2.1 Business Structures & Liability: Sole Proprietorship, Partnership, LLC, and Corporation

Foundations of Business Entity Selection

Selecting an appropriate business entity is one of the most critical structural decisions an entrepreneur and their tax advisor face. On the Special Enrollment Examination (SEE) Part 2, candidates must demonstrate a comprehensive command of how state legal forms intersect with federal tax rules. Entity choice dictates the extent of an owner's personal liability shield, the operational and management structure, the legal transferability of equity interests, the ease of raising equity or debt capital, and the foundational default federal income tax treatment.

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Primary Business Structures: Formation and Liability Profiles

1. Sole Proprietorships

A sole proprietorship is an unincorporated business owned and operated by a single individual. It is not a separate legal entity under state law. No formal state organizational filing is required to establish a sole proprietorship, although the owner must obtain local commercial licenses, permits, and register any fictitious business name (DBA). The owner bears unlimited personal liability for all commercial debts, contractual obligations, and tort liabilities incurred in the business; commercial creditors can attach the owner's personal bank accounts, investments, and non-exempt real property. For federal tax purposes, it is a disregarded entity reported directly on Schedule C (Form 1040), with net profit subject to self-employment tax (Schedule SE) under IRC §1401 on 92.35% of net profit: 12.4% Social Security up to the remaining $176,100 wage base in 2025 and 2.9% Medicare without a wage cap. The 0.9% Additional Medicare Tax can also apply above the filing-status threshold.

2. General Partnerships (GPs)

Under the Uniform Partnership Act (UPA/RUPA), a general partnership is an association of two or more persons carrying on as co-owners of a business for profit. A GP arises by formal written agreement, oral contract, or conduct without filing organizational documents with the state. Every partner acts as an agent under mutual agency, legally binding the firm in ordinary course operations. Crucially, general partners bear joint and several personal liability for all partnership debts, commercial contracts, and tort liabilities caused by any partner or employee. For federal tax purposes, a GP is a pass-through entity under Subchapter K, filing an information return on Form 1065 and issuing Schedules K-1.

3. Limited Partnerships (LPs)

Governed by the Revised Uniform Limited Partnership Act (RULPA), an LP requires filing a Certificate of Limited Partnership with the state. An LP requires at least one general partner (who exercises operational management and bears unlimited personal liability) and at least one limited partner (who contributes capital, shares in profits, and enjoys limited liability capped at their capital contribution). Under traditional RULPA rules, a limited partner who participates in the management or control of the business risks losing their liability shield to third parties. LPs file Form 1065.

4. Limited Liability Partnerships (LLPs)

An LLP is a general partnership that files a Statement of Qualification with the state, primarily used by licensed professional service firms (accountants, attorneys, physicians). The LLP provides a statutory liability shield protecting innocent partners from personal liability for the malpractice, negligence, or wrongful acts of co-partners and employees, though partners remain liable for their own acts and, in some states, general contract debts. LLPs file Form 1065.

5. Limited Liability Companies (LLCs)

An LLC is a flexible statutory entity created under state law by filing Articles of Organization. Owners are "members" whose personal assets are generally shielded from entity obligations, subject to personal guarantees, their own wrongful acts, and applicable state-law exceptions. Governance is established by an Operating Agreement. LLCs may be member-managed (all members possess agency authority to direct daily business) or manager-managed (management authority is centralized in appointed managers, leaving non-managing members as passive investors). Equity transfers are restricted: assignees receive economic rights (profit distributions) but cannot become full voting members without member consent. Tax defaults are pass-through: single-member LLCs default to disregarded entities (Schedule C), and multi-member LLCs default to partnerships (Form 1065).

6. C Corporations

A C corporation is an independent legal entity formed by filing Articles of Incorporation with the state. It possesses perpetual existence, centralized management (Board of Directors and executive officers), and a full liability shield for shareholders, directors, and officers. Shares are freely transferable, and the entity can issue multiple classes of common and preferred stock, providing optimal access to institutional capital. A C corporation is subject to double taxation under Subchapter C: the corporation pays a flat 21% tax on taxable income (IRC §11) on Form 1120, and shareholders pay tax on dividend distributions on Form 1040 (at 0%, 15%, or 20% qualified dividend rates, plus the 3.8% Net Investment Income Tax under IRC §1411).

7. S Corporations

An S corporation is a domestic corporation (or electing LLC) that files Form 2553 to elect pass-through taxation under Subchapter S (IRC §§1361–1379), reporting on Form 1120-S. It combines the corporate liability shield with single-tier pass-through taxation. Strict eligibility rules apply under IRC §1361(b): maximum 100 shareholders (family members treated as one under §1361(c)(1)); eligible shareholders generally include U.S. citizens, resident aliens, estates, qualifying trusts, and certain exempt entities (no nonresident aliens, C corporations, or partnerships); and strictly one class of stock (voting differences permitted under Treas. Reg. §1.1361-1(l), but distribution and liquidation rights must be identical).

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Comprehensive Entity Comparison Table

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Practical Exam Scenario: Analyzing Entity Selection & Liability Exposure

Scenario: Three software consultants—Elena, Marcus, and Dave—form a consulting firm generating $450,000 in gross revenue and $150,000 in operating expenses in 2025, leaving $300,000 in net profit. They distribute $60,000 to each founder and retain $120,000 for business expansion.

• General Partnership: All three face joint and several personal liability for commercial contracts and potential client malpractice claims. Each partner is allocated $100,000 of ordinary business income on Schedule K-1, paying income and self-employment tax on their entire $100,000 share regardless of distributions.
• Multi-Member LLC: The owners enjoy limited liability for entity obligations, subject to personal guarantees and their own wrongful acts. By default, it is taxed as a partnership on Form 1065, yielding identical pass-through tax results to the GP but with a statutory liability shield.
• C Corporation: The entity pays an entity-level corporate tax of 21% on $300,000 ($63,000 corporate tax under IRC §11), leaving $237,000 in after-tax earnings. The $180,000 total distributed to the three founders is taxed a second time as qualified dividends on their individual Form 1040 returns.