Let’s dive into the history behind the business entity and answer these common questions.
- What is a business entity?
- Where do entities exist?
- What types of business entities are currently in existence?
Incorporating a small business as a business entity is important. An incorporated business receives liability protection for its personal assets, tax savings, and added credibility for the company. We know it matters to incorporate as a business entity, but have you ever asked yourself what is a business entity?
Asking what a business entity is creates an interesting domino effect of even more questions. Why do entities exist? Where did they come from, exactly? Why do small businesses need them? This all comes full circle as we look at existing types of business entities and how their existence helps to protect businesses of all sizes.
What is a business entity?
Business entities, at the core, are legal structures that allow businesses to conduct business. Their purpose is fairly simple. Incorporating as a business entity ensures the separation and protection of personal and professional assets.
Why do entities exist?
Have you ever wondered where business entities originate from? Historically speaking, business entities have always been formed at the state level. Many entrepreneurs likely know this, since paperwork for business formations is filed with the startup’s local Secretary of State.
What entrepreneurs may not be aware of, however, is which state helped pave the way for entity formation and its evolution. That state is Delaware. The state has long been referred to as a “corporate darling” for small businesses, and Delaware has maintained that reputation for hundreds of years. As a 215-year-old business court, the Delaware Court of Chancery has written most modern U.S. corporation case law. The Delaware General Corporation Law also boasts the most advanced and flexible business formation statute in the United States. Subchapters within the General Corporation Law cover legal formation, registered agents, stocks, meetings, mergers and consolidations, and much more as it pertains to business.
Today, every U.S. state also provides its own package of incorporation services to entrepreneurs. We take it for granted now, but it was Delaware’s forward-thinking approach to small businesses back then that raised the bar for every other state to simplify their own incorporation process.
What types of business entities currently exist?
There are plenty of business entities entrepreneurs can incorporate as which include but are not limited to
- Limited liability companies (LLCs)
- Nonprofit corporations
Let’s take a (brief) look at each entity formation and why a small business would need it.
Limited liability companies (LLCs)
LLCs are fairly new business entities. The first time it became possible to form an LLC was in 1977 — and the first state to embrace LLC formation was Wyoming. LLCs later caught on with the rest of the country in the 1990s. However, the business entity is still considered “newer” than its counterparts.
Forming an LLC allows small businesses to legally separate the business from its owner — or “member,” which is the name of the owner of an LLC. Under an LLC, personal assets are separated from business assets through liability protection. This business entity is also known for providing its member(s) flexibility to run the business and is relatively inexpensive to incorporate.
One last thing to know about LLC formations? Technically, LLCs still don’t have a specific tax category yet. An LLC is taxed as a sole proprietorship or partnership depending on its number of members. This is referred to as pass-through taxation since all taxable income directly passes through to the personal tax returns of the owners. However, you don’t have to keep the pass-through taxation method if you don’t want it. Those that incorporate as an LLC may choose a different tax structure and elect to be taxed as a corporation or S Corporation.
Corporations have existed substantially longer than LLCs have, thanks to the larger-than-life nature of this business entity. Small businesses have the ability to grow on a global scale when they form a corporation. They may issue shares and stocks, attract potential investors, and go public with an initial public offering (IPO).
While corporations do have liability protection in common with LLCs, this business entity is much more structured. This entity is subject to double taxation, where income is taxed at a corporate and personal level. Corporations must also observe certain formalities, like taking annual meetings and appointing shareholders.
Many businesses want to give back to their community and benefit the general public. One of the most common entity formations for this kind of business model is a nonprofit corporation.
Forming a nonprofit corporation is fairly similar to incorporating a regular corporation. Much like a regular corporation, a nonprofit corporation is registered with its Secretary of State and is run by a set of bylaws. The greatest difference from a corporation, however, is that a nonprofit corporation is established to benefit the public. Due to its pursuit of a nonprofit mission, the business entity may file for tax-exempt status. Many nonprofits opt for 501(c)(3) status, which exempts their corporation from paying federal and state taxes.
It’s not uncommon to want to go into business with a family member or friend. Small businesses are often encouraged to form a partnership as their business entity of choice. Partnerships are business entities that allow partners to make decisions and share profits and losses together.
No matter how well you know or trust your business partner, however, it is still recommended that entrepreneurs create a written partnership agreement. This document essentially helps keep partners on the same track with one another and the business. Partnership agreements cover key areas like the partnership’s term date and capital contributions. The agreement also details the process for admitting new partners and what to do if there is a voluntary withdrawal — or passing — of a partner.
What does the future hold for business entities?
We defined business entities and went back in time, hundreds of years ago, to uncover where legal structures got their start and the various entities that have since entered the small business landscape. Where do business entities go from here?
If I had to make a guess, it would be that we may be due for even more business entities. Certified B Corporations, for instance, is an entity that allows businesses to make a profit and socially impact their communities. The movement for mission-driven companies got its start in 2006, replacing LLCs as the “new” entity on the block. I can’t say with certainty that I know which entities will be established next, but I can say that it’s always possible for new entities to emerge and protect small businesses.
Deborah Sweeney is the CEO of MyCorporation.com which provides online legal filing services for entrepreneurs and businesses, startup bundles that include corporation and LLC formation, registered agent services, DBAs, and trademark and copyright filing services. You can find MyCorporation on Twitter at @MyCorporation.