How and Why Set up Your Business as a Separate Entity

Why Separate Entity Protection Is Important for Your Business

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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).

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 negligence or 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 to 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. 

According to Accounting for Management, 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 eneity separately
  • Compare finaial records with other businesses in the industry

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 is shown 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:

  • Holding shareholders personally liable for the corporation's actions
  • Creditors can't take action against owners of businesses that are separate entities
  • Intermingling of 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 Personal 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. Some partnerships 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 together. The debts and legal liabilities of the business and the individual are combined.

How Do I Keep My Business Entity Separate?

Even though you have set up your business as a separate entity 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.

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:

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. (This goes for family members who work in the business too.)
  • 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 tax payments for the business and you personally 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 owns 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).

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.