The Series 66 often includes questions about specific business forms. It’s important to understand the basics for two reasons:
Entrepreneurs also commonly ask for guidance on which entity to form. The exam doesn’t require expert-level detail. Questions usually focus on core characteristics such as:
These are the specific business entities we’ll discuss in this chapter:
A sole proprietorship is usually the simplest and easiest business form to create. In many states, you can establish one with a simple filing 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 on a customer’s property. 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 or plaintiffs. If the customer sues, the owner could lose business assets and personal assets.
For taxes, all gains and losses flow through to the owner’s personal tax return. As you may recall from the limited partnerships chapter, flow-through losses can be beneficial: if the business has a loss, the owner may be able to use that loss as a deduction 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.
A general partnership requires at least two partners. It’s typically more involved to form than a sole proprietorship, but it’s still relatively straightforward.
General partners have unlimited liability, and the partnership’s gains and losses flow through to the partners’ personal tax returns.
Summary:
For a deeper review, see the chapter covering limited partnerships. Here’s the key structure.
A limited partnership has at least:
A helpful way to remember the roles is:
Tax treatment and liability differ by role:
Limited partnerships are often better at raising capital than general partnerships because investors can participate as limited partners. That allows them to seek returns and potentially use flow-through losses, without taking on unlimited liability. In a general partnership, an investor would typically need to become a general partner to receive flow-through losses - bringing unlimited liability along with it.
Summary:
As the name suggests, limited liability companies (LLCs) limit the owners’ liability. In general, an owner’s liability is limited to their investment (similar to a limited partner).
LLC owners are called members. Members receive flow-through gains and losses.
Forming an LLC often requires legal assistance and may be more complex than forming a partnership, depending on the business and the state.
Summary:
There are two general types of corporations: S corporations and C corporations. S corporations are typically used by smaller businesses.
Owners are called shareholders, and there can be no more than 100. Shareholders may not be non-resident aliens, meaning shareholders must be U.S. residents or citizens. An S corporation may issue only one class of stock (unlike a C corporation, which may issue multiple classes).
Forming an S corporation generally requires about the same level of effort as forming a partnership or LLC.
S corporation shareholders have limited liability. Their liability generally does not 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 maintain. They often rely on attorneys and accountants to keep records and comply with legal and IRS requirements.
C corporations are also the best structure for raising large amounts of capital. They can issue stock and bonds in multiple forms and classes to unlimited investors, with no residency or citizenship requirements. These securities can be registered for public trading, which makes it easier for investors to liquidate* their investments when needed. Because of this capital-raising flexibility, most publicly traded companies are C corporations.
*Most other business forms typically avoid registering their securities, meaning ownership interests are usually sold through 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, meaning 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 the corporation’s operating losses on their personal return. The typical way a shareholder recognizes a tax-deductible loss is by selling the investment for less than their basis (for example, buying at $50 and selling at $30).
C corporations can distribute gains to shareholders, but those gains may be subject to double taxation. For example:
Summary:
Financial professionals typically provide two types of guidance related to these business forms.
First, you may recommend an entity type to a client who is deciding how to form a business. Key factors include:
Second, you may make investment recommendations to an existing business entity. For example, general partners in a limited partnership might hire an investment adviser to recommend securities for the partnership to hold. Suitability standards depend on the business form.
Recommendations to sole proprietorships should consider only the suitability of the single owner. Since one person owns the business, you evaluate that person’s needs, goals, and financial situation.
Recommendations to a general partnership should consider the suitability of each general partner. This aligns with the fact that all general partners have unlimited liability and share in the consequences of poor investment outcomes.
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 ultimately lands on the owners.
Recommendations to C corporations consider the suitability profile of the company itself. A C corporation is a taxable entity, and losses generally do not flow through to shareholders (even though gains may be distributed).
Sign up for free to take 5 quiz questions on this topic