What is a Business Entity?

A business entity is an organization created to carry out business. The type of business entity determines how a company is taxed and its exposure to liabilities.

Summary

• A business entity is an organization created to carry out business activities. The type of entity determines how a company is taxed and its exposure to liabilities.

• Choose a business entity when starting a business. It is formed by sending documents to your state (if necessary).

• There are several types of business entities. Sole proprietorships and corporations, in general, are unincorporated businesses, while limited liability companies offer some investor liability protection—corporations and LLCs separate personal and business responsibilities and taxes.

What is a business entity?

A business entity is a type or structure of a business, not what it does. The way it is structured affects the way taxes are paid, and the liability is determined. A business entity is usually created at the state level, usually by filling out paperwork at the state agency, such as the Secretary of State. An alternative name for a business entity is business structure.

How Business Entities Work

Choosing a business entity is one of the first steps start-ups need to take. Determining which tax form to file and what will happen if your business is sued. Many corporate structures protect your personal belongings. Your business assets may be at risk if you are sued, but your assets may not be.

New business entities are formed by completing the documents as they are, as needed, and paying the necessary fees. The best type of business depends on the type of business and the number of owners. This is one of the most important decisions business owners make, so it is best to consult legal and tax professionals for specific advice for your business.

Tip: The Small Business Administration has local offices that can advise you on starting your business. Work with accredited organizations that offer free or discounted advice and can direct you to the appropriate resources.

Choosing a business entity

When starting a business, you can choose to start a Sole Proprietorship, Partnership, Limited Liability Company (LLC), C Corporation, or S Corporation. Only C Corps is a taxable entity separate from its owners and has its tax return. The income taxes of other entities are paid by the owners using their tax returns. The type of entity chosen will be largely determined by the business, tax, and legal objectives. There are many factors to consider, and this article only provides an overview of federal tax rules. However, state laws that apply to business entities vary widely, and some options may not even be available. For example, professionals, such as architects or doctors, cannot form a limited liability company in California. Therefore, for businesses that are not individually owned, the taxpayer should consult a lawyer or tax expert to decide what type of business to form.

Types of business entities

States recognize more than one business entity, but most entrepreneurs will choose one of the five: sole proprietorship, corporation, limited liability company, general partnership, and limited liability partnership.

Sole Proprietorship 

A sole proprietorship is an unincorporated company with one or two owners who are married. This is the default entity if you start a business and are the sole owner and usually do not need to register in your state. You may need to obtain a business license or permit, depending on the type of business you are conducting.

Consultants and Freelancers are generally sole proprietors. With this business, you file a tax return instead of separate tax returns for individuals and businesses.

General Partnership

A general partnership is typically an unincorporated business with two or more owners, with all partners running the business and sharing the profits. This is the standard form of ownership for multi-owner businesses. As with a sole proprietorship, your assets may be at risk if your business is sued, but all partners share this risk.

Limited Company

A limited company is a registered business entity. There are two types of partners in this entity: general partners, who actively manage and take responsibility for the company, and limited partnerships, which only act as investors without managing the company, limiting their liability and tax burden.

Businesses must file returns to report their income, deductions, gains, and losses but do not pay income tax. The losses and profits are passed on to the partners.

Corporations

A corporation is a separate statutory entity that separates its personal and business assets. Also called a C corporation, a corporation has shareholders, a board of directors, and other executives. Starting a business is more complicated than starting a sole proprietorship or a partnership; there are more documents, and the costs are higher. A C corps' downside is that profits can be taxed twice: once when profits are made and once when dividends are paid.

S Corps are a special type of company that offers pass-through taxation. The profits are transferred to the personal income of the owners without being subject to income tax. An S corps avoids the double taxation that can occur with C corporations. S corporations cannot have more than 100 shareholders, and all must be US citizens.

Limited Liability Company

Limited Liability Companies (LLCs) protects against liability. They are easier to establish than corporations, and you can choose to treat them as a corporation or as a pass-through entity for tax purposes. LLCs can have one or more owners (named members), making them a useful alternative to individual ownership for independent professionals and other individual owners.

Tax consequences of changing the business entity

Sometimes entrepreneurs want to transform their business into another type of entity. Individual ownership is easier to convert to any other type because the business owner is the sole owner, so starting another entity is similar to starting from scratch. Just as easily, a partnership can easily become a limited liability company or a joint-stock company with low tax consequences.

Converting a corporation to another type of corporate entity is more problematic. As a separate tax entity, the business must be dissolved, with tax consequences for the business and owners. There are several tax consequences if a corporation operates as a C corporation but then decides to convert to an S corporation. Any net operating loss carried by a C corporation cannot be carried forward to an S corporation. 

Capital gains tax may be due on any asset whose value is greater than the book value of a C corporation if the asset is sold within ten years of incorporating an S corps. A tax may be due if more than 25% of a C corps' gross receipt is derived from passive investment income such as dividends, interest, rents, and capital gains, and the corporation has accumulated capital gains and profits before conversion.

An LLC has the most flexibility in business entities because it can choose to be taxed as a corporation or C corporation by completing Form 8832, Entity Classification Election, or as an S corporation, in submitting Form 2553, Election by a Small Business Corporation.

Federal Employer Identification Number

To uniquely identify businesses, the IRS uses an Employer Identification Number (EIN) issued to the business when it begins. Most states also use EINs, but some use their tax identification number. Most sole proprietorships can use their social security number. However, employee properties or a qualified retirement plan must use an EIN. A business can apply for an EIN online at IRS.gov or submit Form SS-4, Request for Employer Identification Number. A change in the business entity requires a new EIN.

Although most sole proprietorships do not need an EIN, it can be beneficial to have one to avoid identity theft, as it eliminates the need to use the owner's social security number and allows you to set up a loan on behalf of the owner instead of using the owner's credit.

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