The type of business entity called a limited liability company, or LLC, is a creation of state law. Though LLCs have become commonplace, the IRS has not created a new category for these businesses, but has rather adapted existing tax categories for this new type of company. One of the primary benefits LLCs are intended to provide is the ability for business owners to report the company's profit or loss on their individual returns.
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A disregarded entity, also called a pass-through entity, is one that is distinct from its owner for some purposes, but not when it comes to taxes. Sole proprietorships and partnerships, for example, are disregarded entities because the owners of these corporations report the business's income on their personal tax returns. Corporations are generally an example of a business entity that is not disregarded -- except for S corps and REITs, a corporation generally pays taxes on its profits before distribution to shareholders.
Under the IRS rules, an LLC is classified by default as either a sole proprietorship, if it has only one member, or a partnership, if has more than one member. This means that most LLCs are disregarded entities for federal tax purposes. Nevertheless, an LLC can elect to be taxed as a corporation by filing Form 8832. Upon the effective date of the election, the company loses its status as a disregarded entity. An LLC that is taxed as a corporation, however, may qualify as an S corp, in which case it would again be a disregarded entity.
Effective 2009, the IRS has made some changes to the disregarded entity status of single member LLCs. While those being taxed as sole proprietorships continue to be disregarded entities for income tax purposes, the LLC is now the taxpayer for employment taxes and certain federal excise taxes such as alcohol, tobacco and firearms. This means the LLC will have to have an EIN and bank account in its own name if it is subject to these taxes.
One consequence of owning a disregarded entity LLC is that it most likely makes you liable for self-employment tax. In essence, however, this is only a shifting of what would ordinarily be the employer's share of Medicare and Social Security tax to the owner of the business. If you receive more than $400 from your disregarded entity LLC, you will have to pay self-employment tax on your personal Form 1040.
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