Business Types, United States

Business Types, United States2022-10-02T14:00:50+00:00

Business Types, United States

Disclaimer: This information is for educational purposes only and not to be used as tax or legal advice. Tax law and accounting protocol are constantly changing.

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Business Types, United States

The legal structure of a business is referred to as the business entity. The entity choice has a significant impact on the taxes the owner(s) pay and tax returns that they will need to file. Accounting for different small business entities is similar in that Generally Accepted Accounting Principles (GAAP) will provide guidance so that the business will be on the accrual method, reconcile cash, and maintain a general ledger. Different structures will; however, have distinct differences in accounting for equity. The business entity choice is mix between legal and tax benefits while weighing compliance costs. Most legal benefits and operating rules are governed by the state, while taxation rules will be governed at the federal level.

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Liability Protection and Piercing the Corporate Veil

Different business structures offer different liability protection to owners, depending on the laws of different states. In the case of sole proprietorships and general partnerships, no liability protection is granted under the law. Limited liability partnerships, limited liability companies, and corporations provide liability protection to owners, but not in all circumstances. These entities do little to protect individual owners who are negligent (not taking proper care) or break the law. Self-employed surgeons, for example, cannot rely on a corporation to protect their personal assets if they should happen to kill a patient while performing surgery drunk after a three day party binge on prescription medication stolen from the ER and shared at a club. In such a scenario, no protection is provided for the individual doctor, but shareholders would not be liable. Regardless of the business entity choice, insurance can be used to protect owners against professional liability.

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Holding corporate and limited liability company owners personally liable for wrongful acts is referred to as piercing the corporate veil.  The courts could hold the perpetrators of crimes be held personally liable regardless of the business structure in place. There are other action that owners can do that may effectively erode any protections under the law. If an owner does not follow the required entity protocols by co-mingling funds (combining business and personal accounts), does not pay state fees, or has fraudulent accounting, the courts may ignore the structure for legal purposes. Individual investor owners, chief executive officers, and chief financial officers may be held more responsible for corporate negligence.

 

Sole Proprietorship

The sole proprietorship is the most common entity structure in the United States and can be owned only by one person. A sole proprietorship has one owner that is personally liable for all business debts and lawsuits. To become a sole proprietor, an individual need only start operating as a business: Earning money and having expenses. By default, the sole proprietorship operates under an individual name; however, a business name may be established, known as a “DBA” which stands for Doing Business As. Income taxes are computed at the individual level, but property and local taxes may still be required. The business may have employees and is responsible for related taxes. Typical sole proprietorships are business that do not require outside investors and are small in nature such as: Consulting services, lawn care, and small dental practices.

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Advantages

Sole proprietorships are low cost and require little to no setup. Some cities require registration and business property tax if the sole proprietor has significant property assets. Because it is not a separate entity for tax and legal purposes, business activity is reported on an individual tax return. Although not a best practice, business and personal funds may be co-mingled. Taxing authorities will likely not require double entry accounting due to the cost and complexity for a very small business.

 

Disadvantages

Owners of sole proprietorships have unlimited personal liability for any actions committed by the owner or employees in the course of work. Should an owner or employee commit harm accidentally or intentionally, all of the owner’s assets are subject to seizure in the case of a lawsuit. Sole proprietors can obtain insurance to protect the owner to combat this disadvantage. Financing must either be funded by the individual or loan, as the structure does not allow for outside investment. There is no continuity of life for the sole proprietor ship: For academic purposes the Sole Proprietorship dies when the owner dies.

 

Accounting

Accounting for a sole proprietorship under GAAP requires double-entry, accrual based accounting for purposes of financial statements. Relatively few sole proprietorships; however, issue GAAP statements unless they are required to obtain a loan. Because the sole proprietorship and individual are one in the same, there is no stock, shareholders, or dividends. Owners receive money from the business in the form of a “Draw” which is a distribution of capital. Best practices dictate that draws come in the form of cash withdrawals. If an owner spends business funds for personal use, the accountant will classify the transaction as a draw which is a reduction of equity. Regardless of whether the owner takes a draw or not, the owner is taxed on the overall profit or loss.

 

Summary

Sole proprietorships are cost effective and practical for many small businesses that do not need outside investors. Owners may receive loans to finance operations, but not grant ownership in the company to anyone unless they first change the structure. Because of the lack of continuity in ownership, loans are generally guaranteed against the business and the owner personally. Businesses may start as sole proprietorships and then change the entity structure at a later date to facilitate investment and limited liability.

  • The most common business structure
  • Owners have unlimited personal liability for their individual and employee actions
  • No outside investment is permitted, but loans are
  • Accounting requirements for tax purposes are generally more simple than other entities
  • Tax is based on the profit or loss of the business on an individual tax return
  • Business dies when the owner dies (no continuity)

 

Flow-through Entities and Corporate Double Taxation

Partnerships, limited partnerships, and limited liability companies are referred to as flow-through entities for tax purposes. For tax and accounting, all three entities are similar to partnerships. Flow-through entities to not pay federal or state income tax and therefore “flow” income and loss activity to owners. Owners then report income and deductions on a tax return as an individual or another business entity. There may be state fees and tax for operation, but they are relatively smaller and different from individual and corporate tax. The owner of a partnership, limited partnership, or limited liability company flow-through can be an individual, another partnership structure, corporation, and certain trusts. Some entities, such as trusts, may be a hybrid between flowing out income to beneficiaries and paying tax at the trust level.

Regular corporations (C-Corps) are taxed on profits at the corporate level and are therefore not flow-through entities. Once a corporation has paid tax on profits, dividends may be paid to