What Is a Disregarded Entity LLC?

If you run your own business and form a limited liability company (LLC), it will be a single-member LLC, as LLC owners are called members. You’ll be considered a disregarded entity if you don’t hire employees.

The IRS disregards the LLC as separate from the owner, which means the income, deductions, and credits of the LLC are reported on the owner’s personal tax return. This classification simplifies the tax filing process for single-member LLCs.

Pros of a Disregarded Entity for LLC

1. Simplified Tax Filing: Since the LLC’s income and expenses are reported on the owner’s personal tax return (Form 1040), it eliminates the need for a separate business tax return.
2. Pass-Through Taxation: Income is taxed only once at the owner’s personal tax rate, avoiding the double taxation faced by corporations.
3. Reduced Administrative Burden: Fewer formalities and paperwork are required compared to corporations, which need to file separate returns and maintain detailed records.
4. Flexibility: Owners can choose to change the tax status if the business grows, potentially electing to be taxed as a corporation later on.
5. Limited Liability Protection: Despite being disregarded for tax purposes, the LLC still provides legal protection, shielding the owner’s personal assets from business liabilities.

Cons of a Disregarded Entity for LLC

1. Self-Employment Taxes: Owners must pay self-employment taxes (Social Security and Medicare) on the LLC’s earnings, which can be higher than payroll taxes for employees of a corporation.
2. Perception Issues: Some partners, investors, or clients may view sole proprietorships or disregarded entities as less credible or less stable than corporations.
3. Limited Benefits: Owners may not have access to certain tax-advantaged benefits, like those available to corporation employees (e.g., retirement plans, health insurance).
4. State-Specific Rules: Some states impose additional taxes or fees on LLCs that could negate the simplicity and cost savings at the federal level.
5. Potential for Increased Liability: While personal assets are generally protected, the owner might still face liability if they do not properly separate personal and business finances or if they engage in fraudulent activities.

What’s the Difference Between a Disregarded Entity LLC and a Sole Proprietorship?

The default taxation of a single-member LLC as a sole proprietorship is the primary similarity between a disregarded entity LLC and a sole proprietorship, but several differences exist.

1. Entity Formation

A sole proprietorship does not require registration with the state. To start a sole proprietorship, you simply need to start doing business. There is no cost or paperwork.  

An LLC, on the other hand, requires filing articles of organization with your state. Then, depending on the state, you’ll be required to pay a fee ranging from $40 to $500. 

You’ll also need to appoint a registered agent for your business and include their information on the articles of organization, along with the business name, address, and other information. A registered agent is a person or company authorized to accept and respond to official correspondence on behalf of your business, such as legal, tax, or financial documents. 

As the sole member of the LLC, you can choose to be your registered agent, appoint another person, such as an attorney, or hire a registered agent service. 

2. Management

Single-member LLC and sole proprietorship owners have complete control of their business and can manage it any way they see fit. 

But with a single-member LLC, the LLC is its entity and can enter contracts, take on debt, and purchase property separately from its owner. This creates personal liability protection, as the obligations are on the LLC, not the member. 

With a sole proprietorship, you and the business are legally viewed as the same, so when you enter contracts or take on debt, the debt is yours, and you’re personally liable. 

3. Personal Liability Protection

Again, personal liability protection is the key difference between an LLC and a sole proprietorship. With an LLC, if the business cannot pay its debts or is sued, the member’s assets are generally not at risk.

In a sole proprietorship, if the business cannot pay obligations or is sued, the owner’s assets, including their home, are at risk since the business and the owner is legally the same.

4. Annual Requirements

A sole proprietorship does not have to file reports with the state. It may need to obtain and renew business licenses and permits, but no documents must be filed with the state for the business entity. 

On the other hand, an LLC must file annual or biennial reports in most states. These reports come with a fee, which varies by state.