A disregarded entity is a business that is not recognized as a distinct legal entity by the Internal Revenue Service. This means that the business will not be taxed as a separate entity, and all of its assets and liabilities will be attributed to its owner.
A disregarded entity can be either a sole proprietorship or a limited liability company (LLC) that is wholly owned by a single individual or by another LLC.
The term "disregarded entity" is not used in the Internal Revenue Code or IRS publications. In some tax forms and instructions, however, notably in Form 2553 and Form 8832, the IRS uses the word.
Which Companies Fit the Definition of a Disregarded Entity?
A single-member LLC, which is owned by one person and isn't treated as a separate entity from that person, is the most typical kind of disregarded entity.
Other types of businesses that can be treated as disregarded entities include certain qualified subchapter S corporations and certain partnerships.
Certain types of trusts can also be disregarded by the IRS for tax purposes. These trusts are typically used for estate planning purposes, and the IRS does not tax the trust itself, but the owner is still responsible for paying taxes on any income generated by the trust.
The main advantage of a disregarded entity is that it makes tax reporting easier. There is no need to file a separate return for the company since the owner's personal tax return includes information about the firm's revenue and spending. The owner may end up saving both time and money.
Being a disregarded entity also has the benefit of exempting the company from paying corporate income taxes. By consolidating all the business's assets and liabilities into one entity, the business can reduce its overall tax burden.
This might be a huge benefit for small firms. It will also benefit businesses that have multiple owners or complex ownership structures.
Problems of Being a Disregarded Entity
There are some disadvantages to being a disregarded entity, as well. For instance, the business's proprietor is personally liable for all of the enterprise's debts and liabilities. This implies that the owner's personal assets are in jeopardy if the company is sued.
Another downside is that the business owner cannot take advantage of certain tax deductions and credits that are available to corporations.
For instance, the business owner cannot deduct the cost of health insurance premiums paid for himself or herself and his employees.
How to Convert a Disregarded Entity to a Corporation?
The process of converting a disregarded entity to a corporation varies depending on the state in which your business is registered.
You will need to file incorporation papers with the state, which will create a new corporation. You will then need to transfer all assets and liabilities of the business to the new corporation. Once the transfer is complete, the disregarded entity will be dissolved.
If you have employees, you will need to obtain workers' compensation and unemployment insurance for the corporation. You will also need to obtain a new business license and permit, as well as a new business bank account.
Why Would You Do That?
There are a few reasons why you might want to dissolve a disregarded entity:
To gain personal liability protection. Converting to a corporation can protect your personal assets from business liabilities.
To raise capital. Investors are typically more willing to invest in a corporation than in a sole proprietorship or LLC.
To establish your business as a separate entity. This can make it easier to get business licenses, open a current account, and establish business credit.
Overall, whether being a disregarded entity is right for your business depends on your specific situation. You should consult with a tax advisor to see if this status is right for you.