How to Make a Disregarded Entity Election

A disregarded entity is a business structure the Internal Revenue Service (IRS) does not recognize as separate from its owner for federal income tax purposes. The most common example is a single-member limited liability company (SMLLC). By default, an SMLLC does not file its own federal income tax return; instead, all business profits and losses are reported on the owner’s personal tax return using Schedule C, Profit or Loss from Business.

Understanding the Default Tax Status

The net profit calculated on Schedule C flows to the owner’s personal tax return, is added to any other income, and is taxed at the owner’s individual income tax rates. A consequence of this arrangement is the application of self-employment taxes. The net profit from the business is subject to both Social Security and Medicare taxes, calculated on Schedule SE, Self-Employment Tax.

The self-employment tax rate is 15.3%, consisting of 12.4% for Social Security on earnings up to the annual limit and 2.9% for Medicare with no earnings limit. An additional Medicare tax of 0.9% may apply to earnings over certain thresholds. While disregarded for income tax, the business is still considered a separate entity for employment tax purposes if it has employees.

The Entity Classification Election

An eligible entity, such as an SMLLC, can change its default tax status by making an “entity classification election” with the IRS. This allows the owner to choose a tax structure that may be more financially advantageous for the business.

The two main alternatives are to be taxed as a C Corporation or as an S Corporation. Choosing to be taxed as a C Corporation means the business becomes a separate taxpaying entity. The corporation pays income tax on its profits at the corporate tax rate, and the owner pays income tax again on any dividends distributed from the corporation.

Electing to be taxed as an S Corporation also treats the business as a separate entity, but it is a pass-through entity for tax purposes. Profits and losses are passed through to the owner’s personal return, similar to the default status. An S Corp owner who works in the business can be paid a “reasonable salary” as an employee and can also receive distributions of profits that are not subject to self-employment taxes.

Information and Forms for the Election

To be taxed as a C Corporation, the business must file Form 8832, Entity Classification Election. To complete the form, you will need the business’s name, address, and Employer Identification Number (EIN). If the entity does not have an EIN, one must be obtained before submitting the form.

Form 8832 requires you to specify the desired classification and the election’s effective date, which cannot be more than 75 days prior to the filing date or more than 12 months after. The form also asks for the name and Social Security Number (SSN) or Taxpayer Identification Number (TIN) of the single owner.

For an S Corporation election, the process is more direct, requiring only Form 2553, Election by a Small Business Corporation. Filing Form 2553 is sufficient to elect S Corp status, and it is not necessary to file Form 8832 first. The IRS treats a timely filed Form 2553 as an election to be classified as a corporation for the S Corp election to be valid.

Form 2553 requires confirmation that the entity meets all eligibility rules, such as being a domestic corporation with no more than 100 shareholders and only one class of stock. You will also need to provide information for each shareholder, including their name, address, and consent signature.

Filing the Election Forms

When electing S Corporation status, Form 2553 must be filed no more than two months and 15 days after the beginning of the tax year the election is to take effect. For a newly formed business, this deadline is two months and 15 days from its date of formation.

If you miss these deadlines, the IRS provides procedures for late election relief. To qualify, you must demonstrate reasonable cause for failing to file on time and have acted consistently with the desired classification. This involves attaching a statement to the late-filed form explaining the reason for the delay.

The completed forms must be mailed to the IRS service center designated for your state, as listed in the form instructions. It is advisable to send the forms via certified mail to have proof of filing. After submission, the IRS will send a notification letter within 60 days confirming acceptance of the election. A copy of the filed election form should be attached to the entity’s first tax return filed under the new classification.