Business Entities
Characteristics & Structures
Understand the formation, liability, taxation, and management features that distinguish sole proprietorships, partnerships, corporations, and LLCs.
CPA Regulation (REG)
Why Business Entity Selection Matters
Choosing the right business entity affects everything: personal liability exposure, how profits are taxed, who makes management decisions, and how easily you can raise capital. On the CPA REG exam, you need to identify which characteristics belong to which entity type.
The Four Major Entity Types
Sole Proprietorship
One owner, no legal separation between owner and business
Partnership
Two or more persons carrying on a business for profit as co-owners
Corporation
Separate legal entity created under state law, owned by shareholders
LLC
Hybrid entity combining corporate liability protection with partnership-style taxation
How Entities Are Formed
Liability Protection Spectrum
Taxation: Pass-Through vs. Double Tax
Pass-Through Taxation
Income flows to owners' personal returns. No entity-level tax. Applies to: sole props, partnerships, S corps, and most LLCs.
Double Taxation
Corporation pays tax at entity level, then shareholders pay tax again on dividends. Applies to: C corporations.
Sole Proprietorship Characteristics
1
Formation: No formal filing required. Begins when owner starts doing business.
2
Liability: Owner has unlimited personal liability for all business debts.
3
Taxation: Pass-through. Income reported on Schedule C of the owner's Form 1040.
4
Duration: Automatically dissolves upon the owner's death or decision to close.
5
Transferability: Cannot transfer ownership interest: must sell individual assets.
Partnership Characteristics
General Partnership
All partners share management and have unlimited liability. Each partner is an agent of the partnership.
Limited Partnership
At least one general partner (unlimited liability) and one limited partner (liability limited to investment). Must file with the state.
LLP
All partners have limited liability for the malpractice of other partners. Common for law and accounting firms.
Corporation Characteristics
1
Separate legal entity: Can sue, be sued, own property, and enter contracts in its own name.
2
Limited liability: Shareholders' risk is limited to their investment in the corporation.
3
Perpetual existence: Survives death or departure of any shareholder.
4
Free transferability: Shares can be freely bought and sold (unless restricted by agreement).
5
Centralized management: Board of directors governs; officers run daily operations.
C Corp vs. S Corp: Key Distinction
| C Corporation | S Corporation | |
|---|---|---|
| Taxation | Double taxation | Pass-through |
| Shareholders | Unlimited number | Max 100 shareholders |
| Shareholder Type | Any entity or person | U.S. individuals, estates, certain trusts only |
| Stock Classes | Multiple classes allowed | One class only |
| Election | Default | Must file Form 2553 |
LLC: The Hybrid Entity
Liability
Members have limited liability, similar to corporate shareholders.
Taxation
Default: Single-member LLC taxed as sole prop; multi-member as partnership. Can elect C or S corp status.
Management
Flexible: Member-managed or manager-managed. Governed by operating agreement.
How to Identify an Entity Type
1
Check formation: Was anything filed with the state? If no, it's a sole prop or general partnership.
2
Count the owners: One owner suggests sole prop or single-member LLC. Two or more suggests partnership, corp, or multi-member LLC.
3
Examine liability: If owners have unlimited liability, think sole prop or general partnership. Limited liability points to corp, LLC, or limited partnership.
4
Identify the tax treatment: Double taxation = C corp. Pass-through = partnership, S corp, sole prop, or LLC electing pass-through.
5
Look for restrictions: One class of stock and max 100 U.S. shareholders = S corp. Operating agreement = LLC.
Example 1: Identifying the Entity
1
Formation: No state filing → not a corporation, LLC, or LP.
2
Owners: One person → not a partnership.
3
Liability: Unlimited personal liability → consistent with sole proprietorship.
Example 2: More Complex Facts
1
Formation: Filed Articles of Incorporation → it's a corporation.
2
Tax election: Elected pass-through treatment → filed Form 2553.
3
Restrictions check: \( \le 100 \) shareholders, all U.S. citizens, one class of stock → meets all S corp requirements.
Example 3: The Hybrid Scenario
1
Formation: Filed Articles of Organization (not Incorporation) → points to LLC.
2
Governance: Operating agreement with member-managed structure → classic LLC feature.
3
Liability & tax: Limited liability + pass-through = the hybrid benefit of an LLC.
Common Mistakes to Avoid
✕ S Corp = Different Entity
An S corp is NOT a different type of entity. It's a C corp that made a tax election. Corporate law rules still apply.
✕ LLC = Always Pass-Through
An LLC can elect to be taxed as a C corp or S corp. Don't assume it's always pass-through.
✕ Limited Partners Manage
Limited partners who participate in management may lose their limited liability protection.
Master Comparison Table
| Feature | Sole Prop | Gen. Ptrshp | C Corp | S Corp | LLC |
|---|---|---|---|---|---|
| Formation | None | Agreement | State filing | State + 2553 | State filing |
| Liability | Unlimited | Unlimited | Limited | Limited | Limited |
| Taxation | Pass-thru | Pass-thru | Double | Pass-thru | Flexible |
| Duration | Owner's life | At will | Perpetual | Perpetual | Per agreement |
| Transferability | Assets only | Restricted | Free | Restricted | Restricted |
Question 1 of 5
Which business entity exposes its owner to unlimited personal liability and requires no formal state filing to form?
A sole proprietorship requires no state filing and provides no liability protection. LLCs, S corps, and LPs all require state filings, and LLCs and corps provide limited liability.
Question 2 of 5
An S corporation differs from a C corporation primarily because the S corporation:
The primary difference is tax treatment: S corps are pass-through entities and generally avoid entity-level tax. Both S and C corps have limited liability, require Articles of Incorporation, but S corps are limited to 100 shareholders.
Question 3 of 5
In a limited partnership, which of the following is true about limited partners?
Limited partners risk only their investment. They do not manage operations (that's the general partner's role). If a limited partner participates in management, they may lose their liability protection.
Question 4 of 5
Which characteristic is unique to corporations and is NOT found in general partnerships?
Perpetual existence is a hallmark of corporations. A general partnership may dissolve upon the death, withdrawal, or bankruptcy of a partner (absent a contrary agreement). Both can enter contracts and earn profits. C corps do NOT have pass-through taxation.
Question 5 of 5
An LLC files Articles of Organization with the state. By default, a multi-member LLC is taxed as a:
Under the IRS "check-the-box" rules, a multi-member LLC defaults to partnership taxation (filing Form 1065). A single-member LLC defaults to disregarded entity (sole prop) treatment. The LLC can elect C or S corp treatment, but those are not the default.