An Overview of Business Entity

In its most basic form, a business entity is an organization formed by one or more people to do business, trade, or participate in similar activities. There are many different forms of business entities — sole proprietorships, partnerships, limited liability companies, corporations, and so on — and the entity type of a company determines both its structure and how it is taxed.

 

One of the first things you should do when beginning a business is to decide on the structure of your firm, or, in other words, a business entity type.

 

This decision will have significant legal and financial consequences for your company. The amount of taxes you must pay, as well as the simplicity with which you can obtain a small company loan or raise funds from investors, is determined by the business entity you choose.

 

For founding, maintaining, and expanding a business, you'll need business entities. Every main sort of legal entity, as well as key principles, criteria for selecting an entity, and legal entity management, are covered in this overview to Business Entities.

 

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What is a Business Entity?

 

A business entity is a legal body formed by one or more people to carry out a specific business or to engage in trade or similar activities. At the state level, business entities, also known as business structures, are founded by filing documents with a state agency such as the Secretary of State.

 

Sole proprietorship, partnership, limited liability company (LLC), and corporation are the four major business entity kinds. To lawfully establish a business, the organizations must comply with state regulations by filing specified forms and paying any required costs.

 

The structure of your firm, as well as the documentation you'll need to file, your capacity to acquire funds, how liability is defined, and how taxes are paid, are all impacted by the business entity you choose. The type of business you want to start and the number of owners will have a big impact on the business entity you pick.

 

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Which Type of Business Entity should you pursue?

 

To answer this issue, you must first comprehend the differences between the various forms of corporate entities. There are various types of business groups that exist to serve various reasons.

 

With this in mind, consider the following types of business entities as you begin your entrepreneurial journey:

 

1. Sole Proprietorships

 

An unincorporated business with one or two married owners is known as a sole proprietorship. If you form a business and are the sole owner, this is the default entity. You don't have to register it with your state, but depending on the type of business you're running, you may need to seek a business license or permits.

 

Consultants and freelancers are frequently sole owners. Instead of filing separate business and personal tax returns, you file a single tax return with this business organization. If your business is sued, this arrangement could put your personal assets at danger.
 

Advantages of a Sole Proprietorship

 

• There are no formal corporate procedures or documentation obligations, such as meeting minutes, bylaws, and so on.

 

• Simple to get started (no need to register your business with the state).

 

• It's simple to file your taxes: just fill out Schedule C-Profit or Loss From Business and attach it to your personal income tax return.

 

• Most business losses can be deducted on your personal tax return.

 

Disadvantages of being a sole proprietor

 

• Because there is no true barrier between you and the business, obtaining a business loan and raising funds is more challenging (lenders and investors prefer LLCs or corporations).

 

• As the sole proprietor, you are personally liable for all of the company's debts and liabilities, and a successful lawsuit against your company might result in the seizure of your personal assets (your car, personal bank accounts, even your home in some situations).

 

• Without a registered company entity, acquiring business financing is more difficult.

 

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2. Partnerships

 

A general partnership is a contract between two or more people to run a business together. Profits and losses are shared, and each partner provides capital in the form of work, money, or talent. The partners are responsible for the company's debts.

 

In a limited partnership, each partner's responsibility is restricted to the amount of money they put into the company. When a company goes bankrupt, the owners of the company cannot lose their personal belongings, as is the case with unlimited liability. 

 

When opposed to a sole proprietor, a partnership has more resources and capital accessible, but there is often dispute in decision-making, and earnings must be shared.

 

When a business held by several people does not register with the state as a separate commercial entity, it is normally recognised as a partnership by default. Many people, on the other hand, prefer to work in a collaboration.

 

Advantages of General Partnership

 

• Business owners can deduct the majority of their losses on their personal tax filings.

 

• There is no need for state registration to form or dissolve the business entity.

 

• All owners share in the company's gains and losses.

 

• When establishing a business, corporate formalities and documentation requirements are unnecessary.

 

• Having numerous partners share the startup challenges can be really beneficial.

 

Disadvantages of General Partnership

 

• Each owner is individually liable for the debts and other liabilities of the company.

 

• In some places, each spouse may be individually accountable for the negligent actions or behavior of the other partner (this is called joint and several liability).

 

• Partner disagreements can destabilize a corporation (though drafting a solid partnership agreement can help you avoid this).

 

• Without a recognised business entity, getting a business loan, landing a significant client, and building business credit is more challenging.

 

Advantages of a Limited Partnership

 

• A good way to raise funds because investors can join the partnership without risking their personal assets.

 

• Even after receiving funds from limited partners, the general partner retains control of the business.

 

• Limited partners have the option to leave the partnership without dissolving it.

 

Disadvantages of a Limited Partnership

 

• All business obligations and liabilities are fully borne by general partners.

