What Is a Business Entity?

Clearing Up Confusion About the Tax Classifications

Business People in motion
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When we talk about business entities, we are referring to the type or structure of a business as opposed to what the business does. How a business is structured affects how taxes are paid, liabilities are determined, and of course, paperwork. 

Business entities—organizations created by one or more people to carry on a trade—are usually created at the state level, often by filing documents with a state agency such as the Secretary of State. Types of business entities include corporationspartnershipslimited liability companieslimited liability partnerships, and sole proprietorships.

A sole proprietorship isn't a separate business entity. Someone is automatically a sole proprietor if they conduct business without registering to be any other form of business.

Business Entities and Taxes

Business entities are subject to taxation and must file a tax return.

For federal income tax purposes, some business entities are, by default, considered not to be separate from their owner. Such is the case with sole proprietors and single-member limited liability companies. The income and deductions related to these entities are normally reported on the same tax return as the owner of the business. The IRS calls these disregarded entities because it "disregards" the separate name and structure of the business.

However, a disregarded entity can choose to be treated as if it were a separate entity. This is done by making an Entity Classification Election using Form 8832 and filing this form with the IRS. The purpose of this form is to choose a classification other than the default classification provided by federal tax laws.

For example, suppose John is the sole-owner of XYZ LLC. As a single-member limited liability company, XYZ would be a disregarded entity. The IRS would expect John to report his business income and expenses on a Schedule C filed with his personal Form 1040. In other words, XYZ LLC is being treated as a sole proprietorship by default. John could choose to treat XYZ LLC as if it were a corporation. To do so, he would file Form 8832 to make his choice known to the IRS.

Confusion Over Terms

Distinguishing between the actual organizational structure created under state law and the tax classification can cause confusion, especially if the same words are used for both concepts. Colloquially, when accountants talk about "entities" or "entity returns," they are referring to tax returns other than for individual people. 

Article Sources

  1. Small Business Administration. "Choose a Business Structure." Accessed April 28, 2020.

  2. Small Business Administration. "Register Your Business." Accessed April 28, 2020.

  3. Internal Revenue Service. "Business Structures." Accessed April 28, 2020.

  4. Internal Revenue Service. "Instructions for Form SS-4." Pages 3 and 4. Accessed April 28, 2020.

  5. Internal Revenue Service. "Entity Classification Election." Page 4. Accessed April 28, 2020.