Can an S Corp Be a Disregarded Entity?

An S corporation cannot be a disregarded entity, as they are two distinct and mutually exclusive tax classifications. An S corporation is a tax status elected by a corporation, while a disregarded entity is a business structure ignored for tax purposes, with its financial activities reported by its owner. Confusion can arise because their paths intersect when a business owner wants the liability protection of a limited liability company (LLC) combined with the tax benefits of an S corp.

S Corporation Tax Status Explained

An S corporation is a federal tax election, not a legal business entity. To make this election, a business must first be structured as a corporation or an LLC under state law and then file Form 2553, Election by a Small Business Corporation, with the IRS. This status allows profits and losses to be passed directly to the owners’ personal tax returns, avoiding the double taxation that C corporations face.

The Internal Revenue Code sets eligibility requirements for S corporation status. A business must be a domestic corporation, have no more than 100 shareholders, and have only one class of stock. Its shareholders must be individuals, certain trusts, or estates, and they are required to be U.S. citizens or residents.

Partnerships and corporations are not permitted to be shareholders. Each year, the S corporation must file an informational tax return, Form 1120-S. The S corp must also provide each shareholder with a Schedule K-1, which details their share of the company’s income and deductions.

Disregarded Entity Status Explained

A disregarded entity is a business that is separate from its owner for legal liability but not for federal income tax purposes. The most common example is a single-member limited liability company (SMLLC) that has not elected to be taxed as a corporation. For tax purposes, the IRS ignores the entity’s separate existence and treats its financial activities as those of the owner.

The business itself does not file a separate federal income tax return; instead, all income, deductions, and credits are reported on the owner’s tax return. If the owner is an individual, this information is reported on Schedule C, Profit or Loss from Business, with their Form 1040. If the owner is another corporation, the activities are reported as a division of the parent corporation on its tax return. The entity is still recognized for employment tax purposes, even though it is disregarded for income tax.

The S Corp and Disregarded Entity Connection

The two concepts are distinct, but their paths can cross in two specific scenarios. The first connection is when a single-member LLC, which is by default a disregarded entity, elects to be taxed as an S corporation. By filing Form 2553, the SMLLC changes its federal tax classification from a disregarded entity to an S corporation. Legally, it remains an LLC under state law, providing liability protection. For tax purposes, it adheres to all S corp rules, including paying the owner a reasonable salary and passing through remaining profits as distributions.

The second connection occurs when an S corporation owns another business. An S corporation can own 100% of a subsidiary corporation and elect to treat it as a Qualified Subchapter S Subsidiary (QSub). This election, made using Form 8869, causes the subsidiary to become a disregarded entity for tax purposes. All of the QSub’s assets, liabilities, and financial activities are then treated as belonging to the parent S corporation and reported on the parent’s return.

Making the QSub Election

To make a QSub election, the parent S corporation must file Form 8869, Qualified Subchapter S Subsidiary Election, with the IRS. The following information is required for the form:

• Parent S corporation’s legal name and Employer Identification Number (EIN)
• Address where the parent’s most recent tax return was filed
• Subsidiary’s name and EIN
• Subsidiary’s date and state of incorporation

The form requires a desired effective date for the election, which cannot be more than two months and 15 days before the filing date or more than 12 months after. For a newly formed subsidiary, the parent can elect for the QSub status to be effective upon the date of formation. An authorized officer of the parent S corporation must sign and date the form.

Form 8869 is mailed to the IRS service center where the subsidiary filed its most recent tax return. If the subsidiary is newly formed and the election is effective upon formation, the form is sent to the service center where the parent S corporation filed its last return. There is currently no option for electronic filing. Following the election, a separate return for the subsidiary is no longer required as its financial activities are reported on the parent’s Form 1120-S.