Introduction
Short Answer of what is a disregarded entity:
A “disregarded entity” is a business entity that is not treated as separate from its owner for federal income tax purposes. This classification typically arises when a single-member LLC does not elect to be treated as a corporation under the “check-the-box” regulations.
Background
Hello and welcome to our latest discussion on a topic that’s pivotal in the realms of business and taxation: disregarded entities. I am John Montague, an attorney with over a decade of rich experience in the legal field, particularly focusing on major real estate transactions and venture capital, M & A, and private equity transactions. My journey began in Jacksonville, Florida, and took me through the esteemed halls of Stetson University and the University of Florida’s Fredric G. Levin College of Law.
Throughout my career, first with Lowndes, Drosdick, Doster, Kantor & Reed, P.A, and later at the prestigious AM Law 200 firm Locke Lord LLP, I have had the opportunity to delve deep into the intricacies of various business structures, including disregarded entities. My role has often placed me at the crossroads of complex legal and financial decisions, where understanding the nuances of such entities becomes crucial.
In this blog, I aim to share with you the insights and knowledge I have gathered over the years. Whether you’re a budding entrepreneur, a seasoned business owner, or simply a curious mind, understanding what a disregarded entity is, and how it functions in the business and legal world, is essential. So, let’s embark on this journey together to unravel the complexities of disregarded entities, drawing from real-world examples and legal statutes that I have encountered in my extensive career.
What is a Disregarded Entity?
In the world of business and taxation, the term “disregarded entity” frequently surfaces, yet it is often misunderstood or overlooked. A disregarded entity is a business entity that is separate from its owner for legal purposes but is not considered separate for tax purposes. This unique classification stems from the Internal Revenue Service (IRS) regulations.
Definition and Explanation
At its core, a disregarded entity is a business that is not recognized as a separate entity from its owner for federal tax purposes. This means that while the entity may exist as a separate legal structure (like a corporation or a limited liability company), it is “disregarded” as separate from its owner when it comes to filing federal income taxes.
One of the most common examples of a disregarded entity is a single-member Limited Liability Company (LLC). In such cases, the LLC itself does not pay taxes or file a separate tax return. Instead, all its financial activities are reported on the personal tax return of the single member.
Types of Disregarded Entities
- Single-Member LLCs: As mentioned, single-member LLCs are the classic example. They offer the legal protection of a corporation but are taxed like sole proprietorships.
- Qualified Subchapter S Subsidiaries (QSubs): These are subsidiaries of S corporations that elect to be treated as disregarded entities.
- Certain Trusts: Some trusts can also be considered disregarded entities under specific conditions.
In the following sections, we will explore the importance of these entities in business structures, their legal implications, and practical applications, drawing from my extensive experience in handling such entities in various legal scenarios.
Importance of Disregarded Entities in Business
Disregarded entities play a significant role in the business ecosystem, offering unique advantages and considerations for business owners.
Role in Business Structure
In the realm of business structuring, disregarded entities offer a blend of flexibility and simplicity. They are particularly appealing for small business owners or sole proprietors who seek the liability protection of a corporation but prefer the tax simplicity of a sole proprietorship or partnership.
Advantages
- Tax Simplicity: The primary advantage lies in tax reporting. As the entity’s income and expenses are reported on the owner’s personal tax return, it simplifies tax preparation and avoids the need for separate entity-level tax returns.
- Flexibility in Management: These entities often have fewer formalities and requirements in terms of management structure and administrative overhead.
- Asset Protection: They provide a layer of protection between business liabilities and the owner’s personal assets, which is crucial for risk management.
Common Misconceptions
- Not a “Tax Shelter”: One common misconception is that disregarded entities can be used as tax shelters. However, they are transparent for tax purposes and do not offer tax avoidance mechanisms.
- Limited Liability: While they offer liability protection, it’s important to understand the limitations and ensure proper business practices to maintain this shield.
This nuanced understanding of disregarded entities is essential for anyone looking to make informed decisions about business structure and taxation. In the next section, we will delve into the legal analysis, examining relevant cases and statutes that govern disregarded entities.
