8.2 Business Entity Clients

Investment advisers frequently work with business entities, each with unique characteristics, tax implications, and investment considerations. Understanding these structures is essential for making appropriate recommendations.

Types of Business Entities

Sole Proprietorship

The simplest business structure with no legal separation between owner and business.

- Formation: No formal filing required (may need local license)

- Liability: Owner has UNLIMITED personal liability

- Taxation: Pass-through: reported on owner's personal return (Schedule C)

- Management: Owner has complete control

- Continuity: Ends at owner's death or decision

Investment Considerations: Sole proprietors often commingle personal and business finances. Recommendations should account for both business cash needs and personal financial goals.

General Partnership

Two or more persons carrying on a business for profit.

- Formation: Partnership agreement (can be oral, but written preferred)

- Liability: ALL partners have UNLIMITED personal liability

- Taxation: Pass-through: profits/losses flow to partners' returns (Schedule K-1)

- Management: Shared among partners (per agreement)

- Continuity: May dissolve upon partner death/withdrawal

Key Point: Each general partner can bind the partnership, creating liability for all partners. This unlimited liability makes general partnerships risky for passive investors.

Limited Partnership (LP)

A hybrid structure with two classes of partners.

- General Partner(s): Unlimited liability, active management, for example GP managing a fund

- Limited Partner(s): Liability limited to investment, passive only, for example investors in real estate LP

Characteristics:

- Pass-through taxation

- Limited partners lose liability protection if they participate in management

- Common in real estate, private equity, hedge funds

- Must file with the state

Limited Liability Company (LLC)

Combines liability protection of a corporation with pass-through taxation of a partnership.

- Formation: Articles of Organization filed with state

- Liability: ALL members have limited liability

- Taxation: Flexible: choose partnership or corporate taxation

- Management: Member-managed OR manager-managed

- Continuity: State law varies; can be perpetual

LLC Advantages:

- Limited liability for all owners (unlike partnerships)

- Pass-through taxation (unlike C-corps)

- Flexible management and profit distribution

- Fewer formalities than corporations

C Corporation

A separate legal entity from its owners, offering the strongest liability protection but with double taxation.

- Formation: Articles of Incorporation, bylaws, formal structure

- Liability: Shareholders have limited liability

- Taxation: DOUBLE: corporate income tax + dividend tax to shareholders

- Management: Board of Directors oversees officers

- Continuity: Perpetual existence

Double Taxation Example:

- Corporation earns $100,000 profit

- Pays 21% corporate tax = $21,000

- Distributes $79,000 as dividends

- Shareholders pay ~15-20% dividend tax

- Effective combined tax rate can exceed 35%

S Corporation

A corporation that elects pass-through taxation under Subchapter S of the Internal Revenue Code.

- Requirements: Maximum 100 shareholders, one class of stock, only eligible shareholders

- Liability: Limited (same as C-Corp)

- Taxation: Pass-through (avoids double taxation)

- Eligible Shareholders: U.S. citizens/residents, certain trusts, estates (NO corporations, partnerships, or non-resident aliens)

Entity Comparison Summary

- Limited Liability: Sole Prop: No; Partnership: No; LP: Partial; LLC: Yes; C-Corp: Yes; S-Corp: Yes

- Pass-Through Tax: Sole Prop: Yes; Partnership: Yes; LP: Yes; LLC: Usually; C-Corp: No; S-Corp: Yes

- Formalities: Sole Prop: Minimal; Partnership: Minimal; LP: Moderate; LLC: Moderate; C-Corp: High; S-Corp: High

- Ownership Limits: Sole Prop: 1; Partnership: 2+; LP: 2+; LLC: 1+; C-Corp: Unlimited; S-Corp: 100 or fewer

Investment Considerations by Entity Type

For Business Operating Reserves

Business cash reserves typically prioritize:

- Safety: Principal protection is paramount

- Liquidity: Access when needed for operations

- Yield: Secondary consideration

Suitable Investments: Money market funds, short-term Treasuries, CDs, investment-grade commercial paper

For Long-Term Business Goals

Consider:

- Entity's tax status (pass-through vs. double taxation)

- Time horizon for the specific funds

- Risk tolerance of owners/board

- Any regulatory restrictions on investments

- Fiduciary duties to shareholders

Documentation Requirements

When advising business entities, advisers must verify:

- Who has authority to make investment decisions?

- Are there investment guidelines in governing documents?

- What approvals are required (board resolutions, etc.)?

- Are there restrictions in by-laws or operating agreements?

On the Exam

Common Series 65 questions test:

- Distinguishing between pass-through and double taxation

- Understanding which entities provide limited liability

- Knowing S-Corp restrictions (100 shareholders, one class of stock)

- Recognizing appropriate investments for business cash reserves

Key Takeaways

1. Sole proprietorships and general partnerships offer NO liability protection

2. LLCs provide limited liability WITH pass-through taxation (best of both)

3. C-Corps face double taxation; S-Corps avoid it but have restrictions

4. Business cash reserves prioritize safety and liquidity over growth

5. Always verify who has authority to make investment decisions