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Introduction to Business Entities
Business entities are an integral part of business practice and economic productivity. An effective business practitioner must understand the characteristics of the major types of business entities, as these attributes can dramatically affect the nature of the business’s relationships. This chapter will introduce the concept of the business entity, legal authority for business entities, and the justification for their legal recognition. It will then introduce the most common types of business entities and their notable characteristics. Examination of these characteristics will make obvious the effect of these attributes on stakeholders of the business entity. The characteristics of a business entity affect many other areas of business practices, such as accounting, management, and finance. For further written and video explanation, discussion and practice questions, see Business Entities (Intro)
What are “Business Entities”?
Business entities are legal organizations that exist by virtue of state law. One way to view a business entity is as a separate person. The business entity carries on business activity on its own behalf. The owners of the business entity are representatives of the entity. Business entities benefit society by allowing individuals to aggregate their resources and efforts in furtherance of a business activity. The legal entity is essentially a bundle of contracts that provides for the rights and duties of the owners and employees of the business entity. Each individual state passes its own substantive and procedural laws regarding business entities. A business must choose its state of formation or organization. The home state may be the location where the business is headquartered or it may be any other state where the business organizes and establishes a registered agent. If the business wishes to carry on business outside of its home state, it must qualify to do business and register as a “foreign” entity doing business in the other state. Carrying on business is generally defined pretty broadly to include marketing or sales activity. A business may carry on the majority or all of its business in a state or states where it is registered as a foreign entity. The business entity must comply with the laws of any state in which it does business. For further written and video explanation, discussion and practice questions, see What are "Business Entities"?
What is it important to learn about Business Entities?
Owners and managers of a business seek to organize their resources to maximize productivity and opportunities. These individuals must understand the important characteristics of the business entity to take advantage of all of the benefits associated with carrying on a business activity as a legal entity. Taking advantage of a business entity status means choosing an entity form for your business, operating within your chosen entity form, and undertaking business transactions with various entity types. Understanding business entity characteristics includes familiarizing one’s self with the ownership structure, organizational structure, potential liability, compensation methods, and tax laws applicable to the business entity. Lastly, the owners and managers of a business must comply with the procedural and substantive laws applicable to that business entity. This is generally known as business governance. For further written and video explanation, discussion and practice questions, see Why is studying business entities important?
Closely-Held vs Publicly-Held Businesses
Business entities are often categorized as either closely-held or publicly-held. These designations are not separate types of business entity; rather, they are classifications or defining characteristics of a given business. Generally, the distinction between the two classifications concerns the number of business owners and whether the equity ownership is sold on a public exchange. Closely-held Business - A closely-held business, as the name implies, is held by a smaller or more closely related group of individuals. It is often thought of as a smaller business, such as a mom-and-pop or family business. In truth, however, the closely-held status has little to do with the size or revenue of the business; rather, it simply means that the business is not widely owned by numerous, unrelated people. Another characteristic of the closely-held entity is that it is not traded on a public market. Publicly-held Business - A publicly traded business is any business that is traded on a public exchange. This means that the company has gone through an initial public offering in which its shares were registered with the Securities and Exchange Commission and subsequently listed for sale to the public at large. A publicly-held or publicly-traded company is generally held, or capable of being held, by a large number of unrelated people. For further written and video explanation, discussion and practice questions, see What is a "Closely-held" vs "Publicly-held Business"?
Main types of business entity?
The main types of business entity discussed in this chapter are: Sole Proprietorships, General Partnerships, Limited Partnerships, Limited Liability Limited Partnership, Limited Liability Companies, and Corporations. Some of the less-common types of business entity are the limited liability limited partnership (LLLP) and the professional corporation (PC). The LLLP is a special purpose entity generally used as part of special project, such as a real estate project. A professional corporation is a corporate form for small practitioner firms that is rarely used because of the unfavorable 25% flat corporate tax rate. For further written and video explanation, discussion and practice questions, see What are the main types of business entity?
Primary characteristics of business entities
There are numerous characteristics that make a business entity unique. The major characteristics of a business entity are as follows: Creation & Maintenance, Continuity, Ownership & Control, Personal Liability, Compensation, and Taxation. This list is certainly not exhaustive; however, these primary characteristics provide a great deal of necessary insight for understanding and choosing a business entity. For further written and video explanation, discussion and practice questions, see What are the primary characteristics of business entities?
What is “Creation” of a business entity?