Legal Analysis of Disregarded Entities
Analysis
The cases and regulations cited above provide a fairly consistent definition of a “disregarded entity” in the context of U.S. federal income tax law. The term generally refers to a business entity that is not treated as separate from its owner for tax purposes. This classification typically arises when a single-member LLC does not elect to be treated as a corporation under the “check-the-box” regulations.
Several cases, including Littriello v. U.S., Pierre v. Comm’r of Internal Revenue, and Jacobowitz v. Comm’r of Internal Revenue, discuss the “check-the-box” regulations, which allow a business entity to elect its classification for federal tax purposes. Under these regulations, a domestic entity with a single owner can be “disregarded as an entity separate from its owner.” In other words, the LLC is treated as a sole proprietorship for tax purposes, and the owner is responsible for any taxes owed.
The regulations themselves provide a more detailed definition. 26 C.F.R. § 1.368-2 defines a “disregarded entity” as “a business entity that is disregarded as an entity separate from its owner for Federal income tax purposes,” and provides examples, such as a single-member LLC that does not elect to be classified as a corporation. 26 C.F.R. § 301.7701-2 similarly defines a “business entity” and explains that a business entity with only one owner is classified as a corporation or is disregarded, with the latter option resulting in the entity’s activities being treated as a sole proprietorship, branch, or division of the owner.
Some cases, such as Stanziale v. CopperCom, Inc. (In re Conex Holdings, LLC) and Gordon v. Gazes (In re 22 Fiske Place, LLC), discuss the tax implications of a single-member LLC being classified as a “disregarded entity.” However, these cases do not provide a comprehensive definition or explanation of the term, and their relevance is limited to the specific facts of the cases.
Relevant Cases
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This case is relevant to the research request because it discusses the “check-the-box” regulations that allow a business to elect its classification for federal tax purposes. The court ultimately holds that, in the absence of an election, a single-member LLC is treated as a “disregarded entity” and taxed as a sole proprietorship. However, the case does not provide a comprehensive definition of “disregarded entity” and the proposed amendments to the regulations mentioned in the case may have since been adopted, which would affect its relevance.
“The district court found that the regulations were a reasonable interpretation by the IRS of a tax statute (I.R.C. § 7701) that was otherwise ambiguous, upheld them under Chevron analysis, after noting that it was apparently the first court asked to review those regulations, and held Littriello individually liable for the amounts assessed by the IRS. In doing so, the district court rejected Littriello’s arguments that the Secretary of the Treasury had exceeded his authority in promulgating the entity-classification regulations, that the regulations are invalid under Morrissey, and that they impermissibly altered the legal status of his state-law-created LLC.”
“In short, we agree with the district court’s conclusions: that § 7701 is ambiguous when applied to recently emerging hybrid business entities such as the LLCs involved in this case; that the Treasury regulations developed to fill in the statutory gaps when dealing with such entities are eminently reasonable; that the “check-the-box” regulations are a valid exercise of the agency’s authority in that respect; that the plaintiff’s failure to make an election under the “check-the-box” provision dictates that his companies be treated as disregarded entities under those regulations, thereby preventing them from being taxed as corporations under the Internal Revenue Code; and that he is, therefore, liable individually for the employment taxes due and owing from those businesses because they constitute sole proprietorships under § 7701, and he is the proprietor.”
“Galletti involved a partnership, not a disregarded entity, that was assessed as an employer for unpaid employment taxes.”
“In this recent opinion, submitted as supplemental authority by Littriello, the Tax Court held that imposition of an employment tax on the LLC could not be viewed as equivalent to the imposition of an employment tax on its members.”
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This case discusses the “check-the-box” regulations, which allow a business entity to elect its classification for federal tax purposes. The case specifically mentions that, under these regulations, a domestic entity with a single owner can be “disregarded as an entity separate from its owner.” However, the case does not directly address the research request, as it focuses on the valuation of transferred interests in a single-member LLC for purposes of federal gift tax valuation.
“For employment taxes related to wages paid on or after Jan. 1, 2009, a disregarded entity is treated as a corporation for purposes of employment tax reporting and liability. Sec. 301.7701–2(c)(2)(iv), Proced. & Admin. Regs.”
“Ltr. Rul. 9739014 (June 26, 1997) (a single-member LLC is a qualified subchapter S shareholder because the LLC is disregarded under the regulations).”
