The exam may present questions about business forms and protocols for opening business brokerage accounts. Not only is it important to understand the basics of these entities if you were to provide services to a business client (e.g., providing securities advice to a small business), but knowledge in this area also informs financial professionals and investors on the types of businesses they invest in. Additionally, entrepreneurs often require guidance on what entity to create for their business. Good news - there’s no need to be an expert, as test questions tend to focus on fundamental characteristics, ease of establishing, tax status, liability, and basic suitability.
These are the specific business entities we’ll discuss in this chapter:
A sole proprietorship is commonly cited as the simplest and easiest business form to create. In most states, only a simple form and a small fee are required to establish the entity officially. One owner exists, and their personal finances are often intertwined with the business’s. Many businesses initially start as sole proprietorships, then evolve into one of the business forms below. One of the main reasons relates to liability.
Liability refers to the potential for a lawsuit or legal obligation that may force a payout. For example, let’s assume a small lawnmowing business is formed as a sole proprietorship. The business owner accidentally destroys an expensive tree, obviously upsetting their customer. What if the tree was worth much more than the business itself?
Sole proprietorships are subject to unlimited liability. This means the business owner’s personal assets are subject to litigation. If the customer in the example above were to sue the business, the owner could potentially lose all business assets, plus personal assets. Because of the risk involved, building a liability-prone business as a sole proprietorship is not a great idea.
All gains and losses of the business flow through directly to the owner’s personal taxes. If you recall from the limited partnerships chapter, flow-through of losses is actually a good thing. If the business spends more money than it brings in, the business owner can use the losses as a deduction with their personal taxes.
As we discussed in a previous chapter, a general partnership is comprised solely of general partners that manage and (sometimes) fund the business. Like any other partnership, at least two partners must form this entity. General partnerships are more challenging to create than a sole proprietorship, but still reasonably easy to set up.
General partnerships subject their partners to unlimited liability. Additionally, gains and losses of the business flow through directly to the personal returns of the general partners.
For an in-depth review of limited partnerships, you can visit the unit covering them. We’ll do a quick summary in this section. Limited partnerships comprise at least one general partner and one limited partner. General partners manage and sometimes fund the business venture, while limited partners financially support the business venture. You should consider the general partners as the business managers and limited partners as the investors.
Similar to their status in general partnerships, general partners are provided a flow-through of gains and losses and have unlimited liability. Limited partners also are provided a flow-through of gains and losses, but are only subject to limited liability. Limited partners are usually only subject to losing the amount of capital (money) invested in the partnership.
Limited partnerships are better vehicles for raising capital than general partnerships, given the existence of limited partners. An investor could purchase an interest (ownership) in partnership as a limited partner, allowing them to make a return while offsetting gains with losses (the more losses, the fewer taxes) and avoiding unlimited liability. General partnerships also raise capital from investors, but the only way an investor may be passed through losses is if they become a general partner. By doing so, they’re opening themselves up to unlimited loss! Therefore, investors are more likely to gravitate to limited partnerships.
As the name suggests, limited liability companies (LLCs) limit their owners’ liability. In particular, their liability is limited to their investment (similar to limited partners). LLC business owner(s) are commonly referred to as members. LLC members obtain flow through of gains and losses from the business. Forming an LLC typically requires legal assistance and can be difficult, depending on the business size.
There are two general types of corporations - S and C corporations. S corporations typically involve smaller businesses. Business owners are referred to as shareholders, and there can be no more than 100. Shareholders may not be non-resident aliens, meaning all shareholders must be US residents or citizens. Additionally, the corporation may only issue one class of stock, unlike C corporations which may issue multiple classes. Forming an S corporation requires roughly the same effort as forming a partnership or LLC.
Like limited partners and LLC members, S corporation shareholders are subject to limited liability. Shareholders are not subject to liability above their basis, essentially the amount invested in the business. Additionally, shareholders obtain flow-through of gains and losses.
C corporations are a notoriously difficult business entity to form and manage. These business entities typically employ teams of lawyers and accountants to keep their books and records compliant with relevant laws and IRS requirements. However, it is the best entity to raise significant capital from investors. Stock and bonds of all forms and classes may be issued to unlimited investors with no residency or citizenship requirements. Additionally, these securities can be registered for public trading, making it simple for investors to liquidate* their investments when necessary. Due to the ease of raising capital, virtually all publicly traded companies are formed as 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.
The owners of C corporations are referred to as shareholders. Like limited partners and S corporation owners, shareholders maintain limited liability. Losses will not exceed the investments made by shareholders.
Unlike all the other business forms mentioned in this chapter, C corporations do not allow for the flow-through of losses. The only way for a shareholder to report a tax-deductible loss is to liquidate their investment at a price lower than their basis (e.g., buying a stock at $50 and selling it at $30). If the business faces financial difficulty and experiences losses, it cannot pass through those losses to its shareholders.
C corporations can still pass through gains, but these gains are subject to double taxation. Assume a C corporation makes $100,000 in gross profits. After paying for the cost of goods sold and operational expenses, the business will pay taxes on the remaining income. From there, the corporation has two choices - retain the profits (earnings) and/or distribute part or all of the profits to shareholders in the form of a dividend. If the company pays part or all its profits as dividends, its shareholders will pay taxes on the dividends received. In summary, the business paid taxes on its earnings, then the shareholders paid taxes again on the dividends (shared profits) received.
Financial professionals generally provide two types of guidance related to these business forms. First, recommendations can be made to clients in search of the right entity to form for their business. The ease of starting the business, ability to raise capital, liability, and pass-through status (as we’ve discussed with each entity) are all important factors.
Second, recommendations can be made directly to clients already formed as these businesses. For example, what if the general partners in a limited partnership hired an investment adviser to guide what securities the business should hold? Suitability standards depend on the business form.
Recommendations made to sole proprietorships should only consider the suitability of the single business owner. Given the business is owned “solely” by one person, only their needs, goals, and financial status should be considered.
Recommendations made to a general partnership should factor in the suitability of each general partner. This should make sense; it wouldn’t be fair to only factor in the wealthiest partner’s suitability profile, as all general partners are subject to unlimited liability. If the business makes a bad investment, the losses are shared among all partners.
Recommendations made by financial professionals to limited partnerships are primarily focused on all general partners given 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 of the pass-through of all gains and losses to investors, leaving both business forms without income or losses attributed to the business itself.
Recommendations made by financial professionals to C corporations will only consider the suitability profile of the company itself. This is because the C corporation is considered a “taxable entity,” given losses may not be passed through (although gains can be passed through).
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