Creation of a business entity is the legal or procedural steps that one must undertake to bring the business entity into existence. There is a general dichotomy in the process or steps required to form a business entity. Default Entity Status - Some business entities may arise by default without any formal procedural undertaking by the founder. That is, the business entity may arise simply by the parties undertaking some business activity with the intention of generating revenue or making a profit. Filing for Entity Status - Some business entities require a formal filing process through the state secretary of state’s office. This requires the filing of documents of organization in accordance with the procedural rules adopted by the state of organization. The amount of information and type of document(s) required will vary between states and depend on the type of entity. The general requirements for each business entity type are discussed along with that business entity. For further written and video explanation, discussion and practice questions, see What is "creation" of a business entity?
What is “Maintenance” of a business entity?
Maintenance of a business entity is summarized as the administrative steps associated with starting and carrying on business as a given entity form. It entails the process of filing documents, holding meetings, maintaining records, observing formalities, and reporting necessary information to regulators. The requirements for starting a business vary considerably between entity types. Businesses entities that require formal procedures to organize also require formalized maintenance procedures. At the most basic level, these entities require the owners to file statements each year (along with annual fees) with the Secretary of State’s office, to hold business meetings, to maintain records, and to report information to regulatory authorities. The state may require that an entity maintain certain records, such as meeting minutes and resolutions, ownership logs, capital accounts, financial statements, etc. The Federal Government may require that business entities file specific information related to taxation or securities issuances. State and federal reporting requirements can also be industry specific or based upon the company’s size or status as privately or publicly-held. For further written and video explanation, discussion and practice questions, see What is "maintenance" of a business entity?
What is “Continuity” of a business entity?
The continuity of the business entity concerns the effect on the business of a major change in the ownership and organization structure. More specifically, this question addresses what types of conduct by business owners can cause the business to dissolve. Owners of a business entity must understand the stability and durability of the organization if or when an owner leaves the business. Managers are concerned with the stability of customers and suppliers and should make certain that changes in ownership or structure do not have unintended consequences on the business operations. The primary change affecting the status of a business entity is the death or dissociation of an owner. In some instances this occurrence may be grounds for the dissolution of the business. Another dissolution event may arise through a limitation on the transfer of ownership by any individual in the business. Such a scenario may effectively dissolve the business if one individual wishes to liquidate her interest. For further written and video explanation, discussion and practice questions, see What is "continuity" of a business entity?
What is the “Ownership Structure” of a business entity?
Ownership structure concerns the internal organization of a business entity and the rights and duties of the individuals holding a legal or equitable interest in that business. As owner of the business entity, it is important to understand how the ownership structure of a particular business entity is organized and what that means for the owner’s rights. For further written and video explanation, discussion and practice questions, see What is the "ownership structure" of a business entity?
What is “Control” of a business entity?
This questions concerns who has control over operations or authority to act on behalf of the business. Each business entity type has a default control structure and level of authority vested in individuals in those roles. In many cases the owners and managers of the business are the same people. This relationship becomes convoluted when there are owners who act as managers of the business and others who do not. The issue of overlapping ownership and control becomes increasingly important in closely-held business entities. Third parties dealing with a business entity want to be certain about the level of authority of the individual with whom they are dealing. Further, the business entity is concerned about its agents undertaking transactions that obligate the entity, such as taking out loans or entering into purchaser or sales contracts. For further written and video explanation, discussion and practice questions, see What is "control" of a business entity?
What is the “Personal Liability” of business owners?
Generally, individuals are responsible for their own conduct. The rules of agency may make an individual vicariously responsible for the acts of an agent, if that agent is acting with authority or within the scope of her employment. Some business entities limit the liability of business owners for the actions of agents of the business. This means that the owner is protected from being held personally liable for the debts (contracts) or tortious conduct of the business’s employees or other owners. That is, the business owner does not risk losing her personal assets for debts created or tortious activity committed by the business or its owners. This business entity characteristic is a strong motivation for individuals to form a business entity to carry on their business activities. For further written and video explanation, discussion and practice questions, see What is "personal liability" of owners of a business entity?
How are business owners “Compensated”?
The owners of a corporation may be compensated in two primary manners. The acceptable method of compensation depends upon the type of business entity and the role that the owner plays in the business. Some business entities allow business profits to pass through the business directly to its owners. These owners receive either a percentage of the profits based upon their ownership percentage or a percentage based upon a special allocation of business profits that differs from their ownership percentage. Other business entities (specifically corporations) compensate owners by distributing dividends from business profits. Unlike flow-through profits, payment of dividends is generally a decision by the board of directors and does not represent all profits of the corporation. That is, the corporation determines the amount of any dividends paid to shareholders and may retain any percentage of profits within the corporation. For further written and video explanation, discussion and practice questions, see What is "compensation" of business owners?