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The case discusses a single-member limited liability company that was treated as a “disregarded entity” for federal income tax purposes, and explains the implications of that classification. However, the case does not specifically define the term or provide a comprehensive overview of the concept.
“Petitioner was the sole member of an entity named Sagasolutions.com (Sagasolutions), a single-member limited liability company he established in November 2003.”
“Additionally, during its existence it was a disregarded entity for federal income tax purposes; it never filed Form 8832, Entity Classification Election, with the IRS to be classified otherwise.”
“In particular, a domestic entity that is not a corporation and has a single owner is disregarded as an entity separate from its owner unless the owner elects otherwise. Id. (citing Treas. Reg. §§ 301.7701-2(c)(2)(i), 301.7701-3(b)(1)(ii)).”
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This case discusses the concept of a “disregarded entity” in the context of a bankruptcy proceeding, and references the Internal Revenue Code and Treasury Regulations to explain how a single-member LLC can be treated as a sole proprietorship for tax purposes. While the case does not directly answer the research request, it provides background information on the concept of a disregarded entity and how it is treated for tax purposes.
“Under the IRC, the sole member of an LLC is the sole proprietor unless the member elects to treat the LLC as a corporation. Treas. Reg. § 301.7701-3(a) and (c). When acting as a sole proprietor, the LLC is a “disregarded entity,” which means that the LLC is “ignored” for tax purposes, and the IRS treats the LLC and its owner as the same person. Treas. Reg. § 301.7701-3(b)(1)(ii). In this instance, only the owner files a personal tax return, which contains information about the LLC’s business activities.”
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This case is somewhat relevant to the research request. It discusses the tax implications of a single-member LLC that did not elect to be treated as a corporation, noting that the LLC is a “disregarded entity” for federal income tax purposes. However, the case does not provide a comprehensive definition or explanation of what a “disregarded entity” is, and the discussion is limited to the specific facts of the case.
“Notably, the Debtor is a single member limited liability company that never elected to be treated as a corporation under the applicable Treasury Regulations and thus, the Debtor is a disregarded entity for Federal income tax purposes.”
“For income tax purposes, an LLC with only one member is treated as an entity disregarded as separate from its owner, unless it files a Form 8832 and affirmatively elects to be treated as a corporation. If a single-member LLC does not elect to be treated as a corporation, the LLC’s activities should be reflected on its owner’s federal tax return.”
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This case discusses the concept of a “disregarded entity” in the context of federal tax law, specifically noting that a company can be classified as such if the owner does not elect to have it treated as a corporation. However, the case does not focus exclusively on income tax law, and also discusses the applicability of the “disregarded entity” classification to federal employment taxes.
“The company was therefore classified as a “disregarded entity” and was treated as a sole proprietorship for “federal tax purposes.” See Treas. Reg. §§ 301.7701-3(a).”
“As a result, businesses that are not publicly traded may elect to be treated as a corporation, a partnership or a “disregarded entity” in the case of entities with only one owner. 26 CFR § 301.7701-3. As stated above, Stearn never elected to have Stearn Co. treated as a corporation for federal tax purposes and Stearn Co. was therefore classified as a “disregarded entity” and was treated as a sole proprietorship for “federal tax purposes.””
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This case is relevant to the research request because it discusses the concept of a “disregarded entity” in the context of U.S. federal income tax law, specifically in relation to the classification of a single-member LLC. However, the case does not provide a comprehensive definition of the term, and it is not clear whether the court’s discussion is limited to the specific facts of the case.
“Thus, an entity whose classification as a corporation is not required (referred to in the Regulations as an “eligible entity”), and which has only one owner, has the option of being classified either as an “association”—which is defined in § 301.7701-2(b)(2) as a corporation—or as a “sole proprietorship” that is to be “disregarded as an entity separate from its owner,” id. § 301.7701-2(a). An eligible entity exercises that option simply by filing IRS Form 8832, entitled “Entity Classification Election,” having checked the appropriate box on the Form. See id. § 301.7701-3(c) (the “check-the-box” regulation). In the absence of such an election, an eligible entity that has only one owner is disregarded as a separate entity. See id. § 301.7701-3(b). WFM-LLC, McNamee’s LLC, was not required to be classified as a corporation, and McNamee elected not to have it treated as one.”
