Some digital nomads use a disregarded entity to optimize their tax setup.
Let’s have a closer look at what those tax benefits are, while also assessing the risks and compliance requirements.
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What is a Disregarded Entity?
A disregarded entity is a legal entity which is not recognized as a separate entity for tax purposes.
This means that all income, expenses, and tax obligations flow through to the individual owner’s personal tax return.
Although no income taxes are due on the level of the disregarded entity, you might still have to fulfill some basic filing requirements.
However, while the disregarded entity isn’t recognized for income tax, it can still have to pay other taxes (e.g. excise tax and employment tax).
Moreover, it does also exist for for legal purposes.
The opposite of a disregarded entity which benefit from pass-through taxation is a company subject to double taxation. You can read the more details about the difference between pass-through taxation vs double taxation here.
Which Business Structures Qualify as Disregarded Entities?
There are many business structures which qualify as disregarded entities. Hereby a list of the most common ones for digital nomads:
- US Limited Liability Company
- US S Corporation
- UK Limited Liability Partnership
- Canadian Limited Partnership
How is a Disregarded Entity Taxed?
A disregarded entity itself doesn’t qualify as a taxpayer for income tax purposes. Therefore, you could say a disregarded entity is not taxed.
Yet, you should be aware that the actual tax consequences are determined on the level of the owner. So, the owner might have to pay taxes on the income on a personal level (e.g. self-employment tax) depending on the tax laws of his personal tax residency.
So, when choosing a tax structure which benefits from the disregarded status, you need to fully understand how the income is treated not only at the level of the entity but also at your individual level.
Advantages of Choosing Disregarded Entity Status
For digital nomads operating through a disregarded entity can offer an efficient balance between limited liability and administrative simplicity.
That said, the tax benefits and compliance obligations will vary depending on your country of tax residence. Therefore, I recommend to always check upfront if a US LLC or a similar structure will actually work for you.
Furthermore, a pass-through entity will offer you liability protection. Ensuring any debtors won’t come after you personally.
Drawbacks and Limitations to Consider
The advantages of such a structure, is also the potential liability.
Many digital nomads dive into setting up a US LLC or similar structure without fully understanding how it works from a tax technical point of view. If you do this, you might cause more harm than you do good.
Therefore, a pass-through entity should fit in your overall tax strategy. In some cases, it might actually be better to opt for a setup with double taxation.
With double taxation you’ll pay corporate tax on the level of your business and dividend tax on a personal level. However, because the tax rates for these types of income are generally lower, this can actually work out to be a better solution.
Compliance Requirements and Filing Obligations
The exact compliance requirements and filing obligations you will encounter will depend on the specific entity you choose.
Yet, in most cases you can expect that you’ll at least have to file some forms on an annual basis. For some structures the requirements might be rather low (e.g. US LLC), while for others (e.g. UK LLP) there might be a bit more administration involved.
However, this shouldn’t hold you back from considering a certain setup as each and every setup will come with some form of administration and compliance you have to manage.
How To Do Things Right
If you want to ensure that using a disregarded entity is a good idea, you should consult with a professional. This will enable you to avoid expensive mistakes and ensure an optimal setup from a tax point of view.
You wouldn’t be the first person who actually ended up paying more tax than before because of some misunderstanding of the tax consequences.
Over the years, I have assisted hundreds of digital nomads with their tax setup. Reach out if you also need assistance with determining the best structure for your situation.