The exam may include questions about business forms and the documents required to open business brokerage accounts. You’ll want to understand the basics for two reasons:
Entrepreneurs also often ask for guidance on which entity to form. You don’t need to be an expert - test questions usually focus on the fundamentals: how easy the entity is to form, tax status, liability, and basic suitability.
These are the specific business entities we’ll discuss in this chapter:
A sole proprietorship is usually the simplest business form to create. In many states, you can establish one with a basic filing and a small fee. There’s one owner, and the owner’s personal finances are often closely tied to the business. 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, imagine a small lawnmowing business organized as 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. In the example above, 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. Flow-through losses can be helpful: if the business has a loss, the owner may be able to use that loss as a deduction on their personal return.
Summary:
As discussed in a previous chapter, a general partnership is made up only of general partners. General partners manage the business and may also contribute capital. Like any partnership, it requires at least two partners. It’s typically more involved to form than a sole proprietorship, but 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 unit covering them. Here’s the key summary.
A limited partnership has at least one general partner and at least one limited partner:
A helpful way to remember this is:
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 - typically limited to the amount they invested.
Limited partnerships are often better at raising capital than general partnerships because investors can participate as limited partners. A limited partner can potentially benefit from flow-through tax treatment while avoiding unlimited liability. In a general partnership, an investor generally must become a general partner to receive flow-through losses, which also means accepting unlimited liability.
Summary:
As the name suggests, limited liability companies (LLCs) limit the owners’ liability - generally to the amount invested (similar to limited partners). LLC owners are called members.
LLC members receive flow-through gains and losses. Forming an LLC often requires legal assistance and may be more complex, especially as the business grows.
Summary:
There are two general types of corporations: S and C. S corporations are commonly used by smaller businesses.
Owners are called shareholders, and there can be no more than 100. Shareholders can’t be non-resident aliens, so all 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, generally limited to their basis (the amount invested). Shareholders also receive flow-through gains and losses.
Summary:
C corporations are typically the most complex business entity to form and operate. They often rely on lawyers and accountants to maintain compliance with corporate law and IRS requirements. However, they’re also the most effective structure for raising large amounts of capital.
C corporations can issue stock and bonds in multiple forms and classes to an unlimited number of investors, with no residency or citizenship requirements. These securities can also be registered for public trading, which makes it easier for investors to liquidate* their investments when needed. Because of this ability to raise capital, most 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, 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 a tax-deductible loss from the corporation’s operating losses. The typical way a shareholder recognizes a deductible loss is by selling (liquidating) 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, suppose a C corporation earns $100,000 in gross profits. After expenses, it pays corporate income tax on its remaining income. The corporation can then retain the after-tax earnings and/or distribute some or all of them to shareholders as a dividend. If dividends are paid, shareholders pay tax again on the dividends received.
Summary:
Financial professionals typically give guidance related to these business forms in two ways.
First, you may recommend an entity type to a client who is deciding how to structure a new business. 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 help select securities for the partnership.
Suitability standards vary by business form:
Recommendations made to sole proprietorships should consider only the suitability of the single business owner. Because one person owns the business, only that person’s needs, goals, and financial situation apply.
Recommendations made to a general partnership should consider the suitability of each general partner. This matters because all general partners have unlimited liability and share in the results of the partnership’s investments.
Recommendations made by financial professionals to limited partnerships focus primarily on the general partners (because of their unlimited liability), but the needs and goals of limited partners are also considered.
Recommendations made by financial professionals to LLC members and S corporations must consider the suitability profiles of all members and shareholders. This is because gains and losses flow through to the owners, rather than being taxed at the entity level.
Recommendations made by financial professionals to C corporations consider only the suitability profile of the company itself. This is because the C corporation is a taxable entity and does not pass through losses (even though it can distribute gains).
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