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This case discusses the tax consequences of a single-member LLC being classified as a “disregarded entity” under the “check-the-box” regulations. Although the case does not directly answer the research request, it provides some background information on how disregarded entities are treated for federal income tax purposes. However, the case does not explain the “check-the-box” regulations in detail, which would have been helpful in assessing its relevance.
“The single-member LLCs did not elect to be treated as associations under the check-the-box tax-classification regulations and therefore were treated as disregarded entities separate from their owners.”
“Mellow argues that when a business entity with a single owner is classified as “disregarded” under the check-the-box regulations, the entity is treated as a “nullity” for all federal tax purposes. Appellant’s Br. 21.”
“Id. Therefore, according to Mellow, Mellow’s partners here were the single-member LLCs’ individual owners (Berlow and Melton), not the two LLCs.”
“The record makes it absolutely clear that Mellow’s partners were the single-member LLCs, not their individual owners.”
“The check-the-box regulations merely determine “the tax consequences for that particular entity .””
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The case discusses the concept of a “disregarded entity” in the context of federal income tax law, specifically in relation to a single member LLC. However, the case does not provide a comprehensive definition or explanation, and it is not clear whether the case is binding authority on the issue.
“In support, the Defendant contends that federal income tax law treats Conex as a disregarded entity for federal income tax purposes, and as a result, all of Conex’s income and losses passed through to the Defendant as the parent of Conex. Therefore, Conex’s NOLs for the tax years of 2008–2011 were deemed to be the losses of the Defendant for federal income tax purposes, and neither the NOLs nor the tax benefits derived therefrom are property of Conex’s estate.”
“A single member limited liability company (“SMLLC”) “may elect to be classified as an association taxable as a corporation or to be disregarded as a separate entity, resulting in passthrough taxation of its sole member.” If the SMLLC does not elect to be classified as an association, it is treated as a disregarded entity.”
“A business entity that has a single owner and is not a corporation, such as a single member LLC, is disregarded as an entity separate from its owner.”
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“It held that under Treas. Reg. § 301.7701-3(b)(1)(iii), a single member limited liability company that did not elect to be treated as a corporation is considered as a disregarded entity for federal tax purposes.”
“If an unincorporated business entity with only one member elects not to be treated as an association, it will be treated for federal tax purposes as a disregarded entity and taxed as a sole proprietorship. Treas. Reg. § 301.7701-3(a).”
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“In 1999, MCM was a single-member limited liability company (LLC) and a disregarded entity by default, because it did not file a Form 8832 (which allows an LLC to elect to be treated as a corporation for that year). As such, MCM did not (and was not required to) file a federal tax return for 1999.”
“The parties agree that MCM was a disregarded entity in 1999. “[A] ‘disregarded entity’ … is taxed as a sole proprietor for income tax purposes.””
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“Paradym Group, LLC, admittedly a one-member limited liability company, did not file a Form 8832, Entity Classification Election, electing to be treated as a separate entity for federal tax purposes under the check-the-box regulations, Treas. Reg. § 301.7701-3(a) (26 C.F.R., 2005 ed.). As a result, Paradym was “disregarded” as an entity separate from its owner and deemed to be a sole proprietorship for all federal tax purposes, Treas. Reg.§§ 301.7701-2(a), (c)(2), and 301.7701-3(b)(ii).”
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“”Although an LLC might be considered a company or an association, its proper characterization is not clear from the terms of the Code itself.” McNamee v. Dep’t of Treasury, 488 F.3d 100, 108 (2d Cir. 2007).”
“A domestic entity with two or more members is treated as a partnership, while a domestic entity with a single owner is disregarded. In either case the entity may elect to be treated as a corporation.”
“If a domestic entity with a single owner chooses the default position–i.e., chooses to be “disregarded as an entity separate from its owner”–then “its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner.””
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“OPINION M. SMITH, Circuit Judge: This appeal presents the question of whether entities that are disregarded for federal tax purposes may nevertheless constitute pass-thru partners under 26 U.S.C. § 6231(a)(9) such that their partnership is not eligible for the small-partnership exception contained in § 6231. For the reasons stated in this opinion, we hold that an entity’s disregarded status does not preclude its classification as a pass-thru partner.”
