A disregarded entity is a business entity that is separate from its owner but which elects to be disregarded as separate from the business owner for federal tax purposes. The IRS says,
"If a “disregarded entity” is owned by an individual, it is treated as a sole proprietor. If the “disregarded entity” is owned any any other entity, it is treated as a branch or division of its owner."
The Internal Revenue Code (the regulations governing federal taxes) states that a business entity is a corporation by default. If the entity is not a corporation it is an "eligible entity" and it can elect its classification for federal tax purposes. The Code says, "an eligible entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner." The only business type that fits all the qualifications to be a disregarded entity is a single-member LLC. (SMLLC).
Read more about business types and the disregarded entity, to understand why the Single-member LLC is the only disregarded entity.
A sole proprietorship is not a disregarded entity, because the business is not separate from the owner.
The IRS says, "An SMLLC that does not elect to be a corporation will be classified by the existing federal guidance as a "disregarded entity" which is taxed as a sole proprietor for income tax purposes." So, basically any SMLLC that is not taxed as a corporation is a disregarded entity for tax purposes. That is, the SMLLC is taxed as a sole proprietor. But here's where the confusion comes in: A sole proprietor is NOT a disregarded entity, because the company is not separate from the owner.
The relevant term in the previous paragraph is "taxed as." A sole proprietor files business taxes using Schedule C, and the profit/loss from the Schedule C is included with the individual income tax return. So a Single-Member LLC "taxed as" a sole proprietorship files a Schedule C.
A Single-Member LLC doesn't need to do anything to "elect" to be a disregarded entity, even though it does sound like that. The SMLLC just needs to file its business taxes on Schedule C." The alternative, which is for the SMLLC to be considered an association and taxed as a corporation, is that the SMLLC must file Form 8832 - Entity Classification Election(PDF). Read more about filing an entity election for an LLC.
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.