Business Entity Definition: Everything You Need to Know
Its an organization founded by one or more natural persons to facilitate specific business activities or to allow its owners to engage in a trade.3 min read
The business entity definition is an organization founded by one or more natural persons to facilitate specific business activities or to allow its owners to engage in a trade.
What Is a Business Entity?
Business entities are organizations formed by one or more persons. Since they are formed at the state level, they must comply with state laws. In most states, a business owner is required to file documents with a particular state agency, like the office of the Secretary of State, in order to legally set up their business.
Types of business entities include:
- Sole Proprietorships
- Limited liability companies (LLCs)
- Limited liability partnerships
A sole proprietorship is the easiest type of business entity to set up because it doesn't require any legal forms. However, since there is one owner, that person is legally liable for any damages related to their business activity.
A partnership is a business entity that involves two or more individuals. Like a sole proprietorship, a partnership can be formed without paperwork.
Of course, a corporation is the most popular type of business entity. That's because its owners are protected by limited liability.
What Are 'Disregarded' Business Entities?
Business entities are often subject to taxation, so the business owners must file a tax return for those businesses.
Often, the owner of a single-member limited liability company or a sole proprietorship only needs to file a single tax return. In this case, the business entity and the count as one and the same. Also, the IRS "disregards" those business entities because the owner only needs to report their personal income and deductions. When the business owner files their taxes, they will report their business expenses and income on a Schedule C form along with their personal Form 1040.
Alternatively, a one-member business could be treated as a separate entity. If the owner of the business chooses to go that route, they will have to fill out a Form 8832 to declare an Entity Classification Election and file the form with the IRS. Unless the owner of the sole proprietorship or single-person LLC files the Form 8832 for their business, that business entity will fall into the default classification of a disregarded entity.
What Is the Business Entity Concept for Accounting?
According to the business entity concept — also known as the separate entity or economic entity concept — financial transactions that happen in a business should be kept separate from those of the business's owners or any other business. That means when money moves in or out of that business, those transactions should be kept in their own set of accounting records. Business owners can apply the business entity concept to any type of business to make accounting much easier.
For example, if you loan money to your own company, that counts as one of your business's liabilities because you would need to pay yourself back. Also, if you have a business credit card, make sure you don't use a personal credit card for your business. If you use your personal credit card for your business, that will be counted as a loan or additional capital.
Why Is the Business Entity Concept of Accounting So Important?
There are six reasons why the business entity concept is the preferred type of accounting setup for business organizations. Consider:
- When the accounting records of a particular business are kept separate, business owners can compare that business's profitability, et al to other businesses they own. If the business entity's accounting records include financial information about the business's owners or other businesses, it will be hard to keep track of the finances for each business in question.
- Business owners can measure one business's finances against the finances of any other business during a certain time period.
- Business owners who use this concept can compare their business' finances to other businesses in their industry.
- It will be much simpler to keep track of a business's records and audit them.
- Each business entity a person owns will be taxed separately.
- If the business needs to be liquidated, having separate financial records for the business allows its various owners to determine how they will be compensated.
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