“Under Treasury Regulation § 301.7701–3, “an eligible entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner.””
“The activities of a disregarded entity “are treated in the same manner as a sole proprietorship, branch, or division of the owner,” except in regard to the application of certain special employment and excise tax rules. Treas. Reg. § 301.7701–2(a). The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), Pub.”
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“B. Regulations at issue A single-member LLC may elect to be classified as an association taxable as a corporation or to be disregarded as a separate entity, resulting in passthrough taxation of its sole member. Treas. Reg. § 301.7701-3(a). If no election is made, a single-member LLC is disregarded as an entity separate from the owner for federal tax purposes. Treas. Reg. § 301.7701-3(b)(1)(ii). If the single-member LLC is disregarded as an entity for federal tax purposes, “its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner.” Treas. Reg. § 301.7701-2(a).”
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“Moreover, a “single-member” LLC, such as KRSM, has the option of electing either to be taxed as an association (i.e., a corporation) or, like a sole proprietorship, to be disregarded as an entity separate from its owner. 26 C.F.R. § 301.7701-3(a) (2003).”
“A business entity that is not classified as a corporation under § 301.7701-2(b)(1) [ (3)-(8)] (an eligible entity) can elect its classification for federal tax purposes as provided in this section.”
“Pertinent federal tax regulation provides: Business entities; definitions (a) Business entities. . . . A business entity with only one owner is classified as a corporation or is disregarded; if the entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner. 26 C.F.R. § 301.7701-2(a) (2003) (emphasis in original).”
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“Id. § 1361(b). As discussed in more detail infra, an S-corp is a “disregarded entity” for federal tax purposes and is not taxed on its income. Id. § 1363(a); see alsoTreas. Reg. § 301.7701–3(c)(v)(C) (providing that an entity that elects S-corp status is treated as an “association” rather than as a corporation for tax purposes so that only its shareholders are taxed on the entity’s income).”
“An S-corp is sometimes referred to as a “pass-though” or “flow-through” entity because the entity itself pays no tax but its income, deductions, losses, and credits flow-through to its shareholders, who must report those amounts in their personal income tax returns.”
“For its part, a QSub does not even exist for federal tax purposes.”
“I.R.C. § 1361(b)(3)(D); Treas. Reg. § 1.1361–5(c)(1).”
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“Exterra was the sole member of PLF-XIII, LLC, and PLF-XIV, LLC (together, PLF entities), each of which was a limited liability company (LLC) formed under Delaware state law in February 2007 and treated as a disregarded entity for federal income tax purposes. In turn PLF-XIII was the sole member of Montevina Phase I, LLC, while PLF-XIV was the sole member of Montevina Phase II, LLC; both Montevina Phase I and Montevina Phase II (together, Montevina entities) were LLCs formed under Delaware state law in February 2007 and treated as disregarded entities for federal income tax purposes.”
“In turn the sale of the PLF entities’ membership interests in the Montevina entities is characterized for federal income tax purposes as a sale of the encumbered Livermore property by Exterra. See DAF Charters, LLC v. Commissioner, 152 T.C. 250, 260 (2019) (“[A]ny items of income and loss generated by the [disregarded] entity are directly attributable to and reported by the entity’s owner for Federal tax purposes . . . .”); see also Carter G. Bishop & Daniel S. Kleinberger, Limited Liability Companies § 2:83 Westlaw (database updated June 2023) (“The transfer of the interest in a disregarded entity is not treated as a transfer of the interest for federal tax purposes, but rather as a transfer of the assets of the disregarded entity.”).”
“See Rev. Proc. 2014-20, 2014-9 I.R.B. 614; I.R.S. Priv. Ltr. Rul. 09-53-005 (Dec. 31, 2009).”
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“FLTCH has elected to treat THI of Hobbs and similar facilities as “disregarded entit[ies]” for federal tax purposes. Tabler Depo. at 60:16-61:16.”
“A “disregarded entity” may be defined as “an eligible entity that is treated as an entity not separate from its single ownerfor income tax purposes.””
Relevant Regulations
Relevant Secondary Sources
