What is a Disregarded Entity LLC?
A single-member LLC (SMLLC) is considered a disregarded entity by the IRS. This means that for federal tax purposes the LLC’s status is disregarded and the business is subject to pass-through taxation as if it were a sole proprietorship.
Despite being ignored by the federal government at tax time, all 50 states and Washington D.C. allow for LLCs to be formed with only a single member. As a result, they are recognized as a separate business entity from their owners when it comes to limited liability protection. In this way, they are no different from multi-member LLCs, which are protected like corporations, but taxed like partnerships.
Self-Employment Tax
The owner of an SMLLC is not considered an employee of the company. Rather than receiving a paycheck with income and payroll taxes deducted, SMLLC owners draw profits from their capital accounts. This money is not taxed at the time of withdrawal, but the owners are responsible for paying all applicable state and federal taxes on a quarterly basis.
In addition to income taxes, an SMLLC owner must pay self-employment tax to cover both the employee and employer share of Social Security and Medicare, also known as FICA taxes.
Every business is subject to FICA taxes on some portion of their profits. Currently, the FICA tax rate is 15.3%. In a business with employees, this tax is split between the employer and the employees. When you work for yourself, as the owners of SMLLCs do, you are responsible for the full 15.3%. The employer portion of this tax is deductible for income tax purposes.
For a more in-depth explanation, visit our guide to paying yourself as a disregarded entity LLC.
Taxing an SMLLC With Employees
One exception to the disregarded entity status given to SMLLCs by the federal government concerns businesses with employees. For the purposes of paying employment taxes—which cover all of the taxes deducted from your employees’ paychecks and paid to the federal government—the IRS considers an SMLLC a separate entity from its owner.
You will have to file and pay these taxes separately from your personal taxes using your company’s name and Employer Identification Number (EIN). This separate treatment also applies to certain excise taxes owed by your SMLLC.
For more information about your LLC's EIN requirement, visit our EIN for LLC guide.
Pros and Cons of a Disregarded Entity
Being a disregarded entity comes with both pros and cons. The major benefits of this status include:
- Pass-through taxation: As discussed above, disregarded entities are treated as sole proprietorships for tax purposes. This means all business earnings, losses, expenses, and credits pass through the company to the owner and are reported on their personal tax return. Not only does this make for simpler tax filing, it also avoids the double taxation some corporate profits experience.
- Liability Protection: Despite being disregarded by the IRS, SMLLCs are afforded all the same rights as multi-member LLCs and corporations when it comes to limited liability protections. In most cases, a business owner’s personal assets will be protected from legal action taken against the company.
- Flexibility: Another appealing feature of an SMLLC is its flexibility. While its disregarded entity status and pass-through taxation is the default setting for this business type, an SMLLC owner may also elect to be taxed as either an S corporation or a C corporation. Each classification comes with different tax structures and liabilities, giving a business owner the ability to choose which option is most financially beneficial to their business.
While an SMLLC is an extremely popular business structure, it is not right for everyone. Some disadvantages to consider include:
- Increased paperwork and formalities: If you are a sole proprietorship considering becoming an SMLLC with no employees, there will be added costs and more paperwork involved. Even as the sole owner of the LLC, you will have to strictly maintain a separation of all your business and personal assets and draft an operating agreement to outline how your business runs. There are also annual reporting requirements to follow and fees that must be paid to maintain your status.
- A thinner corporate veil: On paper, an SMLLC enjoys the same limited liability protection as a multi-member LLC. However, in practice, an SMLLC’s corporate veil has been easier to pierce. This means that the personal assets of SMLLC owners are more vulnerable in the event of legal action against a business. The reason for this is that it can be more difficult for SMLLC owners to maintain a clear separation between themselves and their businesses.
When is an Entity No Longer Disregarded?
An SMLLC can shed its disregarded entity status in a few different ways.
- It may elect to be taxed as a corporation.
- It may bring on at least one additional member to become a multi-member LLC.
- It may lose its status as an SMLLC, and thus a disregarded entity, if it fails to remain compliant with all state regulations governing this business type.