How are business owners taxed?
Understanding basic taxation concepts as they apply to each entity type will give you sufficient background to understand the important tax considerations in a transaction by a given business entity. To understand taxation of business entities, it is important to understand personal taxation as well as business taxation. Individuals pay federal and state taxes on a percentage of their adjusted gross income (AGI) in a given tax year. AGI is calculated as an individual’s gross income, minus all deductions (either the standard deduction or itemized deductions) and the individual’s personal exemption. A person’s gross income is comprised of wages or other income, dividends, and investment interest, gains, dividends, rents, royalties, etc. Deductions are numerous categories of expenses that the state and federal government exempts from taxation. A person can either claim individual deductions, known as “itemizing deductions” or claiming a “standard deduction”. The income tax rates for wages and other income are tiered. All individuals pay a fixed percentage on the first several thousand dollars of their AGI, a fixed percentage on the next several thousand, etc. Individuals also pay taxes on gains. Gains consist of value received and recognized when an asset is sold for a higher value than the owner’s basis in the property. Long-term capital gains (gains on certain assets held longer than 12 months) and dividends are taxed at different rates than other forms of gross income. Short-term capital gains are taxed at ordinary income rates. The tax rate for long-term capital gains and qualified dividends may also be tiered based upon income. While they are included in gross income, qualified dividends and long-term capital gains are subject to different tax rates from other sources of income. Business taxation is more complicated than individual taxation. Business entities are either not taxed at all, or they are taxed at a corporate rate. If a business entity is classified as a pass-through tax entity, it does not pay income taxes. Rather, the business owners pay taxes on any business profits. Restated, the profits or losses from the business activity pass through to the individual and are reported on her individual income tax form. Businesses that pay taxes, such as businesses taxed under Subsection C of the Internal Revenue Code ("C-Corps), are taxed at the corporate rate. Like the individual tax system, the corporate tax rate is tiered. Business entities taxed under Subsection C of the Internal Revenue Code (IRC) pay income taxes on profits. Corporations taxed in this manner are known as C-corporations. These taxes are treated as an expense to the corporation. They are deducted, along with other expenses, to determine whether the corporation is profitable or has profits at the end of the tax year. Any distribution of corporate profits to shareholders is a dividend and is taxed to the shareholder at the applicable dividend rate. The shareholder reports those dividends on her personal income tax return. For an explanation of these concepts and further written and video explanation, discussion and practice questions, see What is income taxation of business owners?
What is “Sales & Use Tax”?
Businesses that sell any sort of good are subject to sales and use tax. Sales tax is the amount that the merchant must charge to customers who purchase goods for use (rather than resale). Sales tax is generally a fixed percentage of the value of the good. Other taxes that accompany sales tax may also apply for specialty occupations, such as merchants selling luxury goods, hotels, and restaurants. The merchant must collect the tax from the customer and not simply pay the taxes from the proceeds of the sale. The taxes withheld must be deposited with the state’s department of revenue on a regular basis. The taxing state is the location where the good was sold. It does not matter the location where the seller is located. Use tax is a separate tax that is similar to sales tax and applies to the purchase of goods by individuals or businesses. Use tax is assessed when goods are purchased for use or consumption and sales tax is not paid on the item. This scenario may arise when a merchant purchases goods for resale, which is done free of sales tax, and then converts the item to personal use. Another common use-tax scenario is when an individual or business purchases a good in a state other than the state in which the goods will be primarily used, consumed, or located. If the sales tax assessed in the state of purchase is lower than the sales tax in the state where the goods will be used, consumed, or stored, the purchaser must pay the tax rate difference to the state where the good is used, consumed, or located. For further written and video explanation, discussion and practice questions, see What is Sales & Use tax?
What are “Payroll” and “Self-Employment” taxes?
Employers and employees who receive any form of compensation as part of their employment are generally subject to payroll taxes. Payroll taxes were authorized under the Federal Insurance Contribution Act (FICA) and are made up of Social Security and Medicare taxes. Employers must withhold these taxes from the compensation paid to employees. The employer then contributes a similar amount to that withheld from the employee’s compensation. The employer then deposits these funds with the Internal Revenue Service (IRS). These payments go to fund the Medicare program and the Social Security benefits that the employee will receive when she is eligible. Self-employment taxes apply to individuals who are self-employed or are owners of an entity taxed as a partnership. You can think of it as the employer and the employee are one in the same. As such, the self-employed individual is responsible for paying the employer and employee portion of the payroll tax. For further written and video explanation, discussion and practice questions, see What are payroll and self-employment taxes?
