and less time-consuming than filing for a corporation.
Closing An LLC
Closing an LLC is often more straightforward than closing a corporation. With a disregarded LLC, you must file the appropriate paperwork with your state of formation to wind up the business. This makes it much easier to close a disregarded LLC than a traditional corporation, which typically requires more paperwork and time.
Liability Remains Separate
Finally, one major pro of running as a disregarded LLC is that its owners still benefit from limited liability protection. Although all profits and losses flow through directly to its owners, any debts or liabilities incurred by the business remain separate from the owner's assets; they are, therefore, not liable for any debts or judgments against the company. This is a great benefit, as it helps owners protect their assets while taking advantage of pass-through taxation.
Here are the cons involved in a disregarded LLC.
Disregarded Status Is Only For Federal Taxes
This type of entity does not protect from state taxes. Some states may require additional registration and filings to be eligible for disregarded status, and all applicable state taxes must still be paid.
Self-Employment Taxes Remain
Although the LLC is a disregarded entity, its members are still responsible for paying self-employment taxes on their income derived from the business. This means that while an owner can save time by avoiding double taxation of their profits, they will still need to make quarterly estimated tax payments or pay these taxes at the end of the year when filing their returns. Additionally, payroll taxes must be filed and paid each quarter if any employees are hired.
Disregarded Entity LLC- FAQ
Unless filing for an exception, by default, an LLC is considered a disregarded entity for federal income tax purposes. The status of an LLC as a disregarded entity will be indicated on the LLC's Form 1065, U.S. Return of Partnership Income, filed with the Internal Revenue Service (IRS).
A single member LLC is automatically a disregarded entity.
However, this is not always the case.
A single-member LLC is not disregarded when classified as a corporation, partnership, estate, or trust.
No, a multi-member LLC is not a disregarded entity. A multi-member LLC is considered a partnership for legal and tax purposes. The IRS taxes the income and profits of the business as a pass-through entity, meaning the income "passes through" directly to each member's tax return, which is then reported and taxed accordingly.
Paying yourself from an LLC as an owner is simple. As an LLC member, you can pay yourself through a distribution of profits or a salary determined by the operating agreement or state law. Distributions are taxed as ordinary income and should be reported on your tax return.
Furthermore, this requires that all revenues and expenses be appropriately documented and reported for taxes and accounting purposes. The salary should also be written as ordinary income and comply with IRS regulations. Since LLCs offer certain tax benefits, it's essential to understand the applicable laws to ensure taxes are paid accurately and on time. Having the right accountant can help ensure compliance with tax obligations so you can focus on growing your business.
The type of LLC license you need to operate in your state will depend on the type of business you're using. Each state has its regulations for businesses, and it's essential to check with your state's Secretary of State office or the appropriate licensing agency for the specific requirements.
A disregarded LLC provides a unique legal structure that can help business owners protect their assets and ensure the longevity of their businesses. It also has certain tax benefits, depending on the jurisdiction in which it is formed. Furthermore, disregarded LLCs may be a good option for businesses that prefer to remain small and only have one or two members who take part in ownership or management activities.
Despite these advantages, disregarded LLCs are unsuitable for all types of businesses as they can create challenges regarding taxes and accounting requirements. Ultimately, it is essential that business owners thoroughly research the laws applicable to their jurisdiction before deciding whether or not a disregarded LLC is right for them.