Most tax professionals are aware that a disregarded entity can benefit taxpayers on their returns, but may not know how to properly explain it to their clients.
Providing a clear explanation of disregarded entities can contribute significant value to an accountant’s practice. Clients who resort to researching this matter on their own are likely to experience difficulties with interpreting the material that they come across.
To review, the primary benefit of disregarded entities is that these entities separate tax ownership from liability ownership. Disregarded entities also have significance in the context of Sec. 1031 transactions. These clients preparing to conduct an exchange should make it a priority to understand the usefulness of disregarded entities in this context.
Ownership for Tax vs. Liability Purposes
The simplest way to approach the issue of disregarded entities is to say that these entities are not distinct or separate from their owner for tax purposes. When discussing this point with a client, bring up the fact that a disregarded entity can be an entity of any type of variety.
For instance, it’s possible for a trust to be disregarded to its owner (frequently referred to as “grantor trusts”), as well as a business entity, such as an LLC. If a disregarded entity owns property, then that property may be insulated from the entity owner for liability purposes, but not tax purposes. From a tax perspective, the entity owner is the true owner, rather than the entity itself.
We can see how this fact would be particularly helpful for a client who is thinking about becoming a small business owner in the near future. Suppose you have a client who is thinking about setting up an LLC in the foreseeable future.
If that client decides to add in a second member and that second member is not the client’s spouse (assuming the client lives in a community property state), you will add value by notifying your client that the proposed LLC cannot be disregarded.
This means that, even though it may be a passthrough entity, any property owned in the name of the LLC will be owned for both tax and liability purposes. This can have significant tax consequences at some point in the future.
Disregarded Entities in Sec. 1031 Context
As mentioned, disregarded entities play a role in Sec. 1031 exchanges. One of the primary rules of Sec. 1031 is that the entity which owns the relinquished property must also be the entity which acquires the replacement property.
Moreover, in Sec. 1031, ownership refers to tax ownership, not liability ownership. This means that taxpayers who conduct Sec. 1031 exchanges may have some flexibility in structuring an exchange which involves nominal ownership by a disregarded entity.
For instance, if a disregarded single member LLC owns a piece of real estate, the person who owns this entity can elect to acquire a replacement property which is either in his or her name or in the name of the disregarded entity. Again, this is because the person, rather than the disregarded entity, is considered the true owner from a tax ownership perspective and, therefore, from a Sec. 1031 perspective.
The flipside of this is that a regarded entity must acquire replacement property in its name if the regarded entity owns the relinquished property. This is where accountants can add significant value when discussing disregarded entities with clients.
Referring back to the example mentioned in the previous section, if the client decides to incorporate the LLC with a second member, then this regarded LLC will have to acquire replacement property if the entity ever conducts an exchange. Clients need to think about this problem carefully, because otherwise they may need to employ sophisticated procedures in order to avoid unwanted tax consequences in the future.
The partnership installment note procedure, for instance, is a strategy utilized to minimize negative tax consequences when an exchange involving a regarded entity is conducted. If a client has reason to believe that his or her entity will acquire real property, and has reason to believe that a 1031 exchange may be conducted in the future, then that client may want to avoid incorporating a regarded entity.