What Is a Business Entity?

types of business entities: sole proprietorship, corporation, limited liability companies

The Balance / Julie Bang

DEFINITION

A business entity is an organization that's formed to conduct business. The type of business entity that's formed affects how a business is taxed and its exposure to liability.

Definition and Example of a Business Entity

Business entity categories refer to the type or structure of a business, not what it does. How it's structured affects how taxes are paid and how liabilities are determined. Business entities are created at the state level, often by filing documents with a state agency such as the secretary of state.

  • Alternate name: Business structure

A freelancer might form a limited liability company (LLC) to protect their personal assets from liabilities incurred by their business. They would do that by filing paperwork with the appropriate state agency and paying a small fee in most states.

How Business Entities Work

Choosing a business entity is one of the first steps that a business should take. It affects what tax forms you'll file and what would happens if your business were sued. Many business structures offer protection for your personal assets. Your business assets could be at risk if you're sued, but your personal assets might not be.

New business entities are formed by filing paperwork with your state, if required, and paying any required fees. The best type of business entity to choose depends on the type and nature of your business and the number of owners. It's one of the most key decisions that business owners can make, so it's best to consult tax and legal professionals for advice specific to your business.

The U.S. Small Business Administration has local offices that can advise on setting up your business. The SBA also partners with vetted organizations that provide free or low-cost business advice, such as the Women's Business Center. It can direct you to resources.

Types of Business Entities

States recognize several business entities, but most business owners will choose one of five: corporations, general partnerships, limited liability companies, limited liability partnerships, or sole proprietorships.

Sole Proprietorships

A sole proprietorship is an unincorporated business with one owner or two owners who are married. This is the default entity if you start a business, and if you're the only owner. You don't have to register it with your state, but you may have to obtain a business license or permits, depending on the type of business you're conducting.

Freelancers and consultants are often sole proprietors. You file one tax return with this business entity, rather than separate business and personal tax returns. Your personal assets could be at risk with this type of structure if your business were sued.

General Partnerships

A general partnership is an unincorporated business with two or more owners. All partners manage the business and share the profits. It's the default form of ownership for businesses with multiple owners. As with a sole proprietorship, your personal assets could be at risk if your business were sued, but all of the partners share that risk.

Limited Partnership

A limited partnership is a registered business entity. You have two types of partners in this entity: general partners, who actively manage and assume liability for the business, and limited partners, who act only as investors without managing the business, which limits their liability and their tax burden.

Partnerships must file tax returns to report income, deductions, gains, and losses, but they don't pay income tax. The profits and losses are passed through to the partners.

Corporations

A corporation is an independent, legal entity that separates your personal and business assets. It has shareholders, a board of directors, and officers. Setting up a corporation is more complicated than setting up a sole proprietorship or partnership. There's more paperwork, and fees are higher. One drawback is that profits can be taxed twice: once when the profits are made, and a second time when dividends are paid.

An S corporation is a special type of corporation that offers pass-through taxation. Profits are passed through to the owners' personal income without being subject to corporate tax, thus avoiding double taxation. S corporations can't have more than 100 shareholders. All shareholders must be U.S. citizens.

Limited Liability Companies (LLCs)

A limited liability company (LLC) offers liability protection. It's simpler to set up than a corporation. You can choose whether it's treated as a corporation or as a pass-through entity for tax purposes. LLCs can have one owner (referred to as a "member") or many, so it's a useful alternative to a sole proprietorship for freelancers and other individual business owners.

Key Takeaways

  • A business entity is an organization that's formed to conduct business. The type of entity determines how a business is taxed and its owner's or owners' exposure to liability.
  • You choose a business entity when you start a business. It's formed by filing paperwork with your state (if required). 
  • There are five main types of business entities. Sole proprietorships and general partnerships are unincorporated businesses. Limited liability partnerships provide some liability protection for investors. Corporations and LLCs separate personal and business taxes and liability. 

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