To incorporate, or not to incorporate? This is a consideration that many business owners will grapple with at some point in their company’s lifetime. As newly-created businesses grow and expand, so do their legal obligations, operational complexities, and financial requirements. In these instances, it’s often recommended that owners consider changing their business entity to accommodate their shifting needs.
So what exactly is incorporation? Incorporation of a business simply means registering it as an “LLC” or a “Corporation” with your state officials (LLCs and Corporations are different types of business entities; others include Sole Proprietorships, and General Partnerships).
Once the required documentation is submitted to the local Secretary of State’s office, they will review the forms and either accept or deny your request. If accepted, your business is considered “incorporated” and from thereon treated as its own legal entity distinct from its owners.
That last point is worth reiterating, as it’s oftentimes the primary reason why owners want to incorporate in the first place: once a business is incorporated, it’s treated as its own legal entity. In other words, an incorporated business will have its own bank accounts, tax responsibilities, legal representatives, debts, and other liabilities.
There are a number of consequences to treating a business as a separate entity. Two in-particular are worth mentioning:
- Separation of Personal and Business Liability
- Differential Tax Treatment
In regard to the Point #1, when an owner incorporates their business, they are legally distinguishing their personal assets from the assets of the company; business responsibilities like financial obligations, loans, legal claims, and other company debts are completely disjoint from owners’ personal accounts, essentially creating a protective barrier (sometimes called a corporate veil) for owners. Other types of entities like Sole Proprietorships are not eligible for this protection.
However, when we consider “Disregarded Entities” we’re more interested in Point #2: how are these incorporated businesses being taxed?
What is a Disregarded Entity?
To review, incorporated businesses (usually meaning LLCs and Corporations) are treated as separate legal entities with their own accounts and liabilities. Accordingly, these business entities are also responsible for filing their own income taxes as well.
An incorporated business is required to pay taxes on its income, which occurs before its owners receive their shares of the earnings. Often-times, that money is taxed again when owners’ file their personal income taxes. In these situations, revenue is getting taxed twice: first as business-income taxes from the business, then again as personal-income taxes from the owners. This is colloquially called “double-taxation” and is often unavoidable for incorporated businesses unless the company is a disregarded entity.
A disregarded entity is an incorporated business that is considered separate from the owner for liability purposes (Point #1 above) but is considered the same as the owner for tax purposes (Point #2). In other words, these entities are regarded as separate in terms of liability, but “disregarded” as separate in terms of taxation.
This may seem like a “best of both worlds” scenario for owners of disregarded entities, as they enjoy the liability protections associated with incorporation, while avoiding double-taxation.
Can my Businesses be a Disregarded Entity?
Very likely not. Only a few types of incorporated businesses are eligible to receive the benefits associated with being “disregarded”, among them is the Single-Member LLCs (SMLLCs). As the name implies, an SMLLC is an LLC with one sole owner. The IRS automatically treats SMLLCs as disregarded entities, so long as they don’t specifically request to be treated otherwise:
‘If a single-member LLC does not elect to be treated as a corporation, the LLC is a "disregarded entity," and the LLC's activities should be reflected on its owner's federal tax return.’
Note how the business revenue will be taxed only one time, and only on the sole owner’s individual tax filings. This is unlike multi-member LLCs, which are usually taxed as partnerships.
The bottom line: not all LLCs can be disregarded entities, and in-fact only very few are eligible. If you’re the sole-member of an LLC, then filing your usual SMLLC taxes (using Schedule C) should automatically result in single-taxation.
It’s worth noting that SMLLCs aren’t the only entities that can receive this treatment (two types of Corporations can also be disregarded: a qualified subchapter S subsidiary and a qualified REIT subsidiary), but the SMLLCs is by-far the most common.
It’s also worth mentioning that disregarded entities aren’t the only business structures where an owner can receive single-taxation. For instance, sole proprietorships are taxed only one time on the owner’s individual tax returns. However, these sole proprietorships are not given the “protective barrier” that disregarded entities and other incorporated businesses enjoy. So while non-incorporated structures (like sole proprietorships) certainly avoid double-taxation, the owners are inextricably linked to the liability of their business.
Again, disregarded entities enjoy the “best of both worlds” in this respect, as they enjoy the liability protections associated with incorporating a business, while avoiding double-taxation.