Business entities are essential for starting and managing a business. This guide answers all the questions you might have regarding business entities.
Let us get started.
What is a Business Entity?
A business entity refers to the establishment of an organization to conduct business and engage in trade. It is formed by one or more people.
This business entity definition refers to the tangible aspects such as the structure and type rather than what or how it does.
There are several types of business entities depending on the structure and number of owners. Before we dive into that, let us focus on how they work.
How Business Entities Work
New business entities are formed by registering with your state or local authority. The attributes of your business entity, its structure, and type affect how the business is registered, taxed and what its liabilities are.
Some types of entities do not require registration with the state, whereas some do. While some are taxed separately from that of the owner while some come under their personal taxes. Similarly, if your business is sued, some types of entities protect your personal assets.
Choosing what type of entity you should set up is thus crucial. We recommend you consult the tax and legal professionals before deciding the entity type.
What are Disregarded Entities?
In the business entity concept, some entities are registered separately and some are directly linked to the individual (aka you).
The IRS (Internal Revenue Service) "disregards" the latter ones because you only have to report your personal incomes and deductions of which your business would be a part. You will be asked to attach a Schedule C form along with the personal Form 1040.
If you prefer not to be referred to as a disregarded entity, you can choose to declare your business as a separate entity. You will have to file Form 8832 to declare an Entity Classification Election and file the form with the IRS.
Types of Business Entities
We have been stressing that there are different types of business entities. Wondering what they might be? Here you go.
1. Sole Proprietorship
The simplest of all, the sole proprietorship is owned by one individual (or a married couple). They are the sole operator of the trade.
You can just launch a business single-handedly, and you automatically become a sole proprietor by law. While you need permission from the local authorities to establish it, you need not officially register with the state.
Contingent workers and other self-employed professionals operate as sole proprietors. It also holds true to the small shops near your house.
Partnerships are owned by two or more people.
The advantage is that partnership firms file only the tax returns (income, deductions, gains, and losses) but do not pay income tax.
A partnership can be of two types.
The structure is very similar to a sole proprietorship, except there isn’t just one person on the frontlines. The business can have two or more owners. The profits and losses are shared by the partners.
This type of business entity must be legally registered. The paperwork and other essential details of the entity must be submitted to the state.
There can be two types of partners. The general partners who manage and operate assume power and liabilities, and the silent partners provide financial help by investing in the entity.
These silent or limited partners have limited liability and do not have control over the management or operations of the entity.
Corporations are independent, legal entities that separate your personal and business assets.
These are separate entities in themselves and need to be registered with the state. They can be owned by just one member or shareholders with a board of directors.
Setting up a corporation is more complicated than setting up a sole proprietorship or partnership. There are more legal procedures and higher expenses.
The liabilities and assets of the business entity are separate from that of the owners. In case of loss or if your firm is sued, your personal assets are not affected.
However, with C Corporations, the profits can be taxed twice. Once when the profits are made and a second time when dividends are paid.
The S corporation resolves the tax complication that comes with the previous legal entity type. There is no corporate-level taxation for an S corp meaning that similar to a sole proprietorship or general partnership, the profits and losses of an S Corp pass through to the owners’ personal tax returns.
They are your go-to if you want a corporate structure with tax flexibilities.
To organize as an S corp or convert your business to it, you should file IRS 2553 form.
4. Limited Liability Company (LLC)
An LLC combines the useful features from each of the other business entity types. Like corporations, LLCs offer limited liability protections. On the other hand, they only require less paperwork and procedures, making them more similar to sole proprietorships and partnerships.
An added flexibility here is that you can choose how your LLC is taxed. You can either let the IRS treat you as a corporation or as a pass-through entity on your taxes.
We recommend that you check with professionals and choose the best-suited legal entity structure.
Have more questions on the different types of business entities and what other differences they have? Read our guide to the different types of entities.
Let us move on to how to establish a business entity.
How to Establish a Business Entity?
A task well begun is half done.
Once you take the decision to start a business entity, you are halfway across the bridge. You just have to follow a few simple steps to get to the rest.
1. Name your Entity
Your business name is your brand that people are going to remember. It is going to be known by that name across the globe. These points add more importance when it comes to naming your business.
We recommend you check the availability. Trademarks let you block the name from further use.
2. Choose a Legal Entity Structure
We cannot stress enough the legal entity structure you choose determines how your business will be taxed and what liabilities you personally might hold.
There are different types of business entities you can choose from. Here is a glimpse of those.
3. Select a Location
It only seems logical that you choose locations closer to your target audience. Thus, choose suitable and convenient locations that serve you and your customers well.
4. File Necessary Paperwork
Again, registration is different for different business entity types. Some require you to register with the state authority and agency. However, getting the local permissions would suffice to set up sole proprietorships and general partnerships.
5. Set up Financing and Taxes
Funding is essential to grow and promote your business and brand. Set up proper financing and tax regulations to have a streamlined, smooth setup.
6. Hire Employees
Once your brand is set up, the next thing is hiring qualified people to work to fulfill its purpose. Hiring, though tedious, can get the right employees to work for you.
We suggest hiring employees across borders to expand your brand globally and having a strategized hiring practice to choose the right fit.
Dive deeper with our guide to set up a business entity to learn more.
Things to Keep in Mind Before Choosing the Business Entity Type
Below are the essential aspects you must consider before choosing your suitable business entity.
The Level of Risk You can Assume
Liability would be the foremost thing you would have to consider before choosing an entity type. When it comes to sole proprietorship, the liabilities increase as they affect your personal assets.
We all prefer reducing taxes.
In some legal entities like the LLC, you can choose how you want to be taxed. Sole proprietorship adds the taxes to your personal taxes. While C corp comes with a heftier rate, the S corp evades the added taxes.
The best way to go would be to have minimal taxes.
Difficulty in Setting Up
The requirements for each entity varies. The lesser documents there are, the easier it is for you to set up.
Difficulty can also arise in setting up entities in preferred locations and in hiring the right fit of employees. Having a well-planned expansion and hiring strategy reduces these difficulties.
Business entities are essential to start a business. You can either learn to manage them well or share the responsibility with us.
Book a demo to know more.