It’s not uncommon for entrepreneurs to start as freelancers or contractors who earn money as sole proprietors. However, as they grow more experienced and their income increases, they can expand to become LLCs, corporations, and other businesses—even if they stay a 1-person company.
Each of these business structures come with their own pros and cons, but most structural decisions boil down to taxes. If you are establishing an LLC as an individual or a partnership, you may end up creating a disregarded entity.
But what is a disregarded entity? Learn more about this concept and what it means for your business.
A disregarded entity is a business that is not a separate entity from the business owner. This is primarily used for tax purposes. Instead of the IRS taxing the business, the income is passed on to the individual and the person is taxed instead. This process is known as pass-through taxation.
The most common form of a disregarded entity is a sole proprietorship. A sole proprietor can form an LLC to protect their personal finances, but everything the business earns goes straight to the owner. In this case, the LLC itself doesn’t make any money because it is transferred to the individual. Taxing the business doesn’t benefit the IRS because it doesn’t have profits or income.
Partnerships can also be disregarded entities if the income from the company flows through to the people running the business.
When it comes time for owners of disregarded entities to pay taxes, they will claim all of their income the business made on their taxes—or their portion if they operate as a partnership. The business income becomes their personal income.
Then, the personal income is taxed like any money earned on an individual level. This is the process of pass-through taxation—the tax burden passes through the business and onto the individual.
Not every business that is owned by a sole proprietor is a disregarded entity. Some sole proprietors can form S corporations or C corporations for tax purposes. In this case, the business is a separate entity from the individual. The corporation can have shareholders, employees, and other parties that have a stake in the business. When this is the case, the company will need to pay business taxes and contribute to federal payroll taxes.
Additionally, you can still operate as a sole proprietor without starting an LLC. However, your options may be limited depending on your industry. Your income might also be more vulnerable without the protections an LLC or corporation provides.
If you think your business operates as a disregarded entity or if you want to start an LLC with pass-through taxation, talk to an accountant. They can review your business model and provide advice as to whether this option is right for you. If you qualify to operate an LLC as a disregarded entity, they can also walk you through the process to get your business status set up.
Knowing your business structure options can help you make strategic decisions to protect yourself and your family.