What is an Entity?
An entity is an organization created by one or more individuals to carry out the functions of a business and maintains a separate legal existence for tax purposes. It can be created at the local or state level.
Entities refer to the structure of the business rather than what the business does. They can include sole traders, corporations, partnerships, limited liability partnerships, or limited liability companies.
Economic Entity Assumption
The economic entity assumption is an accounting principle that separates the transactions carried out by the business from its owner. It can also refer to the separation between various divisions in a company. Each unit maintains its own accounting records specific to the business operations.
Many external stakeholders use the records maintained by a business. Governments and investors use a company’s financial records to assess its performance. Hence, it is important that the transactions reflect the activities of the entity.
According to the economic entity assumption, a person evaluating a company’s records assumes all the transactions pertaining to the business being reviewed. A sole proprietor should keep the business transactions separate from his own personal transactions. The assumption is also applicable to businesses with different types of activities.
For example, if a company runs two business divisions – one is a hotel chain while the other is a restaurant chain – separate accounts need to be maintained for each division. The expenses of one line of business cannot be combined with the other. Maintaining separate records will help the company know the true value of each business line.
What is Limited Liability?
Limited liability creates a distinction between a business and its shareholders. Similar to the economic entity principle, limited liability separates business finances from that of its owners. However, the two concepts differ in a few ways. First, the economic entity principle applies to all business entities, regardless of its structure, but limited liability does not apply to certain structures such as a sole trader.
Second, while economic entity is a principle of accounting, limited liability is a form of legal protection. The economic entity principle separates only the financial transactions of a company and its owners, but limited liability prevents the owner from being held liable for the company’s debts and losses.
Types of Business Entities
1. Sole Proprietorships
A sole proprietorship is a business that is run by an individual for his/her own benefit. It is the most basic form of an organization. Proprietorships are not separated from its owners. The liabilities of the business are associated with the personal liabilities of its owners, and the business is terminated in the event of the owner’s death.
Although sole proprietorship is not a separate legal entity from its owner, it is still a separate entity for accounting purposes. For a sole trader, it is easy to start a company with minimum legal restrictions, but it is difficult to raise money for the business and unlimited liability.
A general partnership is an agreement between two or more people who join together to run a business. Each partner contributes capital in the form of labor, money or skill, and profits and losses are shared. The partners are liable for their debts in the company.
In a limited partnership, the liability of each partner is limited to what they own in the business. If a business goes bankrupt, they cannot lose their personal possessions as is the case with unlimited liability. For a partnership, there are more resources and capital available compared to a sole trader, but there is often conflict in decision-making, and profits need to be shared.
3. Limited Liability Company (LLC)
Owners of a limited liability company (LLC) can take advantage of operational flexibility and income benefits, but they also have limited liability. LLCs are similar to a limited partnership; however, there are many legal and statutory differences in a limited liability company. An LLC provides its owners with significant flexibility in structuring the business.
In many places, an LLC has one owner only; they operate as a sole trader but have limited liability. However, due to its high degree of flexibility, the creation of an LLC is a long and tedious process.
A corporation is an entity that operates under state law is limited to the scope of activity restricted by its charter. An article of incorporation must be filed with the state to form a corporation. The stakeholders have limited liability and employees of a corporation can enjoy tax-free benefits such as health insurance.
Corporations are usually taxed twice; the first tax is paid on its profits and the second tax is paid on stockholders’ dividends. The benefits of a corporation include limited liability and perpetual life of a business, which means the company can be passed down to future generations. The drawbacks of a corporation include high costs of setting up the business and government regulations that need to be followed.
Each entity comes with its own advantages and drawbacks, such as limited liability and increased bureaucracy. When choosing a business entity, the tax regulations, liability, and management terms need to be taken into consideration to find out what works best for your business model.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: