As the New Year is upon us, unveiling the dawn of a new tax season, the time is ripe to discuss the “disregarded entity.” Although a variety of different entities can be considered “disregarded entities,” such as grantor trusts and qualified Subchapter S corporations, this discussion will refer mainly to the entity that our office most frequently incorporates into estate plans and that is the limited liability company (“LLC”).
A “disregarded entity” is one that is disregarded for income tax purposes. As a result, in the case of an LLC, the activity of the LLC will be reported on the federal income tax return of the LLC’s owner. In contrast, if the LLC is determined to be a partnership or corporation for income tax purposes, then such LLC would be required to file a separate income tax return in order to report its activity. The fact that an LLC is considered separate from its owner and not “disregarded,” can result in an unfavorable outcome from an administrative and tax planning point-of-view in some instances. Thus, in certain situations (not discussed herein) it will be important to ensure that an LLC is a “disregarded” one.
The Internal Revenue Service (“IRS”) will treat an LLC as either a corporation, partnership, or a “disregarded entity” depending on the elections that the LLC makes. According to the Treasury regulations, also known as the “check-the-box” regulations, an LLC with two (2) or more members can elect to be treated as either a corporation or a partnership. And an LLC with a single owner can elect to be a corporation or to be a “disregarded entity.” By default, however, these regulations provide that if an LLC has two (2) or more owners, it will be considered a partnership, and if it has a single owner, then it will be considered “disregarded.” To change this default classification, the LLC would have to elect otherwise.
This may seem straight forwarded. For if the LLC has two (2) or more members it is a partnership, and if it only has one (1) member, then it is a “disregarded entity.” Of course, tax law could never be that simple. In fact, there are situations where an LLC has two (2) or more members and is still “disregarded.” For instance, according to a Revenue Procedure issued by the IRS, an LLC owned by husband and wife as community property may be treated as a “disregarded entity” notwithstanding the fact that there are actually two owners: the husband and the wife. Importantly, the LLC owned by the husband and wife must be owned as community property.
Further, according to a Revenue Ruling issued by the IRS, it is possible for an LLC (“A”) to have two members or owners, which include another LLC (“B”) and a corporation (“C”), yet still be “disregarded.” In this situation, as long as B is considered “disregarded” by having its sole member be C, then A will also be “disregarded.” In other words, even though A has two (2) members, it will be considered a “disregarded entity” because according to the IRS there is only one owner for income tax purposes and that owner is C.
- Attorney Michael D. Lum