Economic entity assumption clarifies the relationship between you and your business for financial statements. As a small-business owner, your legal and financial identity is closely connected to the identity of your company. However, for accounting and economic reporting purposes, you and your incorporated business are separate entities.
The Principle of Economic Entity Assumption
Economic entity assumption is a fundamental accounting principle assuming that the incorporated business entity exists separate from its owners. Accounting systems for the business must record and track transactions for the business only.
Economic Entity Assumption Violation
It is essential to keep your personal financial transactions separate from your business with separate bank accounts. Maintaining a separate bank account is advisable even for sole proprietorships which are not required by law to do so. Economic entity assumption violation is the failure of corporations to keep economic entities separate. At the least, this failure can create headaches for your accountant. In the worst-case scenario, it can be a violation of tax law.
For example, if you posted the purchase of a new vehicle as a business expense but use the vehicle primarily for your personal use it would be a violation. If you use personal funds to keep your business afloat during times of poor cash flow, you must record it as a personal cash infusion rather than from income that your company earned.
Business Structures and Economic Entity Assumption
The type of economic entity that your company assumes depends on how you decide to structure the business when you register with your state. As a sole proprietorship, your business earnings are personal income and taxed on the individual level, even if you track your business expenses separately from your personal expenses. In partnerships, each partner pays a percentage of the taxes owed based on their equity in the business.
Business owners who have formed an S corporation (S corp) do not pay tax at the corporate level. This structure has elected a special tax status with the Internal Revenue Service (IRS) that allow the profits or losses of the business to be “passed-through” the business. Earnings are reported on the owner’s personal tax returns and taxed at the individual level.
On the other hand, the standard C corporations (C corp) are separate taxable entities and pay taxes at the corporate level. Double taxation can occur if owners are paid dividends from corporate income. In this case, the dividends are personal income and the owner pays tax on the dividends at the individual level.