What is a legal entity created by a state and it is separate and distinct from its owners and managers?

The definition of a separate entity is easy to figure out, but, as they say, the devil is in the details. A separate entity is a business that is separate legally and financially from its owner or owners.

In terms of day-to-day business, a separate entity runs separately from the owner, with a separate bank account and transactions, buying and selling products or services or both, and receiving and paying out its own money. Everything done by the business entity is separate from what is done by the individual owner(s).

Key Takeaways

• A separate business entity is a company that functions independently from the owner.
• It's important to treat your business as a separate entity to shield your personal assets from legal or financial liability.
• To ensure that your business is a separate entity, register it as an applicable type of company and use accounting measures that separate your business and personal finances.

Why Should I Make My Business a Separate Entity?

You can legally set up any type of business, but the primary reason for setting up a separate entity is to separate the liability of the business from the liability of the individual owner(s). A business or individual can have liability for debts and also for lawsuits for negligenceor illegal actions.

Accounting for Separate Business Entities

Business accounting concepts operate on the principle of a business entity as separate from the owner(s) as personal entities. For example:

• If a business owner loans or invests money in the business, it's recorded as a loan or equity from an outside source.
• if a business owns a building and an owner wants to rent office space in that building, they must pay rent like everyone else and record the rent as income to the business.

Accounting for each business as a separate entity is needed to:

• Measure performance of the business, in terms of profit and cash flow
• Audit business records
• Tax each business entity separately
• Compare financial records with other businesses in the industry

Note

All business accounting is based on the separate entity concept, with business transactions kept separate from the owner's personal assets, but having separate accounting doesn't mean your business is a separate entity for liability or other purposes.

Legal and Liability Benefits of a Separate Entity

The concept of liability protection is important because most people can't afford the higher liability incurred by a business.

The concept of the separate entity can be found in the term "corporate shield" or "corporate veil," meaning that the corporation (or other separate entity) is shielded from liability. If the business is a separate entity, that shield or veil can't be pierced. This concept applies in several situations, including:

• Complainants can't hold shareholders personally liable for the corporation's actions.
• Creditors can't take action against owners of businesses that are separate entities.
• Companies cannot intermingle personal and business assets.

For example, you can limit liability by purchasing liability insurance protection, but why should you as an individual pay for insurance for the liability of your business? If you don't have your business set up as a separate entity, you will need lots more personal liability protection, at a higher cost.

Some examples:

• If your business makes and sells products, there is product liability involved if a customer is injured or becomes sick from using a product.
• If your business has employees, there is a liability for all kinds of lawsuits, including discrimination and harassment claims, and employee injuries and accidents.

If you don't keep the separate entity clearly separate, you personally could be liable for any lawsuits or judgments against the business. This might mean personal bankruptcy or selling your personal assets to pay for lawsuits.

What Types of Businesses Are Separate Entities?

All business types except sole proprietorships must register with a state in order to do business. State registration doesn't mean that the business is a separate entity.

A corporation is a separate entity. The business registers with a state and keeps its business separate through its transactions and ownership documents. All types of corporations (including S corporations, professional corporations, and professional service corporations) are separate entities.

A limited liability company (LLC) is also a separate entity because the LLC owners (called members) have their liability limited to their contribution to the business.

Partnerships may be separate entities and have limited liability, depending on the type of partnership chosen. In a general partnership, the partners are each liable personally for the debts and lawsuits against the partnership. But, some specific types of partnerships are designated as having limited liability and are separate entities. You may be able to form a limited partnership or limited liability partnership (LLP) as a separate entity.

Note

Some partnerships are formed by a group of professionals (attorneys, CPAs, or architects, for example) as a separate entity called a Professional Limited Liability Partnership.

A sole proprietor business is not a separate entity. The sole proprietor business is one person, and that person and the business are considered together. The debts and legal liabilities fall to the business and the individual.

How Do I Keep My Business Entity Separate?

Even though you have set up your business by registering it with your state, that's just the beginning. The business must be managed on a day-to-day basis so it's completely obvious to the IRS and the legal system that the business is a separate entity.

There are some ways you can set up your business recordkeeping, accounting, and other processes so they are separate from your personal transactions.

The first things you need are a separate business checking account and a business tax identification number called an Employee ID Number (EIN). This number is like a Social Security Number for a business. It's easy to apply for an EIN online.

Then, make sure all transactions between yourself personally and the business establish your business as a separate entity.

Any money you withdraw from or put into the business must have written documentation:

• If you pay yourself from the business, it should be as an owner's draw, with a business check.
• If you pay yourself as an employee, use the same payment process and documents as for other employees, including withholding and paying employment taxes.

Note

Payment processes and employment taxes also apply to any family members who work in the business as well.

• If you put money into the business, it must be as a loan (with loan documents) or as an investment (with stock certificates and other appropriate documentation). You must also give all dividend payments as you would other stockholders.
• Keep business and personal tax payments separate. For example, pay for tax preparation for your business and personal income taxes with separate checks, even if they are both on your personal return.
• If you or another owner holds any assets (like a building or a vehicle) that are used by this business, you will need to record payments in the same way as any other separate entity. For example, if the business is leasing space in a building you own, make sure the monthly lease payments are recorded to show the expense to the business and the income to your personal bank account or another account separate from this business.

Bottom Line

The concept of a separate entity is important, so be sure to create a good accounting system and use the system for recordkeeping purposes, and in case of an audit.

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