Federal Tax Treatment of Disregarded Entities

A disregarded entity is a business structure that is separate from its owner for legal liability purposes but is not treated as a separate entity for federal income tax. The Internal Revenue Service (IRS) ignores the business’s separate existence for income taxes, meaning its profits and losses are reported directly on the owner’s tax return. This simplifies tax filing, as a separate business income tax return is not required. While state law may grant the entity a distinct legal identity and a liability shield, federal tax law merges the entity with its owner for income reporting.

Types of Disregarded Entities

The most common type of disregarded entity is the single-member limited liability company (SMLLC). When an LLC has only one owner, the IRS automatically classifies it as a disregarded entity by default. This structure provides the owner with limited liability protection, meaning their personal assets are generally shielded from business debts and lawsuits, while the business’s income is passed through to the owner for tax purposes.

Less common structures can also be treated as disregarded entities. A Qualified Subchapter S Subsidiary (QSub) is a corporation that is 100% owned by a parent S corporation that has elected to treat the subsidiary as a disregarded entity. Another example is a Qualified REIT Subsidiary, which is wholly owned by a Real Estate Investment Trust (REIT). In these cases, the subsidiary’s assets, liabilities, and income are treated as belonging to the parent entity for federal tax purposes.

Federal Income Tax Reporting

The method for reporting a disregarded entity’s financial activities for federal income tax purposes depends on the type of owner. The specific forms used for this reporting vary based on whether the owner is an individual, a corporation, or a partnership.

When the owner of a disregarded entity is an individual, the business’s income and expenses are reported on Schedule C (Form 1040), Profit or Loss from Business. This schedule is filed along with the owner’s personal Form 1040. The resulting net profit or loss is then carried over to the owner’s personal tax return. The owner is also responsible for paying self-employment taxes on the net profit calculated on Schedule C.

If a corporation owns a disregarded entity, the entity’s financial activities are treated as if they were conducted by a division of the parent corporation. All of the disregarded entity’s income, deductions, and losses are included directly on the parent corporation’s income tax return, such as Form 1120 for a C corporation. The financial data is simply consolidated into the parent’s overall reporting.

When a partnership is the owner of a disregarded entity, the entity’s operations are reported as part of the parent partnership’s return on Form 1065, U.S. Return of Partnership Income. The disregarded entity’s income and expenses are merged with the partnership’s other business activities. The combined financial results are then allocated among the partners. Each partner subsequently receives a Schedule K-1 detailing their share of the partnership’s tax items to report on their own tax returns.

Employment and Excise Tax Obligations

While a disregarded entity is ignored for federal income tax, this treatment does not extend to all federal taxes. For federal employment taxes—including Social Security, Medicare (FICA), and federal unemployment (FUTA)—the entity is treated as separate from its owner. The disregarded entity itself, not the owner, is liable for these taxes on wages paid to its employees.

A disregarded entity must have its own Employer Identification Number (EIN) if it has employees or is liable for federal excise taxes. If it has no such obligations, it should use the owner’s Taxpayer Identification Number (TIN) for federal tax purposes, though an EIN may be needed for other reasons, like opening a bank account. The entity must use its EIN to file employment tax returns, like Form 941 and Form 940, and to report and pay any applicable excise taxes.

Electing Entity Classification

The IRS establishes default tax classifications for business entities. An LLC with a single member is, by default, a disregarded entity, while an LLC with two or more members is classified as a partnership. A corporation is taxed as a separate entity by default.

Business owners have the option to change their entity’s default tax classification by making a formal election by filing Form 8832, Entity Classification Election. This form allows an eligible entity, such as an LLC, to choose how it will be treated for federal tax purposes. For instance, a single-member LLC can use Form 8832 to elect to be taxed as a corporation instead of being a disregarded entity.

Completing Form 8832 requires specific information about the business. The filer must provide the entity’s legal name, address, and its Employer Identification Number (EIN). The form also requires the filer to specify the type of election being made, the tax year it should become effective, and consent from the owner.