In business, an entity is
referred to as a separate organization unto itself. In accounting, it is an
organization for which a set of accounts is kept. Therefore, each entity has
financial statements that reflect the financial activity that goes on within
it. The entity itself does not use the financial statements because only people can do that. There
are several reasons why it is important to understand the distinction between a
business entity and the people who run the business.- To avoid confusion by keeping the business activities separate from personal activities.
- To recognize legal liabilities of the business entity as opposed to those of the individual.
- To recognize the tax obligations of the entity as opposed to the individual.
Choosing the Right Business Entity
When
starting a new business, one of your first decisions will be to determine what
type of
business entity will work best for you. Essentially, there are six types of
business entities
from which to choose:
Sole Proprietorship
For
most small businesses, a sole proprietorship is by far the easiest and least expensive
to set up and operate. It is a pass-through entity in that the profit or losses from
the business are reported on the individual’s personal Form 1040 tax return.
Only the
income and expenses are reported on Schedule C. No Balance Sheet is required on
the tax return. From a legal standpoint, no differentiation is made between the
business entity and the individual. This means that if you get sued over a
business transaction,
your personal assets are at risk.
Partnership
By
definition, there must be at least two individuals or entities that own the
business. A partnership is a pass-through entity, however, it is required to
file its own Form 1065 tax return. The pass-through information (profit or
loss) is reported on a K-1 form that is given to the partners to report on
their respective tax returns. For partners who are individuals, the K-1
information is reported on Schedule E of their Form 1040 tax return. If the
partner is a General Partner then that partner is personally liable up to the
amount his
percent of ownership represents. A partner can be a “limited” partner who has
no say in management decisions. A limited partner is liable only to the amount
invested in the
company. A Balance Sheet and Income Statement is usually required. A partnership
is fairly simple to set up, but a comprehensive partnership agreement should be
worked out beforehand.
C Corporation
A C
Corporation is more difficult and expensive to set up because of state
registration requirements. Most people hire an attorney to initiate the process
of obtaining the Articles of Incorporation, establishing the by-laws, issuing
stock certificates, writing a stockholder’s
agreement, and chairing the first stockholder’s meeting where the new officers
are voted in, etc. Annual stockholders’ meetings are required. A Balance Sheet
and Income Statement is also required. A C Corporation is not a pass-through entity.
It pays its own taxes based on taxable income. C Corporations file a Form 1120 to
report taxable information. Stockholders who work in the company are considered
employees and must be included in a formal payroll withholding process.
Stockholders are not personally at risk, as the corporate entity assumes that
responsibility.
S Corporation
An S
Corporation has features found in both a C Corporation and a Partnership. It is
a pass-through entity like a partnership in that the stockholders receive a K-1
form. The limited
liability protection remains the same as the C Corporation. The set up is similarly
difficult and expensive, as in the C Corporation, and there are the same requirements
of structure and accounting, as in a C Corporation. The S Corporation files a
Form 1120-S to report tax information. S Corporations have special rules that one
should be aware of before choosing this organizational form.
Limited Liability Company (LLC)
This
form of business organization is relatively new and becoming quite popular. It
is easy
to set up, like a partnership. However, rules may vary from state to state.
Some states
require at least two members (rather than stockholders or partners) to
establish an
LLC. Other states, such as California, now allow one member. It is a
pass-through entity like a partnership and actually files the Form 1065 as a
partnership does. This means the members will receive a K-1 form. Like there is
in corporations, liability is limited. One area to be aware of with an LLC is
whether there is a “gross receipts fee”, as there is in California. These fees
can be a deciding factor when choosing this form of entity.
Non-Profit Organizations
These entities are much more difficult to set up than any of the others. An
application must be filed with both federal and state taxing authorities to
find out whether they agree with your reasons to establish a not-for-profit
organization. This process can take weeks
or months. Structure is formal as in a for-profit organization. There is more scrutiny,
not only by the federal and state taxing authorities, but also by the state Attorney
General’s office. Formal accounting is required and, in many cases, budgeting.
There are no owners in a non-profit organization, only a board of directors who
may be at risk for some liabilities. No taxes are paid unless there happens to
be “unrelated business income”. A federal Form 990 informational return must be
filed each year, with certain parts available for public inspection. Accounting
procedures are similar in many ways to for-profit entities but unique in other
ways.Try
to keep your choices as simple and inexpensive as possible when starting out. Keep
in mind that as your needs change and you outgrow one entity, you can always evolve
into another.
(By
John W. Day, MBA)
