A business entity is an organization that one or more people form to conduct business activities. How a business entity is organized and operates is crucial because it will determine how it is taxed and who will be liable for paying its debts and obligations.
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- Most businesses are organized as sole proprietorships, partnerships, limited liability companies, or corporations.
- The formation and management of a business are governed by the laws of the state where it was organized and registered.
- The type of business entity chosen by its organizers will dictate how it is taxed, managed, and who is responsible for its debts.
- If a business is not registered with the state, it will usually be treated as a sole proprietorship if it is owned by one individual or as a partnership if two or more people own it.
Understanding Business Entities
The term "business entity" describes any organization formed to conduct business. Most businesses operate under one of four primary business structures: sole proprietorships, partnerships, corporations, or limited liability companies (LLCs). Each type of business structure offers owners different benefits and subjects them to specific obligations.
State laws govern business formation, which means that the rights and obligations of business owners are set by the state that is its legal home. Some business entities that operate separately from their owners, such as corporations or LLCs, must be properly registered in their home state to be recognized.
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 or are known as “pass-through" entities because any income it earns will be treated as income to the owner 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 where it was organized as a different type of entity. In that case, it will usually be treated as a sole proprietorship by default for tax and liability purposes.
A partnership is a business organization owned and operated by multiple people who agree to share its profits and liabilities. The partners will each be responsible for any liabilities incurred. Partnerships are also considered pass-through entities because any income they earn is distributed directly to the partners who will pay the personal income tax.
When a business owned by multiple individuals does not register as a separate business entity with the state, it will usually be treated as a partnership by default. However, many choose to operate under a partnership agreement.
Corporations are independent business entities that exist separately from their owners, who usually receive a share of the business in return for their investments. Corporations must register with the state and are required to follow certain formalities to keep their status as separate business entities, like drafting articles of incorporation, electing a board of directors, and holding annual meetings.
There are two primary types of corporations included in the Internal Revenue Code: C-corporations taxed separately from their owners and S-corporations treated as pass-through entities (similar to partnerships) for tax purposes. However, shareholders can protect their personal assets with both types of corporations because they have liability beyond their initial investment.
C-Corporations Subject to 'Double Taxation'
One of the primary disadvantages of organizing a business as a C-corp is that it is taxed separately from its shareholders at the federal tax rate for corporations. That means the C-corp's income is subject to corporate taxes when earned by the business and taxed again when it is distributed to shareholders as dividends. While this so-called “double taxation" encourages businesses to organize as S-corps, where income is only taxed when passed to shareholders, strict rules for registering as an S-corporation prevent most large businesses from qualifying.
Limited Liability Companies (LLCs)
LLCs are known as hybrid business entities because they insulate business owners from personal liability in the same manner as a corporation but are treated as partnerships for tax and operational purposes. Like corporations, LLCs must be registered with the state where the business is organized.
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 local business attorney understands the advantages and disadvantages of organizing a startup under each type of entity and 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 laws and assist you in registering with the state.