 

• An Limited Partnership business requires a state filing, which makes it more costly to start than a General Partnership.

 

• Any Limited Partnership who participates actively in the firm risks personal liability.

 

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3. LLCs (Limited Liability Corporations)

 

A limited liability company (LLC) protects you against lawsuits. It's a lot easier to start than a corporation. For tax purposes, you can pick whether it's classified as a corporation or a pass-through entity. Because LLCs can have one or many owners (referred to as "members"), they're a good alternative to sole proprietorships for freelancers and other small business owners.

 

The advantages of each of the other corporate entity forms are combined in a limited liability company. Limited liability companies (LLCs) are similar to corporations in that they provide limited liability protection. LLCs, on the other hand, have less paperwork and continuous responsibilities, making them more similar to sole proprietorships and partnerships.

 

Another significant advantage is that you have complete control over how the IRS taxes your LLC. On your taxes, you can choose whether the IRS treats it as a corporation or a pass-through organization.

 

Advantages of forming a Limited Liability Company

 

• There are no restrictions on the number of owners in an LLC; they can be as few as one or as many as you choose.

 

• LLC owners are not personally liable for the company's debts and obligations.

 

• To prevent double taxes, you can choose whether your LLC is taxed as a corporation or a partnership.

 

• LLC members who are active can deduct any operating losses from their normal income.

 

Disadvantages of forming a Limited Liability Company

 

• Because LLCs must register with the state in order to do business, they are more expensive to form than partnerships or sole proprietorships.

 

• Fringe benefits such as medical insurance, parking, and group insurance must be treated as taxable income by an LLC with partners who are also employees.

 

• LLC profits are subject to medicare and social security taxes, which means LLC owners may wind up paying more taxes than corporate owners.

 

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4. C Corporation

 

A corporation is a legal entity that operates under state law and is limited in its scope of activity and name by its charter. To form a corporation, you must file articles of incorporation with the state. 

 

Stockholders are protected from responsibility, and stockholders who also work for the company may be eligible for tax-free benefits such as health insurance. A C corporation is subject to double taxation, the first on earnings and the second on stockholder dividends (as capital gains).

 

Corporations are more expensive to establish than other company structures. They also necessitate complex operating operations, accounting, reporting, and tax compliance. 

 

Corporations pay income tax on their profits and, in some cases, are taxed twice: once on profits and again on dividends. They're a good fit for medium-to-high-risk organizations.

 

Dividends are the most common method of distribution to shareholders. Because it can be owned by an unlimited number of stockholders, the C corporation structure is widely employed. It has an unequaled ability to draw funds from investors as a result of this.

 

Advantages of a C Company

 

• Shareholders (owners) are not personally liable for the company's debts and liabilities.

 

• C corporations qualify for more tax breaks than any other sort of company.

 

• Self-employment taxes are cheaper for C corporation owners.

 

• You have the option of issuing stock options, which can help you raise funds in the future.

 

Disadvantages of a C corporation

 

• C corporations are subject to double taxation: the corporation pays taxes on its corporate tax return, and shareholders pay taxes on dividends on their individual tax returns.

 

• Expensive to establish compared to sole proprietorships and partnerships.

 

• Corporations must follow a number of formalities, such as having board and shareholder meetings, keeping meeting minutes, and drafting bylaws.

 

• Business owners are unable to deduct losses from their personal tax filings.

 

 

5. S Corporation

 

The S corporation is a modification of the normal corporation concept. An S corporation does not pay income taxes since its income is passed on to its shareholders. The income is reported on the owners' personal tax returns, avoiding the double taxation that occurs in a conventional C corporation.

 

Advantages of a S Corporation

 

• Shareholders (owners) are not personally liable for the company's debts and liabilities.

 

• No corporate taxation and no double taxation: Because a S corporation is a pass-through company, it is taxed similarly to a sole proprietorship or partnership.

 

Disadvantages of S Corporation

 

• S corporations, like C corporations, are more costly to establish than sole proprietorships and partnerships (requires registration with the state).

 

• When it comes to issuing shares, S corps has more restrictions than C corps.

 

• You must still follow company procedures, such as drafting bylaws and holding board and shareholder meetings.

 

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Watch this | Small Business Tutorial - Exploring business entity types

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Bottom Line: How do you pick the best type of Business Entity?

 

You can now select which type of business entity is ideal for your small business based on a greater grasp of how the various business entity types work and their associated benefits and drawbacks. If you can afford it, consult a company lawyer and a tax consultant to determine which structure is ideal for you, given where your firm is now and where you want to take it.

 

However, while deciding between company entity kinds, there are three fundamental aspects to consider: legal protection, tax treatment, and paperwork obligations. You can see how the entities compare in terms of each of these variables in the section below.