Major Characteristics of a “Sole Proprietorship”
The sole proprietorship is not a true form of business entity. This is because there is no boundary between the individual entrepreneur and business entity. The entrepreneur and the business activity are one in the same. The sole proprietorship, however, is the basis for comparing other entities. The primary characteristics of the sole proprietorship are as follows: Creation, Maintenance, Continuity, Ownership, Control, Personal Liability, Compensation, and Taxation. To learn more about these characteristics and for further written and video explanation, discussion and practice questions, see What are the major characteristics of a "sole proprietorship"?
Major Characteristics of a “General Partnership
The primary characteristics of the general partnership are as follows: Creation, Maintenance, Continuity, Ownership, Control, Personal Liability, Compensation, and Taxation. To learn more about these characteristics and for further written and video explanation, discussion and practice questions, see What are the main characteristics of a "general partnership"?
Major Characteristics of a “Joint Venture”
Joint ventures operate similarly to general partnerships, but they are specifically formed for a limited purpose or a single project. Unlike a general partnership, the joint venture does not arise by default through the activity of the joint venturers; rather, it requires the specific intent and agreement of the parties. As such, a joint venture agreement should be in writing to avoid the interpretation of the activity as a general partnership. Accomplishing a specific goal or working on a specific project is a key characteristic of the joint venture. If the joint venture is repeated, it makes it more likely that a court would interpret the relationship to be a general partnership. For further written and video explanation, discussion and practice questions, see What are the main characteristics of a "joint venture"?
Major Characteristics of a “Limited Partnership”
The limited partnership is a specialized form of partnership. The purpose of the limited partnership is to allow individuals to organize into an entity form that allows the flexibility of a general partnership, while allowing for special rights, duties, and protections for “limited partners”. The major characteristics of the limited partnership are as follows: Creation, Maintenance, Continuity, Ownership, Control, Personal Liability, Compensation, and Taxation. For further written and video explanation, discussion and practice questions, see What are the main characteristics of a "limited partnership"?
Major Characteristics of a Limited Liability Partnership
A limited liability partnership (LLP) is a special, hybrid entity recognized in most states. The LLP has characteristics similar to a general partnership (GP), but has limited liability protections similar to that of a limited liability company (LLC). The main characteristics of an LLP are as follows: Creation, Maintenance, Continuity, Ownership, Control, Personal Liability, Compensation, and Taxation. For further written and video explanation, discussion and practice questions, see What are the main characteristics of a "limited liability partnership"?
Major Characteristics of a “Limited Liability Company” - LLC
A limited liability company (LLC) is a state recognized entity that blends the characteristics of a GP and a corporation. The LLC has quickly become the most popular business entity form in the United States for small businesses with more than one owner. The main characteristics of an LLC are as follows: Creation, Maintenance, Continuity, Ownership, Control, Personal Liability, Compensation, and Taxation. For further written and video explanation, discussion and practice questions, see What are the main characteristics of a "limited liability company"?
Major Characteristics of a “Corporation”
A corporation is one of the earliest forms of legally recognized business entity. Corporations exist under every state’s laws. The corporation is the most formalized and developed form of business entity. Its structure is developed to optimize the relationship between owners (shareholders), high-level decision makers (directors), and operational managers (executives). The main characteristics of a corporation are as follows: Creation, Maintenance, Continuity, Ownership, Control, Personal Liability, Compensation, and Taxation. For further written and video explanation, discussion and practice questions, see What are the main characteristics of a "corporation"?
Requirements to be an “S-Corporation”
To qualify for S-Corporation status, the business must be a corporation and meet the following requirements: Geography - Organized in the United States. Citizenship - All shareholders must be US Citizens or resident aliens. Number of Shareholders - It cannot have more than 100 shareholders. Eligible Shareholders - All shareholders must be individuals, trusts, or certain other exempt organizations. Ownership Classes - The company may only authorize one class of stock (common stock). Tax Year - The company must follow an IRS accepted tax year. Shareholder Election - All shareholders must consent to the S-election. It is fairly easy to run afoul of the S corporation requirements and lose the tax status. For example, a business may exceed the number of eligible shareholders, accidentally transfer an interest in the business to a business entity, or authorize what is deemed a second class of shares. For further written and video explanation, discussion and practice questions, see What are the requirements to be a "S Corporation"?
Flashcard - Study Practice
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