Legal Business Entity: Everything You Need to Know
A legal business entity is governed by state law and has fulfilled any requirements necessary for transacting business. 3 min read
A legal business entity is governed by state law and has fulfilled any requirements necessary for transacting business. There are several different forms of legal business entities, all of which have their advantages and disadvantages.
Through most of history, there have been three types of legal business entities:
- Sole proprietorship
- General partnership
Sole proprietorships are much different than the other legal business entity types. A sole proprietorship is owned by a single person who is also responsible for operating the business. There is no formal process for forming a sole proprietorship. Simply doing business will make you a sole proprietorship.
Sole proprietorships also differ from other business entities in regards to taxation. For the purpose of taxes, sole proprietorships are disregarded entities. This means that the income earned by the business is reported on the owner's tax return instead of a separate business return.
Sole proprietorships end when the owner decides to stop doing business or passes away, and the owner is also personally liable for all debts of the business. Legally, sole proprietorships are not separate from their owners. The accounting of each, however, should be kept separate, meaning the businesses finances should not be mixed with the owner's personal finances.
A general partnership is a type of legal business entity that is created when two or more people decide to start a business together. The partners in the business are equally responsible for operating the business and will also share losses and profits.
General partnerships are a type of pass-through entity. The partnership will file a tax return but will not actually pay the taxes. Instead, the partners will pay the taxes on their personal returns based on their share of the business's income. Similar to sole proprietorships, there is not a formal process for forming a general partnership. In addition, this type of business entity does not provide limited liability protections.
The final traditional type of legal business entity is a corporation. A standard Subchapter C Corporation is a corporation that is owned by shareholders. To form a corporation, Articles of Incorporation need to be filed with the state.
Corporations can issue different stock classes, and these different classes provide the stockholders with different rights. A corporation's shareholders are not involved with running the company. They do, however, have the right to appoint a board of directors, and this board will be responsible for representing the interests of the shareholders. The board of directors will also name officers who will be responsible for managing the company.
Corporations must obey corporate formalities, which usually includes holding an annual meeting for company shareholders.
Forming a Business Entity
If you wish to form a legal business entity, there are several steps that you must complete.
- Draft and file formation paperwork. File the formation paperwork required for the type of entity you have chosen. Generally, when filing your formation documents, you will also need to pay a fee. After your formation documents have been processed, your state should send you a certificate that confirms the existence of your entity. Your business entity also needs a document such as an operating agreement that outlines the responsibilities of company owners, as well as their rights. This document should be kept internally.
- Set up financial accounts. You will need to open a bank account for your business and make sure that you can pay your required taxes. Usually, your business entity will need to obtain an Employer Identification Number (EIN) from the IRS. Once you've acquired your EIN, you can open a business bank account and a business credit card. Remember, your business bank account should be used solely for your business. Never deposit personal funds into the account or use the account for transactions that aren't directly related to your business.
- Complete tax registration. Register your business with the appropriate local and state taxing agencies. Failing to register with these agencies could prohibit you from paying your taxes correctly.
- Purchase business insurance. Legal business entities should also consider purchasing business insurance. A business insurance policy can help to protect your business from serious losses resulting from fire, flood, or even personal injury lawsuits. There are several different types of business insurances, so you should consider the needs of your business before choosing a policy.
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