Knowing when to form a business and which type of legal business entity to create — such as a sole proprietorship, partnership, or disregarded entity LLC — can be a complex decision. Not only is it crucial to understand the right time to move forward and form your business, but you also need to spend time figuring out exactly which kind of business you should create.
A single member LLC is probably the simplest type of business you can form, and it has some real advantages that you should know about. By forming an LLC, you can help protect your personal assets from certain legal liabilities as a business owner, while also having the option to possibly get some tax advantages (since your disregarded entity LLC gets a somewhat different tax treatment than an individual “sole proprietor” business would).
In addition, a lot has changed over the past year for businesses, especially with the new tax law that took effect on Jan. 1, 2018. While many components of the new law are temporary for individual filers, the changes for businesses are largely permanent.
One of the biggest reasons individuals form single-member LLCs is to benefit from the tax laws pertaining to disregarded entities. Let’s take a look at how the new tax law impacts disregarded entity LLCs, as well as some other reasons business owners benefit from this type of organizational structure. Even if this model doesn’t seem to apply to your current business operations, it could be something to keep in mind for future ventures.
What Is a Disregarded Entity?
In a nutshell, a disregarded entity is an LLC that is treated as a sole proprietorship by the Internal Revenue Service (IRS). Basically, you and your business are one in the same in the eyes of the IRS. When it's time to file, you will organize your tax documents so that your business income and expenses are integrated with your personal information and income activities.
With a disregarded entity LLC, you file a 1040 and Schedule C that itemizes your business expenses, which keeps it pretty simple. In addition to this simplicity at tax time, there are many other reasons why using a disregarded entity LLC can benefit business owners.
Top Three Reasons to Form a Disregarded Entity LLC
There are a few major benefits that you should be aware of when choosing the best way to structure your next business. We always recommend speaking with a professional advisor before starting any type of business. But in general, a disregarded entity LLC offers a few key advantages related to taxation of your business income, compliance with regulations, efficiency of business administration, and more.
1. Pass-Through Taxation Benefits
The number one reason why most people organize a disregarded entity LLC is related to the benefits of pass-through taxation. In fact, the new tax law directly addresses pass-through taxation for disregarded entity LLCs: it creates a 20 percent deduction on pass-through income for businesses.
This new pass-through business income deduction does have some caveats and limitations for certain households that run service-based businesses. For example, if your taxable income is more than $157,500 for singles ($315,000 for married filing jointly), you will not qualify for this deduction. In general, though, if you do your research and talk with a professional tax advisor, this pass-through deduction could give you some new incentives to consider a disregarded entity LLC for your business.
Regardless of the percent of deduction you can take, pass-through taxation is a major reason why many business owners decide to form disregarded entity LLCs. In essence, a pass-through tax treatment keeps owners from being taxed on the same money twice, like they would if they operated as a C Corporation.
2. Organizing Company and Tax Documents
When you're busy trying to get your new business idea off the ground, the last thing you want to deal with is more paperwork and administrative activities. After all, no one starts a new business because they love logging receipts and reconciling transactions in their accounting software!
As the owner of a disregarded entity LLC, your bookkeeping and overall compliance paperwork can potentially be much simpler and easier to keep organized than if you used a more complex business structure. For example, LLCs have minimal compliance and reporting requirements compared to C Corporations. In many states, you only have to file an annual report for your LLC to keep your business "legal" and in good standing with the authorities. With just a small bit of paperwork, you can get all the benefits of operating your business as a disregarded entity LLC.
3. Legal Business Protections
Keep in mind that even if you're paying taxes as a sole proprietor, your disregarded entity LLC is still giving you important legal protections as a business owner. You'll want to maintain this “corporate shield” over your personal assets by keeping accurate records and ensuring your business transactions remain separate.
You can potentially lose your legal protections as a business owner if you conduct business in a way that unlawfully intermingles your business and personal expenses and activities, such as personally guaranteeing loans to your business or integrating your personal and business funds. This is called “piercing the corporate veil.”
The Bottom Line
Setting up a disregarded entity LLC can give your business enhanced credibility, help you limit your personal liability in the event of a lawsuit against your company, and potentially give you some tax advantages.
Our incorporation experts can help you evaluate your options for forming a disregarded entity LLC, or another type of structure if it makes sense for your business.
Ben Gran is a freelance writer from Des Moines, Iowa. Ben has written for Fortune 500 companies, the Governor of Iowa (who now serves as U.S. Secretary of Agriculture), the U.S. Secretary of the Navy, and many corporate clients. He writes about entrepreneurship, technology, food and other areas of great personal interest.