Business Structures
Introduction
Choosing the right business structure affects liability, taxation, management, and transferability of interests. The REG exam tests the formation, characteristics, and tax treatment of each major entity type. This chapter compares sole proprietorships, partnerships, LLCs, LLPs, and corporations.
Sole Proprietorship
A sole proprietorship is the simplest business form — a single individual operating a business without forming a separate legal entity.
| Feature | Rule |
|---|---|
| Formation | No formal filing required; may need a DBA ("doing business as") registration |
| Liability | Owner has unlimited personal liability for all business debts |
| Taxation | Profits and losses reported on the owner's individual return (Schedule C); subject to self-employment tax |
| Duration | Terminates upon death or decision of the owner |
Example: A CPA operates a small tax preparation practice as a sole proprietorship. All business income flows to her personal Form 1040, and she is personally liable for any malpractice claims.
General Partnership
A general partnership is an association of two or more persons carrying on a business as co-owners for profit (governed by the Revised Uniform Partnership Act — RUPA).
| Feature | Rule |
|---|---|
| Formation | No formal filing required; can be formed by oral agreement, written agreement, or conduct |
| Management | Each partner has equal rights in management unless otherwise agreed |
| Authority | Each partner is an agent of the partnership and can bind it in ordinary business matters |
| Liability | All partners have joint and several unlimited personal liability |
| Taxation | Partnership files an informational return (Form 1065); income/loss passes through to partners (Schedule K-1) |
| Transferability | A partner may assign a right to receive profits but cannot transfer management rights without consent of all partners |
A partnership is a pass-through entity for tax purposes — it does not pay income tax at the entity level. Each partner reports their distributive share of income, deductions, and credits on their personal return.
Example: BIF Partners is formed by three individuals who agree to share profits equally. Partner A, acting within the scope of the partnership business, signs a lease. All three partners are personally liable for the lease obligation, even if Partners B and C did not authorize the lease.
Limited Partnership
A limited partnership (LP) has at least one general partner (with management authority and unlimited liability) and one or more limited partners (passive investors with limited liability).
| Feature | General Partner | Limited Partner |
|---|---|---|
| Liability | Unlimited personal liability | Liable only to the extent of their capital contribution |
| Management | Full management authority | Generally no management participation (or risk losing limited liability under older statutes) |
| Formation | Must file a certificate of limited partnership with the state | Same |
Under the Revised Uniform Limited Partnership Act (RULPA), a limited partner who participates in control of the business may lose limited liability protection. Modern statutes (ULPA 2001) have largely eliminated this risk, but the concept is still tested.
Limited Liability Company (LLC)
An LLC combines the liability protection of a corporation with the tax flexibility of a partnership.
| Feature | Rule |
|---|---|
| Formation | File articles of organization with the state |
| Operating agreement | Governs management, profit sharing, and member rights (may be oral in some states) |
| Liability | Members have limited liability; not personally liable for LLC debts |
| Management | Member-managed (all members participate) or manager-managed (designated managers) |
| Taxation | Default: pass-through (partnership taxation for multi-member; disregarded entity for single-member). May elect to be taxed as a corporation. |
| Transferability | Economic interest is transferable; full membership rights require consent of other members (unless the operating agreement provides otherwise) |
Example: Illini Entertainment forms an LLC with three members. The operating agreement designates two members as managers. All three members enjoy limited liability, and the LLC is taxed as a partnership — each member reports their share of income on Schedule K-1.
:::tip Exam Tip
An LLC with a single member is treated as a disregarded entity for federal tax purposes (reported on the owner's Schedule C) unless it elects corporate taxation.
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Limited Liability Partnership (LLP)
An LLP is a general partnership that has elected LLP status by filing with the state. It provides partners with protection from liability for the negligence and malpractice of other partners.
| Feature | Rule |
|---|---|
| Formation | File an LLP election with the state (often annual renewal) |
| Liability | Partners are not personally liable for obligations arising from the negligence or misconduct of other partners or employees not under their supervision |
| Own acts | Each partner remains liable for their own negligence and the acts of those they directly supervise |
| Common use | Professional firms (accounting, law) |
Example: Gies Co. is an accounting firm organized as an LLP. Partner A commits malpractice during an audit. Partner B is not personally liable for Partner A's malpractice, but Partner A and the firm's assets are exposed.
