What Is a Disregarded Entity LLC?

By Tom Speranza, J.D.

What Is a Disregarded Entity LLC?

By Tom Speranza, J.D.

A limited liability company (LLC) is a business entity that provides its owners, called members, with the liability protections of a corporation and the ability to structure ownership interests and management rights with the flexibility of a partnership. If an LLC meets certain requirements it qualifies as a disregarded entity by the U.S. Internal Revenue Service (IRS), meaning it is taxed like a sole proprietorship and is not required to file its own tax return.

Man in suit looking over documents in office

Most LLCs are taxed as partnerships, meaning that they allocate their income and losses to the members, who include such items on their personal tax returns. An LLC taxed as a partnership files its own federal tax return, called U.S. Return of Partnership Income (Form 1065), but does not pay tax separately as an entity—the members pay the required taxes.

LLCs That Qualify as a Disregarded Entity

To be a disregarded entity, an LLC must pass two tests:

  • It has one owner, meaning that it's a single-member company.
  • It has not filed an Entity Classification Election (Form 8832) to be taxed as a corporation.

If an LLC fails either of these tests, it is not a disregarded entity:

  • If a limited liability company has more than one owner, it is a partnership by default unless it elects corporation tax treatment. Both partnerships and corporations file their own tax returns and are therefore not disregarded entities.
  • If a single-member company files Form 8832 to elect either C corporation or S corporation tax treatment, it is no longer a disregarded entity because corporations must file separate tax returns.

Tax Implications of Owning a Disregarded Entity LLC

A disregarded entity is a sole proprietorship for tax purposes. The member reports the LLC's income, loss, and expenses on their individual tax return using Profit or Loss From Business (Form 1040, Schedule C) or Net Profit From Business (Form 1040, Schedule C-EZ) and, to the extent applicable, Supplemental Income and Loss (Form 1040, Schedule E) and Profit or Loss From Farming (Form 1040, Schedule F).

The member cannot legally be an employee of a disregarded entity, so they must file Self-Employment Tax (Form 1040, Schedule SE) with their annual return to report self-employment income and pay the 15.3 percent self-employment tax on the LLC's net income.

The member must also make quarterly estimated tax payments using Estimated Tax (Form 1040-ES).

Deducting Disregarded Entity Losses and Expenses from Nonbusiness Income

One of the advantages of a sole proprietorship is that the owner can usually deduct business-related expenses and operating losses from the other income declared on the owner's personal tax return, including a spouse's income if the owner and spouse file a joint return. But the IRS imposes various limitations on the ability to offset personal income with business expenses and losses. For example, an owner must "materially participate" in the business to deduct its expenses and losses. One test for material participation is working at least 500 hours in the business during the year. In addition, certain business activity, such as owning rental properties, is usually considered "passive" by the IRS, which means that the expenses and loss can only be deducted from business income, not personal income.

The IRS regulations on offsetting personal income are detailed and complicated, so it makes sense to consult an accountant for help if you're having trouble determining whether your tax return is fully compliant.

If you are a sole proprietor, you may be able to form a single-member LLC that qualifies as a disregarded entity. If you do so, you'll need to become familiar with the tax forms and implications required to maintain disregarded entity status.

This portion of the site is for informational purposes only. The content is not legal advice. The statements and opinions are the expression of author, not LegalZoom, and have not been evaluated by LegalZoom for accuracy, completeness, or changes in the law.