What Is a Business Entity?
Starting a new business is exciting. Entrepreneurs have a lot to think about, from getting a business loan to opening a new bank account. One important decision is choosing which business entity is right for your business. A business entity is an organization that one or more people form to conduct business. The way you organize and operate a business entity is crucial. It determines how you tax it and who pays its debts and obligations.
This article briefly overviews different business entity options available to small business owners.
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- Most businesses are sole proprietorships, partnerships, limited liability companies, or corporations
- State laws govern the formation and management of a business
- Business entities face different taxes and differ in who handles their debts
- If a business isn't registered with the secretary of state's office, it's treated as a sole proprietorship if one person owns it. If two people own it, it is a partnership
Business entities are legal structures entrepreneurs choose when starting a new business. The choice can impact how you pay federal income tax and your liability protection. The Internal Revenue Service (IRS) recognizes several types of business entities. State laws can also offer more options. Picking the right entity can protect business assets. It can also influence how you handle your business moving forward.
The term "business entity" describes any organization formed to conduct business. Most businesses operate under one of four primary business structures:
- Sole proprietorships
- Limited liability companies (LLCs)
State laws govern business formation. This means that the rights and obligations of business owners are set by the state that is its legal home. Some business entities operate separately from their owners, like corporations and LLCs. These entities must be properly registered in their home state.
A sole proprietor is someone who owns a business by themselves. For the IRS, their business income and personal money are the same. They report business profits and losses on their income tax return. They pay self-employment taxes and might get a business loan easily. Yet, they don't have liability protection. This means if someone sues the business, the owner's personal assets might be at risk.
A business with one owner, or two if the owner is married, who does not operate the business as a separate legal entity is a sole proprietorship. Sole proprietorships are often used by the self-employed. They operate as “pass-through" entities because the owner reports any income they earn on their personal tax returns. The owner will also be personally responsible for any liabilities the business incurs.
Suppose an individual operating a business does not register it with the state as a different type of entity. In that case, the state will treat the business as a sole proprietorship for tax and liability purposes.
A partnership is a business organization owned and operated by multiple people. These individuals agree to share their profits and liabilities. The partners will each be responsible for any liabilities incurred. Partnerships are also considered pass-through entities. This is because any income they earn is distributed directly to the partners. The partners then will pay the personal income tax.
Suppose two people own a business but do not register with the state as a separate business entity. In this case the business is a partnership by default, but many people begin a partnership through a partnership agreement.
There are a few different types of partnerships. There are general partnerships and limited partnerships. There are also limited liability partnerships and limited liability limited partnerships. In a general partnership, two or more people team up to start a business. All partners share profits, losses, and responsibilities. General partners can be liable for the business's actions.
Limited partnerships (LPs) have both general partners and limited partners. Limited partners only invest money. They don't manage the business on a day-to-day basis. They also have more protection from business debts. Then, there's the limited liability partnership (LLP). In an LLP, all partners receive liability protection.
Corporations are independent business entities that exist separately from their owners. The owners usually receive a share of the business in return for their investments. Corporations can own assets, get sued, and pay taxes. Corporations must register with the state. They also have to follow certain formalities to keep their status as separate business entities. This includes actions like drafting articles of incorporation and electing a board of directors. Corporations also have to hold annual meetings.
There are two primary types of corporations included in the Internal Revenue Code. These two types are C-corporations and S-corporations. C-corporations face taxes separately from their owners. S-corporations are pass-through entities for tax purposes, just like partnerships. However, shareholders can protect their personal assets with both types of corporations. This is because they have liability beyond their initial investment.
Corporations can also be nonprofit corporations. These are set up for causes, not profit. If they follow set rules by the IRS, they can be tax-exempt.
C-Corporations Subject to "Double Taxation"
C-corporations, or C-corps, are a specific type of corporation. They face what is called double taxation. First, the company pays taxes on business income. Then, when the business gives money (distributions) to its owners, these owners pay taxes again on their personal income tax return. This can be costly for the business.
Limited Liability Companies (LLCs)
Limited liability companies (LLCs) are a mix of corporations and partnerships. LLCs are hybrid business entities because they insulate business owners from personal liability. At the same time, they are like partnerships for tax and operational purposes.
Like corporations, owners need to register the business with the state. The Small Business Administration (SBA) likes LLCs because they offer flexibility. Business income and losses get reported on the owners' personal tax returns. They do not face double taxation.
Questions on How To Structure Your Business Entity?
The choice of how to structure a business entity is one of the most important decisions a small business owner must make. An experienced attorney understands the pros and cons of organizing a startup under each type of entity.
They can help you determine which one offers the most significant benefits while exposing you to the least liability. Additionally, a skilled lawyer will help you draw up the documents and bylaws needed for your business to comply with state-level laws. They can also assist you in registering with the state.
Speak to an experienced local business attorney about business entities today.
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