What Is a Business Entity? (With Types and Examples)
By Indeed Editorial Team
Published April 2, 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Although creating a business can be a rewarding and worthwhile experience, it's often risky and may encounter a variety of challenges. To manage these challenges, business owners often define their new company as a particular business entity before starting operations. Learning about different types of entities and their functions can help you better understand the status of the company you work for and may assist you in performing any tax-related tasks. In this article, we discuss what a business entity is, list different types of business entities and provide examples of how they function.
What is a business entity?
A business entity is an organizational structure that determines the way the government taxes a business and how it assumes liability. Often, a person or group of people creates a business entity to manage the risks that an individual assumes while running a company. There are multiple types of business entities that affect how much liability a person assumes and how it properly processes the profits it earns. You can register a business entity either on a local or state level, which often requires prior research to determine whether it's the right entity to choose.
How do business entities work?
Business entities function by determining how the government requires the business to distribute its income and how it taxes the company. When you register a business, you choose an entity type. This type informs the government how to distribute the income of the company and who pays the related fees, debts and taxes associated with operating the business.
Types of business entities
Here are some common types of business entities:
A sole proprietorship is a business entity that has one sole owner responsible for the business. That person assumes all liability and debts that the entity may encounter. The owner also reports business income from this type of entity as their own income. If the owners of a business are a married couple, however, they can file the business entity as a sole proprietorship because they share finances.
A general partnership is an unincorporated business with two or more owners who manage the business and share the profits. Instead of one person assuming the liability of a company, all co-owners in a general partnership assume equal risk.
A limited partnership works similarly to a general partnership, but in addition to general partners who co-own the business, there are limited partners who solely act as investors. These types of partnerships file tax reports to record the income of the company but don't pay income taxes on these reports. Profits pass from the general partners to the limited partners. This gives limited partners reduced control over the company but also offers a reduced risk of potential losses.
Limited liability company
A limited liability company (LLC) offers liability protection by separating the income of the business from the person or people who own the company. You can have a single owner for an LLC or multiple owners who function like a general or limited partnership. An LLC is a state-regulated entity status and the requirements may change depending on the location of a business.
Similar to an LLC, a corporation separates an individual's income from the income of their business by creating a distinct taxable entity. In a corporation, shareholders own a portion of a company and receive a proportional amount of the profits. While corporations offer the strongest amount of liability protection, they can take greater amounts of time and money to establish. Corporations are often the largest, most complicated type of business entity and contain subtypes that can change how the entity or owners pay taxes. Here are a few special types of corporations that one can use for a company:
A C corporation is the most common type of corporation. This is a flexible entity type because it establishes the company as financially independent from shareholders, which reduces their liability. It has no limit to how many shareholders a company can have nor restricts shareholders' locations, which may benefit larger companies or businesses with shareholders in multiple areas. Under a C corporation, the owners of a corporation may have to pay income tax twice: once for the corporation and once regarding their individual income.
S corporations are a special type of corporation that typically includes smaller businesses, often containing fewer than 100 shareholders who all have to be U.S. citizens. This particular type allows owners to register their business as a pass-through entity, which means that the company's income assumes taxes as part of a shareholder's personal income. This prevents a shareholder from paying taxes twice.
If a company's main purpose is not to benefit shareholders, its owners can register it as a nonprofit corporation. With this type of entity, the business donates all profits to a particular cause, except for a small amount of money meant for expenses. Nonprofit corporations can qualify for some government tax exemptions and other nonprofit benefits.
A benefit corporation, also known as a B corporation, is a state-controlled business entity meant to benefit for-profit companies that want to perform some public good. Registering as a benefit corporation can give owners more flexibility when addressing shareholders or making business decisions. This type is similar to a nonprofit corporation in that there's usually a charitable aspect to the company, except the business still has a greater focus on profit.
Examples of business entities
Here are a few examples of how business entities function:
Example one: sole proprietorship
Married couple Alex and Ana decide to create a catering company together. They're a married couple, which means that when they open a business together, they can register the catering company as a sole proprietor business entity with the two of them as joint owners. The profits from their company count as personal income, and they pay taxes for the business personally.
Example two: general partnership
Three friends decide to build a bicycle repair shop. When they create the store, Super Great Bike Repair, they register the business as a general partnership. This means that all three share the profits and responsibility of the store. They also evenly distribute the risks and taxes between them. After opening the store, the friends decide they want to expand. All three of them find someone willing to invest in their business. In return, the three new people become limited partners and assume a small stake in the repair shop.
Example three: LLC
Jackson is a freelancer who creates custom artwork for different advertising agencies. He decides to create an LLC to separate the income he generates from his freelance work and his personal income. He researches the requirements in his state and applies for an LLC license. With an LLC, Jackson now has less liability for his freelance work if any unexpected disruptions occur. He also has the option to label his LLC as a pass-through entity. Therefore, he doesn't have to pay taxes twice for his freelance company.
Example four: corporation
A group of carpenters decides to create a cabinet-making business together. They start by creating an LLC, which separates the profits from the business and their personal income. After a few years, the business expands, and they gain new investors. The carpenters decide they want to turn their LLC into a corporation.
When registering their company as a corporation, they list the group of carpenters and their investors as shareholders. One of them realizes that there are fewer than 100 total shareholders and all of them live in the United States. This means they can register as an S corporation and only pay taxes once for the corporation.
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