A disregarded entity is a special tax classification for certain trusts (specifically, grantor trusts) and business entities. The proper name for such classification is “an entity disregarded from its owner for tax purposes.” Although in most cases the entity is legally a separate person, it is essentially treated as non-existent for tax purposes. This means that any activities of the disregarded entity are, for tax purposes, considered to have been activities of the entity’s owner.
Such a designation can be very beneficial in certain situations. For example, if a person owns an LLC that is taxed as a disregarded entity, they enjoy limited liability while not having to file an informational return (such as a 1065 partnership return or 1120S S corporation return) to the IRS. Instead, the LLC’s income is merely reported on its owner’s tax return (if the owner is a natural person, then this would be IRS form 1040 Schedule C)
Another example of disregarded entity benefits regards the holding of S corporation stock. Only a natural person (who is also a U.S. citizen) or certain trusts may hold S corporation stock. However, if the owner of an S corporation is sued, their stock can be seized, and if a majority of voting stock is seized, then the creditor can vote to liquidate the corporation, and then seize corporate assets to satisfy its debt-claim. Using a charging order protected entity, such as multi-member LLC or LP, would protect the stock from creditor attachment, but at the same time it would disqualify the corporation’s subchapter S tax status. However, if the LLC or LP was a disregarded entity (preferably, a multi-member disregarded entity, such as a DEMMLLC), then according to an IRS Private Letter Ruling, the S corporation would not lose its subchapter S election.
Although using a disregarded entity is not always appropriate or desirable, the above are only a couple examples of the many benefits a disregarded entity may provide.