If you are starting a company and thinking of forming a limited liability company (LLC), you may have heard the term “disregarded entity”. For federal tax purposes, the IRS considers a single-member LLC with no employees a disregarded entity.
An LLC is a business entity that offers liability protection for owners, as well as pass-through taxation, much like a sole proprietorship. To learn more, read this Step By Step article on LLCs.
How LLCs are Taxed
LLCs are unique in terms of taxation as their owners have a choice about how the company will be taxed. By default, an LLC is taxed like a sole proprietorship if it has one member and a partnership if it has more than one member. If it has no employees, a single-member LLC is considered a disregarded entity by the IRS for federal tax purposes. There is no federal tax form to file for a disregarded entity.
In both cases, business income “passes through” to the members, while profits and losses are reported on their individual tax returns. The LLC itself is not taxed, which simplifies the process for members. Also, losses and operating costs of the business can be deducted personally by the members. Taxes are paid at the personal tax rate of the members, although the owners may also have to pay self-employment taxes.
Note that a multi-member LLC must also file form 1065 with the IRS, which is the U.S. Return of Partnership Income. Attached to this will be K-1 forms for each member, showing their share of the business income.
But LLCs owners can instead choose to be taxed as a corporation. To do so, the LLC must file a document, referred to as an election, with the IRS. The LLC must then decide if it wishes to be taxed as an S corporation or a C corporation.
C Corp status means profits are taxed at the current rate for corporations (21% as of early 2022), which is significantly lower than the typical individual taxpayer rate. But keep in mind, C Corp shareholders, which includes members, must also pay taxes on their distributions (but not self-employment taxes). Thus, the C Corp is subject to what is sometimes referred to as double taxation.
As with sole proprietorship and partnership status, S Corp taxation considers the LLC a pass-through entity, which means income passes through the company and into the hands of the owners. At this point, taxes are applied at the same rate as those of individual taxpayers.
S-Corps use Form 1120S to file their taxes, which is used to report the income, losses, and dividends of S corporation shareholders. S-Corp shareholders do not pay self-employment taxes, which is the primary advantage of S-Corp status compared to sole proprietorship or partnership.
The answer to the original question is that a disregarded entity LLC is simply an LLC with only one member and no employees. Such an LLC is disregarded by the IRS for federal tax purposes, and there is no form to file for the business at tax time. You will report income or losses on your personal tax return on a Schedule C. Still, before you form an LLC, it’s a good idea to get the advice of a tax advisor to determine if it’s the right business structure for you, and which tax status you should choose. You can learn more from this Step By Step article on starting an LLC.