If an entity is considered to be a “disregarded entity” (DRE), the US IRS will not tax it as an entity separate from its owner. It is a pure tax fiction that has no parallel in the legal world. While there are several different entities that can become a disregarded entity, this article will primarily focus on the benefits of structuring a limited liability company (LLC) as a disregarded entity and how this decision impacts mergers and acquisitions. [1]
Under the IRS entity classification rules, a single-member LLC will be considered a DRE. Such is the default classification and there is no need to make any tax elections with the IRS to receive the DRE treatment. The member may be an individual, a corporation, a partnership or even another LLC, but the key is that there is only one member. Where a married couple residing in a community property state such as California operates its business in LLC format, it is possible for the LLC to be treated as a DRE for federal tax purpose if the LLC is wholly owned by the couple as community property under state tax.
In a DRE scenario, the assets, liability, income, and deductions of the LLC are treated as belonging to the owner for tax purposes.[2] The LLC does not file a separate federal income tax return; instead, the tax items are reflected and reported on the owner’s tax return.
Advantages & Disadvantages to the LLC Structured As a Disregarded Entity
Now that we know what a disregarded entity is, we’ll consider a few of their benefits and their impact on impact mergers and acquisitions involving LLCs. For more on other types of disregarded entities, see our article on Alphabet Soup: When S-corporations Meet F Reorganizations. First, here are a few advantages of becoming a disregarded entity if you own an LLC:
- “Flow-through” tax treatment: The LLC’s income and expenses “flow through” the entity to the owner. As a result, only the owner reports taxes on the LLC and a double layer of tax is avoided.
- Simplified tax filing:since only the individual owner or parent company is taxed, only one tax return is necessary, thus saving time or money otherwise spent on filing an extra tax return.
- Separate liability:One quirk of the American legal system is that states consider LLCs (regardless of whether they are a disregarded entity federally) as a separate entity from its owner. As a result, the LLC’s assets are protected from legal claims that may be brought against the owner’s property.
Here are a few disadvantages associated with structuring an LLC as a disregarded entity:
- Separate liability: some states may require LLCs to pay additional taxes (e.g. employment, franchise, or excise taxes) even if it is considered a disregarded entity for federal tax purposes
- Federal self-employment taxation: the owner still pays self-employment taxes to the IRS. The owner of an LLC can avoid paying self-employment taxes by electing to be treated for tax purposes as an S-corporation (see our article on S corporations: Advantages and Disadvantages) instead of as a disregarded entity.
- Inability to have investors: a single-member LLC, by definition, means that there can only be one member and therefore it will not be possible to have investors in the company
Advantages to Disregarded Entities in M&A
- A purchase of 100% of a disregarded entity is treated as an asset purchase.
- Exchanges of property between a corporation or individual owner and a disregarded entity are not a taxable event.[3] However, there is an important caveat: Internal Revenue Code Section 1031 only allows property to be exchanged (not sold) tax-free.
So why would this last point be a benefit? Consider this scenario:
A real estate development corporation (let’s call it RED Corp.) owns 100% of Central Perk, LLC which is a DRE. RED Corp exchanges one of its assets, a vacant lot, for one of Central Perk’s industrial warehouses. From a legal standpoint, RED Corp now owns the warehouse and Central Perk owns the vacant lot. However, because Central Perk is a DRE, the transaction is ignored for tax purposes.
Why would you want to do this? A corporation or an LLC with plans to sell at some point in the future might want to consider divesting itself of or acquiring certain property in order to look more attractive to potential buyers. For example, RED Corp is planning to sell Central Perk to a developer that builds hotels, not warehouses. The hotel developer would understandably be more interested in buying unoccupied property. By switching properties with its parent company, RED Corp, Central Perk is able to appear more attractive to the hotel developer without paying additional taxes. The example above illustrates how a company could successfully trim its assets without increasing tax liability.[4] However, a knowledgeable tax adviser is an important person to have in your corner, since there are a number of restrictions on what kinds of property may be transferred between the parent company and the disregarded entity.
Conclusion
While structuring an LLC as a disregarded entity can protect owners from liability and provide a more beneficial tax regime to small business owners or parent companies, one of the often-overlooked reasons structuring as a disregarded entity involves mergers and acquisitions. Deciding to structure a business as a disregarded entity has the added benefit of opening up possibilities in the field of mergers and acquisitions. Although only corporations are allowed to undertake tax-free reorganizations, disregarded entities may be involved in certain scenarios.[5] There are a number of options to consider, including but not limited to: F Reorganizations, Asset Sales, Stock Sales, and D Reorganizations.[6]
Other articles mentioned in this article: S corporations: Advantages and Disadvantages, Alphabet Soup: When S-corporations Meet F Reorganizations, Asset Sales vs. Stock Sales
[1] LLCs are a commonly used form of DREs. Other examples of DREs include grantor trusts, qualified subchapter S subsidiaries (discussed in Alphabet Soup: When S-corporations Meet FReorganizations), and qualified REIT subsidiaries.
[2] 26 CFR §§301.7701-2, 301.7701-3(a).
[3] This is the substance over form doctrine in action all over again—since someone cannot pay themself, the economic realities of the business remain unchanged. However, the legal form could change.
[4] IRC §1031(a)(1).
[5] IRC §368(b), 26 CFR §1.368-2.
[6] Also see our articles, Alphabet Soup: When S-corporations Meet F Reorganizations and Asset Sales vs. Stock Sales for more information.