A business entity is simply an entity that is doing business. It can be one person, some partners, or a corporation. More precisely, a business entity is the legal classification of a business that decides who runs the business, who is liable for the debt of the business, who will pay the taxes, and how will the business be taxed.
If it’s still unclear, an overview of the business entity types might help. There are several specific business entities, but the four most common are:
This is the most common type of entity that most, entrepreneurs, and small businesses choose. In it, you are the business. You are liable for all business activities and obligations. And the taxes on the business are filed under personal income tax (pass-through taxation). There is no legal distinction between you and the business. Assets are interchangeable. If you have two cars, one for yourself and one for your business, the government sees them both equally as assets owned by you.
A sole proprietorship is the easiest to set up. You don’t even have to register your business as a “sole-proprietorship.” The good news is that you won’t be liable for the 21% corporate tax, but on the flip side, you might need to pay a 15.3% self-employment tax on top of your regular income tax.
A partnership can be of main two types: General and Limited Partnership (LP). Legally a general partnership is just like sole-proprietorship but with more people. Partners have unlimited liability for the business, which means they are fully responsible for the business’s debts and operations. Their personal assets are business assets, and the pass-through taxation allows the tax to be deducted from the personal income tax of all partners.
In LP, a general partner has unlimited liability, and limited partners carry liability equivalent to their investments in the business.
A corporation (specifically a C Corporation) is a business entity in itself. It exists separately from its owners. It pays its own taxes, responsible for its debts and actions. It’s a legal and liability shield for its owners. It has its own assets as well. The downside is cost. Corporations incur “double taxation.” The corporation and its owners are taxed separately.
A specific type – S Corporation is a separate legal entity as a normal corporation, but it doesn’t pay its taxes. The owners/partners are taxed for the business via pass-through taxation. The main advantage in the S Corporation that only salary the owner takes is subject to Social Security and Medicare taxes, and not the whole income as in a partnership or sole proprietorship, but the salary has to be reasonable compensation based on fair market value.
Limited Liability Company
An LLC is a separate legal entity, but from a taxation perspective it is a hybrid entity. An LLC by default is taxed as a sole proprietorship (if only one owner), or as a partnership (more than one owner). An LLC can make an election to be taxed as an S or C type corporation as well. The advantage is while the LLC is taxed as a sole proprietorship or partnership, there is legal protection to the owners.
The business entity you choose to register as can have serious legal and tax implications. So you must have a clear idea about your business model and future goals. It’s much safer to consult the specialists in this regard. The time and money you spend on choosing the right business entity will save you a lot of hassle and taxes in the long run.