Being self-employed can be rewarding, but as your business grows, you might wonder, “Do I need a business entity?” followed by, “Wait- what is a business entity?” Understanding what a business entity is and the different kinds of entities can help you decide the best structure for your business.
In this article, we’ll explain what a business entity is, the different types and share some common examples for small, self-employed businesses.
Business entity defined
A business entity, or legal entity, is a structure that individuals and organizations use to conduct business. You’ll also hear a business entity called a business structure. Some business entities provide a layer of liability protection between your personal assets (like your home, car, or bank accounts) and business-related lawsuits, debts, and liabilities.
Business entities are established at the state level, usually by filing formation paperwork with state agencies. Your business entity will be required to follow the state laws pertaining to your business type and structure.
How business entities impact your business
The type of business entity you choose will impact how you’re taxed, how much liability protection you have, and how much paperwork you’re required to do. For example, corporations are taxed differently than sole proprietorships.
The type of business entity may also determine who is legally responsible for the business debts and liabilities. For example, shareholders in a corporation are not usually liable for corporate debt, while a sole proprietorship is personally liable for the business’s debt.
Types of business entities
There are many business entities out there, but not all of them are right for the self-employed. Here are the most common types of business entities for solopreneurs.
Sole Proprietorship
A sole proprietorship is an unincorporated business owned by a sole owner. An owner of a sole proprietorship is called a sole proprietor. You don’t have to do anything to set up a sole proprietorship, you simply start doing business and you become a sole proprietor by default.
A sole proprietorship is often the simplest way to start a business because there isn’t any paperwork to file and you don’t have to pay any fees. The drawback is that a sole proprietorship has no liability protection. That means the owner has personal liability for business debts and liabilities.
A sole proprietorship has a simple tax structure. The profits from the business are reported on the owner’s personal income tax return. Then the owner pays self-employment tax and income tax on the profits.
General partnership
A general partnership is an unincorporated business with two or more owners who share ownership and management of a business. A general partnership can be formed in one of two ways: through a written partnership agreement or by simply doing business together.
A general partnership is the most common type of partnership. All partners share in the profits and losses, decisions making, and management responsibilities.
A general partnership has no liability protection. Each partner is personally liable for the debts and liabilities of the business, meaning their personal assets aren’t protected. Also, each partner is responsible for the actions of their other partners.
Unlike a sole proprietorship, a general partnership requires separate tax filings and the profits from the business are reported on the partners’ personal tax returns via a Form K-1 from the partnership. The partners then pay income tax and self-employment tax on their share of the profits, whether its distributed or not
Limited Liability Company (LLC)
A limited liability company, or LLC, is a business entity that provides limited liability protection to its owners. Unlike a sole proprietor, an LLC owner doesn’t have personal liability for its business debts or lawsuits. That protects the owner’s personal assets because those assets are separate and distinct from the business assets.
An LLC is different from a sole proprietorship because it’s a registered business entity. In other words, you’ll need to file formation paperwork with the state to start an LLC. You may also need to file annual reports and pay state taxes and fees to keep your LLC in good standing. And, you’ll need to follow your state laws regarding LLCs.
An LLC can have one owner or multiple owners. An LLC with a sole owner is called a single-member LLC and an LLC with two or more owners is called a multi-member LLC.
LLCs have a simple tax structure. If an LLC only has one business owner, then it’s taxed like a sole proprietorship. If an LLC has multiple members, it’s taxed like a partnership. In both cases, the profits from the business are reported on the owner (or owners’) personal tax returns.
Corporation
A corporation is a separate legal entity from its owners and owners have limited liability for debts, lawsuits, and other liabilities of the business. Like a limited liability company, a corporation has to be registered with the state before it can conduct business.
Corporations can have only owner (called a single-member corporation) or multiple owners (called a multi-member corporation). Corporations have to file more paperwork and pay more fees than other business entities.
They have a complex tax structure since the corporation itself is taxed separately and the owners also pay taxes on income received by the corporation. This is what’s known as double taxation. The corporation pays taxes at the corporate tax rate and individuals pay taxes on the income distributed to them.
How to choose a business entity type
There are three key things to think about when selecting a business entity type: legal protection, tax treatment, and documentation requirements.
Legal protection
When choosing your business entity consider how much personal liability you want. Consider your personal assets and how high-risk your business activities are.
Remember, sole proprietorships and general partnerships offer no legal protection while a limited liability company and corporation offer some level of legal protection.
Tax treatment
Consider how the tax treatment of each business entity will affect you. For example, corporations have more complex tax structures than sole proprietorships and general partnerships and have double taxation. Added complexity usually means added cost when it comes to tax preparation and ongoing tax advice.
Another factor to consider is that both LLCs and corporations have tax flexibility which means you can choose how the business is taxed. For example, you can ask to have your LLC taxed as an S Corp, which could lower self-employment taxes.
Documentation requirements
Finally, consider the paperwork and fees associated with each business entity type. Corporations require more paperwork than sole proprietors and LLCs require more paperwork than general partnerships. For business entities that are registered with the state, there may be one time filing fees and ongoing fees that you’ll need to pay.
FAQs
What does business entity mean?
A business entity is a legal structure used to conduct business activities. What business entity you choose will impact the legal, tax, and financial aspects of your business.
What is a business entity report?
A business entity report is a document that lists the owners and other important information about the business.
Is entity the same as LLC?
No, an LLC is one type of business entity, but there are other types of business entities as well.
What is an example of a business entity?
The most common types of business entities are sole proprietorships, general partnerships, limited liability companies (LLCs), and corporations.
Key takeaways
- Business entities are structures that individuals and organizations use to conduct business.
- The type of business entity you choose can impact the legal protection you have between your personal assets and business-related lawsuits and liabilities.
- There are different types of business entities for self-employed people, like sole proprietorships, general partnerships, limited liability companies (LLCs), and corporations.
- Each type of business entity has different impacts on taxation, liability protection, and paperwork requirements.
- When selecting a business entity type, consider the legal protection it provides, its tax treatment, and any filing fees or ongoing paperwork.
Choosing a business entity is an important decision and by understanding the different types of business entities, you can make an informed decision that best fits your needs.
