Disregarded entity: Overview, definition, and example
What is a disregarded entity?
A disregarded entity is a business structure that is legally separate from its owner for liability purposes but is treated as part of the owner’s personal tax return. In other words, for tax purposes, the income and expenses of the disregarded entity are reported directly on the owner’s tax return, rather than filing a separate return for the entity. The most common example of a disregarded entity is a single-member limited liability company (LLC), where the LLC is considered a separate legal entity for legal and liability purposes, but its profits and losses are passed through to the owner for tax purposes.
For tax purposes, disregarded entities are treated as "transparent," meaning that the IRS does not recognize the entity as separate from the owner. Instead, the owner reports the business’s earnings, deductions, and credits on their individual tax return. This can simplify the tax filing process and reduce the need for separate corporate tax filings.
Why is a disregarded entity important?
A disregarded entity is important because it offers the liability protection of a separate legal entity (such as an LLC) while allowing for simplified tax reporting. For business owners, this means they can protect their personal assets from business liabilities while avoiding the complexity of corporate taxation.
Additionally, disregarded entities can be beneficial for sole proprietors or individuals who want to limit their liability without the administrative burden of filing separate business taxes. By having the option to pass profits and losses directly through to the individual’s tax return, owners may reduce their tax filing workload and save on associated costs.
Understanding disregarded entity through an example
Imagine a person named John who operates a small consulting business and decides to form a single-member LLC for legal and liability protection. John's LLC is a disregarded entity, so instead of filing a separate corporate tax return for the LLC, he reports the income, deductions, and expenses from the LLC on his personal tax return (Form 1040) using a Schedule C.
John's LLC protects him from personal liability in case of business debts or lawsuits, but for tax purposes, the IRS treats the LLC's income as his personal income. If the business earns $50,000 in profit, John will report that $50,000 on his personal tax return, and he will be taxed based on his personal income tax bracket, without the need for a separate business tax return.
In another example, a real estate investor forms an LLC to hold rental properties. The LLC is a disregarded entity, and the investor reports rental income, deductions, and depreciation on their personal tax return. The legal structure of the LLC helps protect the investor from personal liability for the property-related issues, but for tax purposes, the income is passed through directly to the investor’s personal return.
An example of a disregarded entity clause
Here’s how a disregarded entity clause might appear in a business agreement or contract:
"The Company is a disregarded entity for tax purposes, and as such, the income, expenses, and liabilities of the Company will be reported on the Owner's personal tax return. For all legal purposes, the Company is a separate entity from the Owner; however, for tax purposes, the Owner will treat the Company as a sole proprietorship."
Conclusion
A disregarded entity is a business structure that provides the benefits of limited liability while simplifying the tax reporting process. By allowing the income and expenses of the business to be reported on the owner’s personal tax return, disregarded entities reduce the need for separate tax filings, making them particularly appealing to small business owners, sole proprietors, and individuals who want to protect their personal assets without the complexity of corporate taxation. Understanding the implications of disregarded entity status helps business owners make informed decisions about their business structure and tax filings.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.