2. Business Entities
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.
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 bind the partnership in business transactions (agency authority)
- 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. One partner's bad business decision can put everyone's personal assets at risk.
Limited Partnership (LP)
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.
Limited Liability Company (LLC)
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.
C-Corporation
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.
S-Corporation
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 | U.S. citizens or resident aliens only; 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.
Master Comparison: All Business Entity Types
| Entity | Liability | Taxation | Key Restriction |
|---|---|---|---|
| General Partnership | Unlimited (all partners) | Pass-through (K-1) | Any partner can bind the business |
| Limited Partnership | GP: unlimited; LP: limited | Pass-through (K-1) | LP loses 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.