Defining "Disregarded Entity"
A disregarded entity is a business type that is separate from the owner for liability purposes, but it is the same as the owner for tax purposes. That is, it pays taxes through the owner's personal income tax return. So there are two pieces to the disregarded entity puzzle, both of which must be present:
- The business type is separate from the individual for liability purposes, and
- The business is taxed through the individual's personal tax return, on Schedule C.
Why Choose a Disregarded Entity
There are two reasons why a business may want to be considered as a disregarded entity: (1) To protect your personal assets from business bankruptcy or lawsuits, and (2) to save money on tax preparation by using the simple Schedule C form.
Are These Business Types Disregarded Entities?
Businesses are set up under state regulations, through the secretary of state for each state, and no state recognizes a "disregarded entity" as a business type. Look at each of the legal types of business to see how it compares to the requirements for a disregarded entity:
- Sole proprietorship, in which you and the business are the same entity. The sole prop is taxed on Schedule C, but there is no separate business entity to provide liability protection for you if the business can't pay its bills or gets sued. A sole proprietorship is NOT a disregarded entity. (You do not register a sole proprietorship with your state; you just need a local business license and possibly a fictitious name/dba statement).
- A single-member limited liability company (LLC) is a separate entity for liability purposes, registered with the state(s) where you are doing business, and the LLC taxes are figured on Schedule C. A single-member LLC IS a disregarded entity.
- A multiple-member LLC is registered with the state and this business type provides liability protection, but this entity pays income taxes as a partnership, so it is NOT a disregarded entity.
- A partnership, as noted above, is NOT a disregarded entity (including a limited partnership or limited liability partnership) because partnership taxes are not figured on Schedule C. (Read more about partnership taxes on How a Partnership Pays Income Tax.)
- A corporation is a separate business entity from the owners, providing liability protection, and it pays taxes on Form 1120, so a corporation is NOT a disregarded entity.
- A subchapter s corporation (s corporation), on the other hand, provides liability protection and it files an information return on Form 1120-S,. The owners are taxed on their personal income tax return, but not on Schedule C. An S corporation is NOTa disregarded entity.
What about Liability Issues for a Disregarded Entity?
A disregarded entity is considered the same entity as the owner for tax purposes, but not for liability purposes. For more information on this subject, read this article in which attorney Robert Warwick discusses disregarded entity tax and liability issues.