If your business structure is a single-member limited liability company (also known as a single-member LLC or SMLLC), the Internal Revenue Service (IRS), by default, categorizes your business as what’s called a “disregarded entity” for tax purposes.
But, as a business owner, you may have questions on what, exactly, that title means—and what it means for you as a taxpayer and for your personal income tax return. What, exactly, is a disregarded entity? How does it impact your tax treatment? And as the owner of a single-member limited liability company, is being taxed as a disregarded entity your only option—or is there a different way you can structure your business for income tax purposes?
What Is a Disregarded Entity?
When you’re running your own business, it makes total sense to structure it as a single-member LLC; establishing your business as a Limited Liability Company creates a separation between you, the person, and you, the business. This protects you from any personal liability should something happen in your business (for example, if a client or customer took legal action against you, if you were structured as a LLC, they couldn’t come after your personal assets—whereas if you didn’t have the liability protection a LLC offers, your assets could be at risk).
Even though, from a liability perspective, establishing a single-member LLC creates a separate entity for your business, from a tax perspective the IRS doesn’t always view SMLLCs as separate business entities; in fact, the IRS, by default, categorizes single-member limited liability companies as a disregarded entity—which means that the LLC is taxed like a sole proprietorship.
How Does Being Considered a Disregarded Entity Impact Your Tax Status?
Being categorized as a disregarded entity impacts the way you’re taxed in a few different ways, including:
- Disregarded entities don’t file separate business taxes. Because the single-member LLC isn’t considered a separate business entity, the business owner doesn’t need to file a separate income tax return for the business.
- Disregarded entities are subject to pass-through taxation. Because your business isn’t looked at as a separate entity, for tax purposes, any profits from your business will pass through to you—and you’ll report that income on your personal tax return.
- Disregarded entities are responsible for paying self-employment taxes. As mentioned, a disregarded entity is treated as a sole proprietorship by the IRS. And, just like a sole proprietor pays self-employment tax, so does a disregarded entity. SMLLCs that are categorized as disregarded entities must pay self-employment tax, which covers both Social Security and Medicare—and equates to 15.3 percent of your income (in addition to state and federal income tax).
In addition, depending on what type of business you run and who (if anyone) you end up hiring, as a disregarded entity, you may also be on the hook for additional taxes, like excise tax or payroll tax.
Pros and Cons of Being Categorized As a Disregarded Entity
Like any other business structure, there are pros and cons to being categorized as a disregarded entity.
But what, exactly, are those pros and cons?
- One tax return. As mentioned, if you’re considered a disregarded entity, when tax time rolls around, you only have to worry about filing one tax return—your personal tax return. Instead of filing a separate business tax return, you would just report all your business income and expenses on Schedule C of Form 1040, U.S. Individual Income Tax Return. Not only does this simplify the tax filing process, but if you work with a tax professional, filing a single tax return will be more cost effective than filing separate personal and business tax returns.
- No double taxation. C-Corporations have to deal with double taxation—which means that not only does the corporation have to pay corporate tax on any income, but once that income is distributed to shareholders, they also have to pay personal income tax. As a disregarded entity, you can avoid paying both corporate and personal tax—and only have to worry about paying personal tax on your LLC’s income.
- Self-employment taxes. As mentioned, when you’re a disregarded entity, you’re responsible for paying self-employment taxes—which consumes 15.3 percent of your income and is arguably the biggest drawback to the “disregarded entity LLC” categorization.
- Investment issues. A disregarded entity doesn’t have the same credibility as a corporation—which can make investors hesitant when you pitch them to invest in your company. If you’re planning on targeting investors at some point in the future, a disregarded entity status could end up holding you back from getting the capital you need to take your business to the next level.
Are There Alternatives to Being Classified As a Disregarded Entity For Federal Tax Purposes?
While the IRS, by default, categorizes single-member LLCs as disregarded entities, it’s not the only entity status option for your business. SMLLCs can also elect to be categorized as a corporation—with many businesses opting to be taxed as an S Corporation (or S Corp).
Being taxed as an S corp changes the structure of your business and how you’re taxed—and, in some situations, can lower your total taxes owed vs. if you stick with your disregarded entity status. If you’re thinking about categorizing your single-member LLC as an S corp, it’s important to talk to a tax professional; while there are certain tax benefits to being taxed as an S corporation (like avoiding self-employment taxes), you’ll also need to implement certain changes in your business (like implementing a payroll service and paying yourself a salary). A tax professional can advise you on the tax implications of changing your entity status, help you determine whether it’s the right fit for your business, and, if so, instruct you on how to file Form 2553 with the IRS and change your tax status.
Use the Entity Status That's the Best Fit for Your Business
As a single-member LLC, your business is automatically categorized as a disregarded entity by the IRS—and for many businesses, that structure is the most advantageous. But being a disregarded entity isn’t the only option—so if you’re concerned that your status is causing you to pay too much in taxes, talk to a tax professional to determine if another classification (like S Corp) could lower your tax burden—and allow you to pocket more of your business profits.