Corporation
Formation
A corporation is formed by filing articles of incorporation with the state. The articles must include:
- Corporate name (must include "Inc.," "Corp.," or similar designator)
- Number of authorized shares
- Registered agent and office
- Name and address of the incorporator(s)
Types of Corporations
| Feature | C Corporation | S Corporation |
|---|---|---|
| Taxation | Double taxation — corporation pays tax on income; shareholders pay tax on dividends | Pass-through — income/loss passes to shareholders (Form 1120-S, Schedule K-1) |
| Shareholders | Unlimited number; may include entities and nonresident aliens | Maximum 100 shareholders; only U.S. individuals, estates, and certain trusts |
| Classes of stock | Multiple classes permitted | One class of stock (voting differences allowed) |
| Entity-level tax | Yes (IRC §11) | Generally no (but built-in gains tax and excess passive income tax may apply) |
To qualify as an S corporation, the entity must file Form 2553 (Election by a Small Business Corporation) with the IRS. All shareholders must consent to the election.
Corporate Governance
| Role | Responsibilities |
|---|---|
| Shareholders | Elect directors; approve fundamental changes (mergers, amendments, dissolution); do not manage daily operations |
| Board of Directors | Sets corporate policy; appoints officers; declares dividends; oversees management |
| Officers | Manage day-to-day operations (CEO, CFO, Secretary, etc.) |
Piercing the Corporate Veil
Courts may pierce the corporate veil and hold shareholders personally liable when:
- The corporation is used as a mere alter ego of the shareholder
- Corporate formalities are not observed (no meetings, commingled funds, inadequate capitalization)
- The corporate form is used to perpetrate fraud or injustice
Example: The sole shareholder of MSA Records uses the corporate bank account to pay personal expenses, holds no board meetings, and keeps no corporate minutes. A court may pierce the veil and hold the shareholder personally liable for MSA Records' debts.
Fiduciary Duties
Directors, officers, and partners owe fiduciary duties to the entity and its owners:
| Duty | Description |
|---|---|
| Duty of Care | Act with the care an ordinarily prudent person would exercise; make informed decisions (business judgment rule protects good-faith decisions) |
| Duty of Loyalty | Act in the best interest of the entity; avoid self-dealing, usurping corporate opportunities, and conflicts of interest |
| Duty of Good Faith | Act honestly and not in conscious disregard of duties |
The business judgment rule protects directors from liability for decisions made in good faith, with reasonable care, and in the honest belief that the action was in the corporation's best interest. It does not protect decisions made with a conflict of interest or in bad faith.
Comparison of Business Structures
| Feature | Sole Proprietorship | General Partnership | Limited Partnership | LLC | LLP | C Corp | S Corp |
|---|---|---|---|---|---|---|---|
| Formation | None | No filing required | State filing | State filing | State filing | State filing | State filing + IRS election |
| Owners' liability | Unlimited | Unlimited (joint & several) | GP: unlimited; LP: limited | Limited | Limited (own acts excepted) | Limited | Limited |
| Taxation | Individual | Pass-through | Pass-through | Flexible | Pass-through | Double taxation | Pass-through |
| Management | Owner | All partners equally | General partners | Members or managers | All partners | Board/officers | Board/officers |
| Max owners | 1 | No limit | No limit | No limit | No limit | No limit | 100 |
| Transferability | N/A | Requires consent | Requires consent | Requires consent | Requires consent | Freely transferable | Restrictions may apply |
Summary
| Topic | Key Rule |
|---|---|
| Sole proprietorship | Simplest form; unlimited liability; Schedule C taxation |
| General partnership | No filing; all partners jointly and severally liable; pass-through |
| Limited partnership | Must file; LPs have limited liability if they don't participate in control |
| LLC | Articles of organization; limited liability; flexible taxation |
| LLP | Protects partners from others' malpractice; common for professional firms |
| C corporation | Separate entity; double taxation; unlimited shareholders |
| S corporation | Pass-through; max 100 U.S. individual shareholders; one class of stock |
| Piercing the veil | Alter ego, commingled funds, ignored formalities |
| Fiduciary duties | Care, loyalty, good faith; business judgment rule |