The concept of business entity states that the business-related transactions must be recorded separately from its owners and other businesses. To do this a separate accounting record is used for the company that excludes the liabilities and assets completely of any other owner or the entity. The record of different entities would be intermixed which makes it pretty hard to distinguish the taxable or financial results of the single business.
Among all the choices made when starting the business, the most important one is selecting the type of legal structure for the company. This decision will have an impact on the taxes paid as well as the paperwork required for the business, the ability to raise the money, and the personal liability faced in business. The main reasons for putting the business in the entity is to keep safe the personal assets from the liabilities faced in the business. But this advantage should not be overstated. If the business has few assets, no track record, and earnings, then the business owner has to personally co-sign on important contractual obligation such as bank loans, equipment leases etc. but the business entity protects the assets from different other possible liabilities. For example, a business may end up with the accountability for injuring anyone at the company.
Secondly, the business entity enables sharing ownership, raising capitals and governance rights. Theoretically, this could achieve similar results through complicated contracts with colleagues and investors. But this becomes very simple to gather all the liabilities and assets into the ‘fictional person’ and parcel out the finance-related claims on that fictional person and control rights over it. If it is needed to raise the capitals outside and there are more than one business owner then it is definitely the best decision to form the business entity. Otherwise, the risk running should be taken into consideration and how to protect them, realistically how much safety the entity will give to the owner, and how much it will cost to form and maintain the entity.
The other reasons for why the business entity is needed include:
- Separately tax each business entity
- To calculate the financial position and financial performance of the business entity
- It is also needed when the company is settled, so to determine the incomes of the different owners.
- It is required from the perspective of liability, to determine the available assets when it comes to the legal judgment against the business entity.
- Audit of the business records is not possible if the records mix up with those of other individuals and/or entities
Types of Business Structures
There are different types of business entities such as corporations, government entities, partnership business which is established with more than one owner and no papers are filed with the state to become an LLC (Limited Liability Company), or sole proprietors which is the simplest legal entity for owning the business. All the business losses or incomes must be reported on the personal income tax return, the business itself is not separately taxed.