Types of Business Entities

Why This Matters

When you're tested on business entities, you're really being tested on three interconnected concepts: liability protection, tax treatment, and management structure. Every business entity represents a different combination of these elements, and understanding why entrepreneurs choose one form over another is the key to answering both multiple-choice and free-response questions effectively. The exam loves to present scenarios where you must recommend an entity type based on specific client needs—number of owners, desire for liability protection, tax preferences, or capital-raising goals.

Don't fall into the trap of memorizing entity names and isolated facts. Instead, focus on the trade-offs each structure represents. Why would someone accept double taxation in exchange for easier capital access? Why might professionals choose an LLP over a general partnership? These "why" questions drive exam success. Master the underlying principles—limited liability as a legal shield, pass-through taxation as a tax strategy, formality requirements as compliance burdens—and you'll be able to analyze any business scenario thrown at you.

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Unincorporated Entities with Unlimited Liability

These are the simplest business forms, requiring minimal formalities to create. The trade-off for simplicity is significant: owners face personal liability for all business debts and obligations, meaning creditors can pursue personal assets like homes and savings.

Sole Proprietorship

• Single owner with complete control—the simplest entity to form, requiring no state filing in most cases
• Pass-through taxation means all business income is reported on the owner's personal tax return, avoiding entity-level taxation
• Unlimited personal liability exposes the owner's personal assets to all business debts, lawsuits, and obligations

General Partnership

• Two or more owners sharing management—formed automatically when people conduct business together for profit
• Joint and several liability means each partner can be held responsible for the entire debt of the partnership, not just their share
• Partnership agreement governs profit-sharing and decision-making, but without one, profits and losses split equally by default

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Partnership Variations with Liability Protection

These hybrid structures emerged to address the harsh unlimited liability of traditional partnerships. By adding "limited" to the name, the law creates a shield for certain partners, though the protection varies based on the specific structure.

Limited Partnership (LP)

• Two classes of partners—general partners manage the business and face unlimited liability; limited partners invest capital but stay passive
• Limited partners' liability capped at investment—they can lose what they put in, but creditors cannot pursue personal assets
• Common in investment ventures like real estate and private equity, where passive investors want returns without management responsibilities

Limited Liability Partnership (LLP)

• All partners receive liability protection—no partner is personally liable for another partner's negligence or malpractice
• Professional services favorite—law firms, accounting firms, and medical practices commonly use this structure
• Partners remain liable for their own actions and for general business debts in some states, so protection is not absolute

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Corporate Structures with Full Liability Protection

Corporations represent a fundamental legal concept: the business exists as a separate legal "person" distinct from its owners. This separation creates the liability shield shareholders enjoy, but it comes with formalities, compliance requirements, and—for C-Corps—potential double taxation.

Corporation (C-Corporation)

• Separate legal entity with its own rights to sue, own property, and enter contracts independent of shareholders
• Double taxation burden—the corporation pays tax on profits, then shareholders pay tax again on dividends received
• Unlimited capital-raising potential through stock issuance makes this the preferred structure for companies seeking venture capital or public markets

S-Corporation

• Pass-through taxation eliminates double taxation—profits and losses flow directly to shareholders' personal returns
• Strict eligibility requirements—maximum 100 shareholders, all must be U.S. citizens or residents, only one class of stock permitted
• IRS election required—the entity must file Form 2553 and maintain compliance to preserve S-Corp status

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Flexible Hybrid Entities

The LLC emerged as a modern solution combining the best features of partnerships and corporations. It offers maximum flexibility in both taxation and management while maintaining the liability shield entrepreneurs want.

Limited Liability Company (LLC)

• Liability protection without corporate formalities—members are shielded from business debts without mandatory boards, officers, or annual meetings
• Tax flexibility through "check-the-box" rules—can elect to be taxed as a sole proprietorship, partnership, S-Corp, or C-Corp
• Operating agreement governs everything—members have tremendous freedom to customize profit-sharing, voting rights, and management structure

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Special Purpose Entities

These structures serve specific goals beyond profit maximization for owners. Their defining feature is that the entity's purpose—whether charitable mission or member benefit—shapes their legal treatment and tax status.

Nonprofit Corporation

• Mission-driven, not profit-driven—organized for charitable, educational, religious, or social purposes under state law
• Tax-exempt status under IRC §501(c)(3)—the organization pays no federal income tax, and donors can deduct contributions
• No private benefit allowed—profits must be reinvested in the mission; founders and directors cannot receive dividends or ownership stakes

Cooperative

• Member-owned and democratically controlled—each member typically gets one vote regardless of investment size
• Operates for member benefit—profits are returned to members as patronage dividends based on usage, not ownership percentage
• Common in agriculture, housing, and retail—examples include credit unions, agricultural co-ops, and REI

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Contractual Business Arrangements

A franchise isn't technically a separate entity type—it's a contractual relationship that can operate through any business structure. Understanding this distinction is critical for exam questions about business expansion strategies.

Franchise

• Licensing arrangement, not an entity—the franchisee operates an independent business (often an LLC or corporation) using the franchisor's brand and systems
• Fee structure includes upfront and ongoing payments—initial franchise fees plus continuing royalties (typically 4-8% of gross sales)
• Controlled expansion model—franchisors grow using franchisees' capital while maintaining brand consistency through detailed operating requirements

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Quick Reference Table

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Self-Check Questions

1. Which two entity types provide liability protection to owners while allowing pass-through taxation, and what key restriction distinguishes them from each other?

2. A client wants to open a restaurant with three friends, sharing management equally, but is concerned about being held responsible if one partner causes a car accident while making deliveries. Compare the liability exposure in a General Partnership versus an LLP for this scenario.

3. Identify which entity type best fits each scenario: (a) a tech startup seeking venture capital funding, (b) a husband-wife consulting business prioritizing simplicity, (c) a law firm where partners want protection from each other's malpractice.

4. Explain why a business owner might choose to accept double taxation by forming a C-Corporation instead of an S-Corporation or LLC.

5. Compare and contrast how profits are distributed in a Nonprofit Corporation versus a Cooperative—if an FRQ presented a community organization choosing between these structures, what factors would determine the best choice?