CFA Level I Exam · Business Models

Forms of Business Organisation: Sole Proprietors to Corporations

Updated 7 October 2026 · Fact-checked

Forms of business organisation are the legal structures a business can take: sole proprietorship, partnership or corporation. They differ in ownership, liability, tax treatment, ability to raise capital and continuity. To solve questions, identify who owns the firm, who bears losses, and where owners and managers may have conflicting interests (agency problems).

Understand Business Models: Sole Proprietors to Corporations

A business needs a legal form. The form decides who owns it, who is responsible for its debts, how it is taxed, and how easily it can raise money.

A sole proprietorship has one owner. The owner and the business are legally the same person. The owner keeps all profit and has unlimited liability: creditors can claim the owner's personal assets. It is simple and cheap to set up, but it is hard to raise large amounts of capital, and the business usually ends when the owner dies or leaves.

A general partnership has two or more owners who share profit, control and liability. Each general partner usually has unlimited liability, often joint and several, so one partner can be pursued for the whole debt. A limited partnership adds limited partners. They contribute capital and have liability capped at that capital, but they do not manage the business. At least one general partner must still carry unlimited liability. An LLC or limited liability partnership gives owners limited liability with partnership-style flexibility. Exact rules vary by country.

A corporation is a separate legal entity. Shareholders own it and have limited liability: they can lose what they invested but no more. It can raise large sums by issuing shares and bonds, and ownership is easy to transfer. It has perpetual life. The costs: more regulation and disclosure, and in many countries double taxation, where profit is taxed at company level and again when paid out as dividends.

Because ownership and control separate in larger corporations, agency problems arise. Shareholders (principals) hire managers (agents). Managers may pursue their own interests, such as pay, power or empire building, instead of shareholder value. Other conflicts exist too: shareholders versus creditors (shareholders may favour risky projects), and controlling versus minority shareholders. Governance, board oversight, and pay tied to performance help reduce these costs.

Key formulas to remember

Maximum loss: sole proprietor or general partner: Loss exposure = business investment + personal assets (unlimited); Creditors can reach personal assets. In a general partnership liability is often joint and several.
Maximum loss: shareholder or limited partner: Maximum loss = amount invested (limited liability); Limited partners keep this protection only if they do not manage the business.
Agency relationship: Principal (shareholders) → hires → Agent (managers); Agency costs arise from monitoring and from divergent interests. Ownership and control separate most in large corporations.
Double taxation (typical corporation): Profit taxed at corporate level, then dividends taxed at shareholder level; Not universal. Many partnerships and sole proprietorships are taxed only at owner level (pass-through).

How to solve Business Models: Sole Proprietors to Corporations questions

Use this sequence for any question on forms of business organisation or agency issues.

1Read the stem and identify the number of owners and whether they manage the business.
2Name the form: sole proprietorship, general partnership, limited partnership, LLC or corporation.
3Decide the liability of each party: unlimited for sole proprietors and general partners, limited to capital for shareholders and limited partners.
4Check the feature asked about: capital raising, taxation, continuity, transferability or regulation.
5If the stem mentions managers acting against owners, identify the principal and the agent and label it an agency problem.
6If creditors, minority shareholders or controlling holders appear, identify the other conflict type.
7Eliminate the two options that attribute the wrong liability or the wrong feature to the form, then choose the remaining option.

Quickest way: Liability-first elimination

When to use it: Use it when you have about 90 seconds and the question compares forms or asks about owner risk.

Ask only one question first: who can lose personal assets?
Strike any option that gives a sole proprietor or general partner limited liability.
Strike any option that gives a shareholder liability beyond their investment.
If the question is about conflicts, find who hires whom. That is the principal and agent.
Pick the remaining option and check it against the stem.

Common mistakes in Business Models: Sole Proprietors to Corporations

Saying a limited partner always has limited liability.
The name suggests full protection.
Fix: Remember limited partners are protected only if they do not take part in management. Every limited partnership needs at least one general partner with unlimited liability.
Assuming all corporations suffer double taxation.
It is taught as the standard corporate drawback.
Fix: Treat it as typical, not universal. Tax rules vary by country and by entity type, so go by what the stem says.
Treating sole proprietor and business as separate legal persons.
Students mix this up with the corporate form.
Fix: Only a corporation is a separate legal entity. A sole proprietorship has no separation, so liability is unlimited.
Confusing the agency problem with a creditor conflict.
Both involve conflicting interests.
Fix: Manager versus shareholder is the classic agency problem. Shareholder versus creditor is a separate conflict about risk-taking and payouts.
Believing limited liability means shareholders cannot lose money.
The word 'limited' is read as 'none'.
Fix: Shareholders can lose their whole investment. The limit means they cannot lose more than that.

Worked examples

Example 1

A general partnership is owned by three partners, and all three manage it. The partnership defaults on a debt of $900,000 and its assets are worth $300,000. Which statement is most accurate? A. Each partner's loss is limited to the capital contributed. B. Creditors can claim the shortfall from the general partners' personal assets. C. Only the partner who signed the loan is liable.

Show the solution

The stem states a general partnership, so all three owners are general partners.
General partners have unlimited liability for the partnership's debts.
Shortfall = $900,000 − $300,000 = $600,000.
Creditors can pursue the general partners' personal assets for the $600,000. This rules out A, which describes limited liability.
Unlimited liability is not confined to the one partner who signed, so C is not the best statement.

Answer: B

Example 2

Shareholders of a listed company complain that the CEO approved an expensive acquisition mainly to enlarge the company and her own pay, even though it lowers expected shareholder value. Which issue does this illustrate? A. A conflict between shareholders and creditors. B. An agency problem between shareholders and management. C. A consequence of unlimited owner liability.

Show the solution

Identify the principal: the shareholders, who own the firm.
Identify the agent: the CEO, hired to act for them.
The agent pursues her own interest (size and pay) at the cost of value to the principal.
That matches an agency problem. No creditor is involved, which rules out A.
Shareholders in a listed company have limited liability, so C is unrelated.

Answer: B

Exam tips

Every question has three options (A, B, C), so decide on liability first and eliminate two options quickly.
Watch for the exact words 'limited' and 'general'. They flip the answer.
If the stem describes managers versus owners, the answer is almost always agency; do not overthink it.
Do not assume tax treatment unless the stem states it. Use 'typically' reasoning only when options force it.
There is no penalty for wrong answers, so never leave an item blank.

Practice questions from Business Models

Business Models: Sole Proprietors to Corporations in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Business Models: Sole Proprietors to Corporations: frequently asked questions

What is the difference between limited and unlimited liability?

With limited liability, an owner can lose only the amount invested. With unlimited liability, creditors can claim the owner's personal assets once business assets run out. Corporations give limited liability. Sole proprietors and general partners face unlimited liability.

Why do corporations find it easier to raise capital?

Shares are easy to transfer and owners have limited liability, so many investors can take small stakes. A corporation can also issue bonds. This lets it raise much more than a sole proprietor or small partnership.

What is an agency problem in a corporation?

It is a conflict that arises when managers (agents) act in their own interests instead of those of shareholders (principals). Ownership and control are separate, so shareholders cannot watch everything. Boards, pay design and disclosure reduce the problem.

Are limited partners ever personally liable?

Their liability is normally capped at their capital contribution. The protection can be lost if they take part in managing the business, depending on local law. At least one general partner always has unlimited liability.