Disregarded entities are used extensively in both business and trust planning. This article defines disregarded entities and explains how they can simplify taxes while accomplishing non-tax goals like liability protection.
What is a Disregarded Entity?
A disregarded entity is an LLC or trust that is disregarded as an entity separate from its owner for federal tax purposes. The entity is “disregarded” in the sense that U.S. tax law does not recognize it as a separate taxpayer.
The term disregarded entity refers only to the federal tax classification. It does not affect the state-law classification of the entity. When the Internal Revenue Code characterizes an LLC or trust as a disregarded entity, it creates two systems of classification:
- State Law Classification. For state law purposes, the LLC or trust is respected as a valid entity that is separate from its owners. It has all the state-law rights and obligations of any other LLC or trust. It can sue and be sued, take legal action, and—in the case of LLCs—protect its owners from liability.
- Federal Tax Classification. For federal tax purposes, the entity is treated as though it does not exist. The entity does not file a tax return and is not treated as a taxpayer.
Usually disregarded entity status is a good thing. It allows the owner to reap the state-law benefits of entity formation but keeps taxes simple. The owner need not file a separate income tax return for the entity or otherwise keep up with tax filing requirements. All income earned by the disregarded entity is treated as earned by the owner of the disregarded entity and reported on the owner’s tax return.
This separation of state-law treatment from federal tax treatment creates planning opportunities.
Three Types of Disregarded Entities
Three main types of disregarded entities are commonly used in sophisticated LLC, trust, and tax planning:
- Single-Member LLCs. The Internal Revenue Code treats a single-member (one-owner) LLC as a disregarded entity by default. The LLC’s income and assets are treated as the owner’s income and assets as through the LLC did not exist.
- Grantor Trust. A grantor trust is disregarded for federal tax purposes while the person that created the trust (the grantor) is alive. For tax purposes, all assets owned by the grantor trust are treated as owned by the grantor, and all income earned by the grantor trust is treated as earned by the grantor.
- LLCs Owned by Married Couples in Community Property States. If a married couple in a community property state—like Texas or California—owns a qualified entity as community property, they may treat the entity as a disregarded entity for federal tax purposes. The IRS will respect the position that the entity is disregarded.
For the last category, an LLC is a qualified entity if both spouses own it as community property, no one else has an interest in the LLC, and the spouses have not elected to treat the LLC as a corporation for tax purposes.
Under these rules, an LLC is treated as owned by a single owner for tax purposes if it is jointly owned by (a) by an owner and his or her grantor trust; (b) by an owner and his or her other single-member LLC; or (c) as a qualified entity held in community property by a married couple. In these situations, the LLC is a multi-member LLC for state law purposes but a single-member LLC for tax purposes.
Business Planning with Disregarded Entities
Disregarded entities are valuable tools for tax and asset-protection planning. Disregarded entity classification allows business owners to take advantage of enhanced state-law liability protection while simplifying tax reporting requirements. Disregarded entities create tax treatment that differs from state law treatment. For state law purposes, the LLC is owned by multiple owners. But for tax purposes, the LLC is treated as a single-member LLC.
Liability protection is a matter of state law. It is independent of the LLC’s tax classification. Under state law, an LLC with more than one owner provides charging order protection to the LLC owners. Charging order protection means that a creditor of one LLC member is limited to any distributions that would otherwise be made to that member. The creditor may not seize the member’s interest in the LLC or participate in the management and operations of the LLC.
Charging order protection protects an innocent member from financial threats relating to another member’s actions. Without charging order protection, for example, the bankruptcy of one LLC member could allow a creditor to break up the LLC and liquidate its assets. Liquidating the LLC would hurt the innocent member by wiping out the LLC.
The rationale behind charging order protection is protecting the innocent member from the bad decisions of his or her partner. This rationale breaks down for single-member LLCs. Because there is only one member, there is no policy reason to stop that member’s creditor from liquidating the LLC. There is no innocent party to harm.
Because the rationale for charging order protection does not apply to single-member LLCs, many states limit charging order protection to multi-member LLCs. Federal bankruptcy courts have also withheld charging order protection from single-member LLCs, allowing the creditor (through the bankruptcy trustee) to force the LLC to liquidate and distribute funds to the creditor to satisfy the judgment.
Disregarded entities can help obtain charging order protection for LLCs without introducing tax complexity. The owner that would otherwise form a single-member LLC may form a multiple-member LLC by adding a disregarded entity as an owner. For example, instead of owning the LLC as the single owner, the owner could jointly own the LLC with his or her grantor trust or another single-member LLC. Doing so has two important consequences:
- Under state law—which determines liability protection—the LLC would be a multi-member LLC and should be entitled to charging order protection.
- Under federal tax law, the LLC is treated as though it is owned by a single owner as a disregarded entity. No special tax reporting or returns are required.
This strategy provides enhanced asset-protection planning opportunities at no tax cost.