Quick Answer
Business-entity clients fall along two axes: liability (limited vs. unlimited) and taxation (pass-through vs. double). General partnerships, limited partnerships, and S-corporations are pass-through, and an LLC defaults to pass-through but may elect corporate taxation; only the C-corporation is automatically subject to double taxation. Knowing which entity offers which combination is the core exam skill.
When a business opens an investment account, the adviser must understand the entity's structure because it determines who has authority to act, how profits are taxed, and what liability the owners face. This section covers the five major business entity types tested on the exam.
What Is a General Partnership?
A general partnership is formed when two or more people agree to share ownership, management, and profits of a business.
- All partners have unlimited personal liability for partnership debts
- Any partner can generally bind the partnership for transactions in the ordinary course of its business (agency authority); binding the partnership on unusual or extraordinary matters typically requires the other partners' authorization
- Pass-through taxation: Profits and losses flow to each partner's individual tax return via Form K-1; the partnership itself does not pay income tax
- No formal filing is required to form a general partnership; it can be created by verbal agreement
Exam Tip: Gotchas
In a general partnership, each partner is liable for the actions of the other partners taken in the ordinary course of the partnership's business (or otherwise authorized). One partner's bad business decision can put everyone's personal assets at risk.
How Does a Limited Partnership Differ from a General Partnership?
A limited partnership (LP) has two classes of partners with very different roles:
| Role | General Partner | Limited Partner |
|---|---|---|
| Liability | Unlimited personal liability | Limited to investment amount |
| Management | Manages daily operations | No management role |
| Number required | At least one | One or more |
- Pass-through taxation (same as general partnership; profits flow through on Form K-1)
- Commonly used for real estate, oil and gas, and private equity investments
- Must file formal paperwork with the state to create an LP
Exam Tip: Gotchas
If a limited partner participates in management of the business, they may lose their limited liability protection and be treated as a general partner for liability purposes. The exam tests this distinction frequently.
What Makes an LLC (Limited Liability Company) Different?
A Limited Liability Company (LLC) combines the best features of partnerships and corporations.
- Limited liability: Members (owners) are generally not personally liable for LLC debts; maximum loss is their investment
- Flexible management: Can be member-managed (all owners participate) or manager-managed (designated managers run operations)
- Tax flexibility: By default, a single-member LLC is taxed as a disregarded entity (like a sole proprietorship) and a multi-member LLC is taxed as a partnership. However, an LLC can elect to be taxed as:
- A partnership (default for multi-member)
- An S-corporation
- A C-corporation
| Feature | LLC | General Partnership |
|---|---|---|
| Liability | Limited (members protected) | Unlimited (all partners) |
| Taxation | Flexible (partnership default) | Pass-through only |
| Formation | State filing required | No filing required |
| Management | Member-managed or manager-managed | All partners manage |
Exam Tip: Gotchas
Unlike an LP, an LLC member can actively manage the business without losing liability protection. This is a key distinction the exam tests between LPs and LLCs.
Why Does a C-Corporation Face Double Taxation?
A C-corporation is a separate legal entity from its owners (shareholders).
- Limited liability: Shareholders' maximum loss is the amount they invested in the company's stock
- Double taxation: The corporation pays income tax on profits at the corporate level, and shareholders pay income tax again on dividends received
- Corporate profits → corporate income tax → dividends distributed → personal income tax on dividends
- Can issue multiple classes of stock (common stock, preferred stock, different voting classes)
- Has unlimited life: The corporation continues to exist regardless of changes in ownership
- Ownership is freely transferable through the sale of shares
Think of it this way: The company earns $100 and pays $21 in corporate tax, leaving $79. When that $79 is paid out as a dividend, the shareholder pays tax on it again. The same dollar of profit gets taxed twice.
Exam Tip: Gotchas
Double taxation is the defining disadvantage of a C-corporation. The exam will test whether you can identify which entity types are subject to double taxation (only C-corps) versus pass-through taxation.
How Does an S-Corporation Avoid Double Taxation?
An S-corporation is a corporation that elects special tax treatment under Subchapter S of the Internal Revenue Code.
- Pass-through taxation: Income, losses, deductions, and credits flow through to shareholders' personal tax returns, avoiding double taxation
- Shareholders still enjoy limited liability (same as a C-corporation)
S-Corp Restrictions (frequently tested):
| Restriction | Rule |
|---|---|
| Maximum shareholders | 100 (family members may count as one) |
| Shareholder types | Generally individuals who are U.S. citizens or resident aliens (certain trusts and estates may also qualify); no partnerships or corporations |
| Stock classes | Only one class of stock allowed |
| Voting rights | Differences in voting rights are permitted (voting vs. nonvoting shares are OK) |
Exam Tip: Gotchas
The S-corp "one class of stock" rule is a frequent exam trap. Remember: voting vs. nonvoting shares are allowed because they have identical distribution and liquidation rights. The restriction is about economic rights, not voting rights.
How Do All Five Business Entities Compare?
| Entity | Liability | Taxation | Key Restriction |
|---|---|---|---|
| General Partnership | Unlimited (all partners) | Pass-through (K-1) | Any partner can generally bind the business for ordinary transactions |
| Limited Partnership | GP: unlimited; LP: limited | Pass-through (K-1) | LP may lose protection if they manage |
| LLC | Limited (all members) | Flexible (can elect) | State filing required |
| C-Corporation | Limited (shareholders) | Double taxation | Taxed at corporate and individual level |
| S-Corporation | Limited (shareholders) | Pass-through | Max 100 U.S. shareholders; one stock class |
With business entities covered, let's turn to trusts and estates, which are common institutional client types with unique fiduciary considerations.
What Should You Check on Exam Day?
- General partnership: all partners have unlimited liability, any partner can generally bind the business in the ordinary course, pass-through taxation on Form K-1, no formal filing required to form.
- Limited partnership (LP): general partner has unlimited liability and manages; limited partners are capped at their investment and may lose that protection if they take part in management.
- LLC (Limited Liability Company): members have limited liability and can actively manage without losing that protection, unlike LP limited partners.
- Only the C-corporation is automatically subject to double taxation (corporate level, then again on dividends); every other entity here is pass-through by default, though an LLC may elect C-corporation taxation.
- S-corporation restrictions: maximum 100 shareholders (generally individuals who are U.S. citizens or resident aliens, though certain trusts and estates may also qualify; no partnerships or corporations), and only one class of stock, though voting vs. nonvoting shares are allowed.
- All five entities can open investment accounts, so know who has authority to act on each: any partner in a GP, only the general partner in an LP, and the members/managers as defined in an LLC's or corporation's governing documents.