The exam is likely to ask about specific business forms. You’ll want to understand the basics for two main reasons:
Entrepreneurs also often need guidance on which entity to form. The exam typically stays at the fundamentals: key characteristics, ease of formation, tax status, liability, and basic suitability.
These are the specific business entities discussed in this chapter:
A sole proprietorship is usually the simplest business form to create. In most states, you can establish it with a simple form and a small fee. There’s one owner, and the owner’s personal finances are often intertwined with the business’s finances. Many businesses start as sole proprietorships and later convert to another form, often because of liability concerns.
Liability is the risk of a lawsuit or legal obligation that could require a payout. For example, suppose a small lawnmowing business is a sole proprietorship. The owner accidentally destroys an expensive tree, and the customer demands compensation. What if the tree is worth more than the business itself?
Sole proprietorships have unlimited liability, meaning the owner’s personal assets can be reached by creditors. If the customer sues, the owner could lose business assets and personal assets. Because of this, a business with meaningful liability exposure is usually not a good fit for a sole proprietorship.
For taxes, all gains and losses flow through to the owner’s personal tax return. As discussed in the limited partnerships chapter, flow-through losses can be valuable: if the business has a loss, the owner may be able to deduct that loss on their personal return.
Summary:
You should already understand limited partnerships from a previous unit. A general partnership is similar to a limited partnership, but it has no limited partners. All owners are general partners who manage and (sometimes) fund the business. Like any partnership, it requires at least two partners. It’s more involved than forming a sole proprietorship, but it’s still relatively straightforward.
General partners have unlimited liability. The partnership’s gains and losses also flow through to the partners’ personal tax returns.
Summary:
For a deeper review, see the chapter covering them. Here’s the quick version.
A limited partnership has at least one general partner and at least one limited partner:
General partners have unlimited liability and receive flow-through gains and losses. Limited partners also receive flow-through gains and losses, but they have limited liability. In general, a limited partner’s loss is limited to the amount of capital they invested.
Limited partnerships are often better at raising capital than general partnerships because investors can participate as limited partners. That structure lets an investor seek returns, potentially use flow-through losses to offset other income, and avoid unlimited liability. In a general partnership, an investor generally must become a general partner to receive flow-through losses - meaning they would take on unlimited liability. As a result, investors often prefer limited partnerships.
Summary:
As the name suggests, limited liability companies (LLCs) limit the owners’ liability - typically to the amount invested (similar to limited partners). LLC owners are called members. Members receive flow-through gains and losses.
Forming an LLC often requires legal assistance and can be more complex, especially as the business grows.
Summary:
There are two general types of corporations: S and C corporations. S corporations are typically used by smaller businesses. Owners are called shareholders, and there can be no more than 100.
Key restrictions include:
Forming an S corporation generally takes about the same effort as forming a partnership or LLC.
S corporation shareholders have limited liability. Their liability generally doesn’t exceed their basis (the amount invested). Shareholders also receive flow-through gains and losses.
Summary:
C corporations are typically the most complex business form to create and operate. They often rely on teams of lawyers and accountants to maintain compliance with corporate and IRS requirements.
C corporations are also the best structure for raising significant capital:
Because they can raise capital efficiently, virtually all publicly traded companies are C corporations.
*All other business forms typically avoid registration of their securities, meaning interest (ownership) in those entities is obtained in private transactions. The more private the transaction, the more liquidity risk the investor is subject to.
Owners of C corporations are called shareholders. Shareholders have limited liability, so losses generally won’t exceed the amount invested.
Unlike the other business forms in this chapter, C corporations do not allow flow-through of losses. A shareholder generally can’t claim a tax-deductible loss unless they sell (liquidate) their investment for less than their basis (for example, buying at $50 and selling at $30). If the corporation has operating losses, those losses stay at the corporate level.
C corporations can distribute gains to shareholders, but those gains may be subject to double taxation. For example, suppose a C corporation earns $100,000 in gross profits. After expenses, it pays corporate income tax on its taxable income. The corporation can then retain the remaining earnings and/or distribute some or all of them as a dividend. If dividends are paid, shareholders pay tax on the dividends received. In other words, the corporation pays tax on earnings, and shareholders may pay tax again when those earnings are distributed.
Summary:
Financial professionals generally provide two types of guidance related to these business forms.
First, you may recommend an entity type to a client who is deciding what to form. Key factors include:
Second, you may make recommendations to an existing business entity. For example, general partners in a limited partnership might hire an investment adviser to advise the partnership’s investments. Suitability standards vary by business form.
Recommendations to sole proprietorships should consider only the suitability of the single owner. Since one person owns the business, only that person’s needs, goals, and financial status apply.
Recommendations to a general partnership should consider the suitability of each general partner. This matters because all general partners have unlimited liability. If the partnership makes an unsuitable investment, the consequences can affect every partner.
Recommendations to limited partnerships focus primarily on the general partners because they have unlimited liability, but the needs and goals of limited partners are also considered.
Recommendations to LLCs and S corporations must consider the suitability profiles of all members and shareholders. Because gains and losses flow through, the economic impact is borne by the owners rather than the entity itself.
Recommendations to C corporations consider only the suitability profile of the company itself. This is because the C corporation is a taxable entity: losses don’t flow through to shareholders (even though gains may be distributed).
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