If you disregard something, you ignore it. The term “disregarded entity” is used quite frequently in the IRS world and in the legal world, so you’ll need to understand both aspects of the term. An entity is a legal structure that has legal rights, including being recognized by the IRS as a tax payer, independent of you as an individual. The two areas where you are most likely to encounter disregarded entities are when you use a living revocable trust and/or an LLC.
The Tax World
Living Revocable Trust
The IRS considers the living revocable trust as a disregarded entity. That means the IRS doesn’t recognize the entity as anything different from you. You will not get a tax ID number (EIN – Employer Identification Number) for a living revocable trust. Note that this is different from the irrevocable trust created when you die, which usually needs its own EIN (see below). Your personal representative or successor trustee will use your trust documents to create the EIN as part of their trustee duties. But while you are alive, the trust is you. No separate tax information is needed.
The IRS considers all revocable trusts as “grantor trusts.” A grantor is the person that creates a trust. If the grantor retains the power to control or direct the trust’s income or assets, then the trust is considered a grantor trust. All revocable trusts are by definition grantor trusts, because the grantor reserves the right to revoke the trust. Once it is determined that the trust is a grantor trust, the grantor is treated as the owner of the assets for tax purposes, and the IRS just “disregards” the trust. The IRS treats the assets and income as the grantor’s just as if the trust didn’t exist.
Note that ALL revocable trusts are considered grantor trusts, and thus are disregarded entities. That includes the land trusts popular today as real estate holding entities. Disregarded entities do not need a tax ID number. The grantor treats the income derived from trust assets as if the trust did not exist and takes all of the income directly into their pocket for tax purposes. The grantor files his or her 1040 and includes the income as if they had received it directly. The revocable trust does not file a 1041 tax return.
Although certain irrevocable trusts are not automatically considered grantor trusts, if the grantor retains certain powers to control the assets or income of the trust, then it will be considered a grantor trust and thus become a disregarded entity. The IRS has lots of rules as to when an irrevocable trust can be treated as a grantor trust. The rules are contained in Internal Code §§ 671, 673, 674, 675, 676, and 677.
Living revocable trusts will usually become irrevocable upon the death of the grantor. The trust will have language in it which limits the new trustee powers over the assets of the trust so that the successor trustee(s) will not have enough power over the trust to make it a grantor trust. Thus, in most cases after the death of the original grantor, the trust will become a standalone taxing entity, will have to get an EIN, and start filing a 1041 tax return each year for the IRS. The trustee needs to be careful to “distribute” out all of the income from the irrevocable trust each year, because the trust gets a deduction for the income it distributes. You don’t want the trust to pay taxes on any income because at about $13,000, a trust already hits the highest tax bracket.
An LLC can be a disregarded entity if it is owned by a single owner and the owner chooses to be taxed as a sole proprietorship. Actually, the sole proprietorship is the default tax choice for an LLC with only one owner. The owner could take action and choose to have the LLC taxed under Subchapter S or under Chapter C of the IRS Code. People refer to the LLC as being an S Corporation or C Corporation, but that is not technically correct, because the LLC has nothing to do with a corporation. It is simply being taxed under Subchapter S or Chapter C.
Assuming the choice is made to tax the single member LLC (LLC with one owner) as a sole proprietorship, or no action is taken and the single member LLC defaults to a sole proprietorship tax structure, the LLC will NOT get its own tax ID number (EIN). The profits or losses of the LLC will be entered on the single owner’s 1040 form as Schedule C entry. The LLC will use the owner’s Social Security Number for tax purposes. The IRS disregards the fact that there is an LLC and treats the taxes as if the single owner earned the money directly.
The Legal World
Living Revocable Trust
Living revocable trusts and revocable trusts in general are disregarded by the legal world, at least as far as asset protection is concerned. Obviously, the trusts avoid probate and act as a substitute for a will, and they work well. They hold property for the benefit of the beneficiaries under the management of the trustee. But if they have the word “revocable” in them, and if the word revocable is in the trust, the trust does NOT provide any asset protection while the grantor is alive.
Land trusts are also living revocable trusts. The myth of land trusts is that if the beneficiary is an LLC, there will be asset protection. It doesn’t matter who the beneficiary is, if the grantor is sued, the courts will simply tell the grantor to revoke the trust and turn the trust’s property over to the court (creditors).
LLCs are legal entities that offer double the asset protection of a corporation. They have the corporate shield protection (limited liability) of a corporation. Additionally, LLCs have the charging order protection of a partnership. How an LLC is taxed does not affect the asset protection. The asset protection of an LLC is in place even if the LLC is viewed as a disregarded entity in the IRS’s eyes. The IRS may disregard an LLC taxed as a sole proprietorship, but the law certainly doesn’t disregard it when it comes to a lawsuit, and you can’t disregard it as a company that will protect you.
Thus, the legal world and the tax world are quite different when it comes to defining a disregarded entity, but it is important to understand that the tax world and the legal world of entities are two different worlds that really don’t include much overlap. Disregarded entities are a lot more meaningful in the tax world than the legal world.
Will the new tax law affect the disregarded entity unfavorably because the LLC passthrough income gets a 20% discount?
A disregarded entity can still get the 20% discount.
Thanks for the insight, fellow lawyers!
I have a query so lets say a 1041 has a 100% ownership in an LLC and all the incomes and losses are reported on the trusts return and the SMLLC never filed a Form 568 in the state of CA. What should be the further step in this matter. Please guide
I don’t know the answer to your question. One piece of advice – move out of California.
If the ssn isn’t a tax id# what is it
A Social Security Number is a tax ID for an individual. An EIN is a tax ID for a company. I probably said a disregarded entity doesn’t need tax ID number, you just use your SSN. You don’t get an EIN, just use your SSN, so in a sense the company doesn’t have a tax ID number. You know what I mean.