Separate Business Entity: Everything You Need to Know
Separate business entity refers to the accounting concept that all business-related entities should be accounted for separately.3 min read
Separate business entity refers to the accounting concept that all business-related entities should be accounted for separately. This idea may also be known as the economic entity assumption, and it posits that all businesses, other related businesses, and business owners should be accounted for separately.
In other words, the business owner and the business are two separate entities. Their accounting should be kept separately. Transactions performed by the business are separate from those performed by the business owners. For example, if an owner purchased an asset for their personal use, the asset may not be considered the property of the business.
In addition, the personal affairs and finances of the owners must not be included within business financial records. This allows accurate recording of the business' performance. An investor will be able to determine whether a company has a profitable cash flow from its operations or whether its owner keeps funding the company with their own contributions.
Initial capital is any money contributed to the business by the owner. This amount is considered an investment and is owed back to the owner at some point in the future. If the owner withdraws any money from the business, it's considered repayment of the initial investment. These reimbursement transfers from business account to personal accounts are called “drawings.”
A partnership and a corporation are also two separate entities. The activities of the partners and shareholders must be kept separate from the actual partnership and any corporate transactions because they are distinct economic entities.
The concept of separate business entity assumption does not apply to a legal entity in 100 percent of cases. For example, a parent corporation and its subsidiaries may issue joint financial statements without contradicting the principle. If the understanding of “entity” is considered to be within a sole company, this might mean that the company segregates business operations by department.
Why Divide a Business Into Separate Business Entities?
You may choose to divide your business into multiple entities for numerous reasons, in a similar way that you initially chose to select a particular form of business entity for numerous reasons.
Consider how the following four significant concerns interact with one other:
- Tax concerns.
Startups often begin as general partnerships or sole proprietorships, and for good reason: They're simple and easy to form, and the pass-through taxation nature is logical for a small business in which initial profits will be reinvested into the company immediately. Since corporate entities receive double taxation, an LLC may decide to be taxed as a partnership rather than a corporation.
- Liability protection.
Unlike an LLC or corporation, a sole proprietorship or general partnership has unlimited personal liability for business debts. General partners may be responsible for the business actions of all other partners. Risk management is an important consideration when it comes to liability protection. For some, the unlimited personal liability may not be worth it when it comes to a restaurant business that serves food to the general public, but more tolerable for an online sales company.
- Management structure.
When it comes to decision making, a sole proprietor has the ultimate freedom. General partners share decision making equally. In a regular C corporation, shareholders elect the company's board of directors, which make decisions together. An LLC may be managed by its members, like a general partnership, or by its managers, like a limited partnership. There are countless other possibilities. Flexibility in management is only one piece of the puzzle, as investors may desire a structure in which they have some management control.
Some types of business entities are much easier to transfer than other types. Consider how you may wish to transfer stock, asset sales, or your successors. As an example, if you wish to run your restaurant well into your last years, then leave it to your children. However, if you wish to franchise food trucks and sell your popular bottled barbecue sauce to make some fast cash in order to finance your restaurant's expansion, it's best to consider separating each aspect of the business into separate business entities and then structuring each one to maximize profit.
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