If you’ve started a business on your own and have yet to form a business entity, you’re operating as a sole proprietorship. If you’ve formed an LLC and you are the only owner, or member, you’re operating as a single-member LLC. In both cases, your business is a disregarded entity in the eyes of the IRS.
But what exactly does that mean? Keep on reading to learn all you need to know about disregarded identities and how it might impact your business.
Disregarded Entity Status
As a single-member LLC or a sole proprietorship, the Internal Revenue Service views your business as a disregarded entity by default. This means that the business is not taxed and need not file a tax return. It also doesn’t need to have an employer identification number (EIN), unless you hire employees.
An EIN is like a social security number for your business and is used by the IRS to identify your LLC. If your business is a disregarded entity with no employees, your social security number can be used for tax purposes.
Taxation of Single-Member LLCs
A single-member LLC is taxed, by default, as a sole proprietorship, which is a disregarded entity and, again, is not taxed. Profits and losses pass through to you, as the sole member, to be reported on your personal tax returns on Schedule C. You’ll pay taxes on profits at your personal income tax rate.
You’ll also, however, be responsible for paying self-employment taxes, which fund Social Security and Medicare. The current self-employment tax rate is 15.3%.
Advantages of a Disregarded Entity
A disregarded entity has a few advantages.
1. Simple tax filing
A disregarded entity does not need to file a tax return. Profits and losses are reported on the business owner’s personal tax return. It’s a very straightforward form of taxation. You also do not have to file a state tax return for your LLC.
2. Pass through taxation
Disregarded entities are not taxed. Profits and losses pass through to the owner to be reported on their personal tax return. This is in contrast to a corporation, which is taxed at the corporate tax rate. Your corporate salary is also taxed, as are any dividends you receive.
3. Personal liability protection
As a single-member LLC, even though you are a disregarded entity, you still have personal liability protection because you and the LLC are separate entities. This is in contrast to a sole proprietorship, which is also a disregarded entity but does not offer personal liability protection. In a sole proprietorship, you and the business are legally one and the same.
Disadvantages of a Disregarded Entity
A disregarded entity has a few drawbacks as well.
1. Self-employment taxes
As mentioned, as a single member LLC, you’re responsible for self-employment taxes on the profits of the business. However, at some point, you can avoid some self-employment taxes by electing to have your LLC taxed as an S-Corporation. Generally, when you get to a certain level of profit, this can be advantageous. It’s best to speak with a tax advisor to find out when and if this might be right for you.
2. Difficulty raising investor capital
Investors are hesitant to invest in single-member LLCs, mainly because ownership is difficult to transfer. On the other hand, shares are easily transferrable as a corporation.
As a single-member LLC, you have the advantage of choosing to keep your disregarded entity status or electing to be taxed as a corporation. Complex calculations are involved in selecting the best tax status for your LLC, so consult your tax advisor to make the right choice for you and your business.