REG, Regulation

Sources for Choosing and Running a Business Entity

Last reviewed 2026-09-14

The standards and authorities behind PocketCPA's REG lessons on Choosing and Running a Business Entity. The topic rests on RUPA, RULLCA, and the Model Business Corporation Act.

About this topic

A fact pattern can change one of the four and leave the other three exactly where they were.

What the examiner grades is a classification made before any arithmetic starts, and the arithmetic is usually straightforward once the classification is right. Was the act in the ordinary course of business, or outside it? Which act governs, the current one or the one it replaced? Was the owner exposed by status, or by that owner's own conduct? The most expensive habit is reading a capital percentage as voting power, because the unincorporated forms count owners per capita and a seventy percent contributor can hold no authority at all. Close behind it is treating paperwork as an entity, since an agreement, an employer identification number and LP or LLC in the trade name are all consistent with having formed nothing.

Key points

• A limited partnership requires a filed certificate; a general partnership does not require any filing.
• An LLC provides limited liability for all members by default and may elect partnership or corporate taxation.
• A corporation is formed by filing articles of incorporation and is a separate legal entity from its shareholders.
• Entity selection depends on liability protection, tax treatment, management structure, and transferability of interests.

What the lessons cover

1. The entity menu
2. Rights and duties of owners and managers
3. Distributions
4. Dissolution
5. Authority: whose act binds the entity
6. Shares, transfer restrictions, and cumulative voting
7. The liability shield and the ways it fails
8. Tax classification and the S corporation eligibility gate

Authoritative references

Where these requirements sit in the literature. Each entry names the provision, then breaks out the subsections that carry separate rules.

• IRC Sec. 701 is the reason a partnership is a conduit: a partnership as such is not subject to the income tax, and persons carrying on business as partners are liable for income tax only in their separate or individual capacities.
• IRC Sec. 11(a) and Sec. 11(b) impose the corporate income tax on the taxable income of every corporation, at 21 percent. Sec. 11(c) excepts certain mutual savings banks, subchapter L insurance companies, and subchapter M regulated investment companies and REITs.
• IRC Sec. 7701(a)(2) and Sec. 7701(a)(3) are the classification definitions, and each of the two is itself a list.
  • Sec. 7701(a)(2), partnership, reaching any unincorporated syndicate, group, pool, joint venture, or organization through which a business or venture is carried on that is not a trust, an estate, or a corporation.
  • Sec. 7701(a)(3), corporation, reaching associations, joint-stock companies, and insurance companies.
  • The default partnership treatment of a multi-member LLC is cited to the Sec. 7701 classification rules at section level.
• IRC Sec. 1363(a) and Sec. 1366 carry S corporation conduit treatment: no entity-level tax, each shareholder's pro rata share of separately stated and nonseparately computed items under Sec. 1366(a)(1), and character preserved as if realized directly under Sec. 1366(b).
• IRC Sec. 1361(b)(1) is the small business corporation definition and the eligibility gate.
  • (A) no more than 100 shareholders, in a domestic, non-ineligible corporation.
  • (B) no shareholder who is not an individual other than an estate, a Sec. 1361(c)(2) trust, or a Sec. 1361(c)(6) organization.
  • (C) no nonresident alien shareholder.
  • (D) one class of stock.
  • Sec. 1361(b)(2) lists the ineligible corporations.
• IRC Sec. 1361(c)(1) counts a husband and wife, and all members of a family, as one shareholder. Members of a family is a common ancestor, that ancestor's lineal descendants, and their spouses or former spouses, with the ancestor no more than 6 generations removed from the youngest generation of family shareholders.
• IRC Sec. 1361(c)(4) and Sec. 1361(c)(5) are the two escapes from the one-class rule: voting differences among common shares are disregarded, and straight debt is not a second class where the rate and payment dates are not contingent on profits or the borrower's discretion, the instrument is not convertible, and the creditor is a qualifying holder.
• IRC Sec. 1362(a) and Sec. 1362(b) govern making the election.
  • (a)(2) consent of all shareholders on the day of the election.
  • (b)(1) filing during the preceding year, or on or before the 15th day of the 3rd month.
  • (b)(2) an otherwise timely election slid to the following year for an earlier Sec. 1361(b) failure, or for a nonconsenting person who held stock earlier in the year.
  • (b)(3) the same result for a late filing, and (b)(5) reasonable cause relief.
• IRC Sec. 1362(c), Sec. 1362(d), Sec. 1362(f) and Sec. 1362(g) govern duration and exit.
  • (c) effective until terminated.
  • (d)(1) revocation by holders of more than one-half of the shares.
  • (d)(2) automatic termination on ceasing to be a small business corporation.
  • (d)(3) termination for accumulated E and P plus more than 25 percent passive investment income for 3 consecutive years.
  • (f) inadvertent relief, and (g) a 5-year bar on re-election.
• IRC Sec. 1367(a) and Sec. 1366(d)(1) run shareholder basis, the first moving it and the second capping what it can absorb.
  • Increases, for income items.
  • Decreases, not below zero, for distributions excluded by reason of Sec. 1368, for losses, and for nondeductible noncapital expenses.
  • The ceiling. Sec. 1366(d)(1) caps the deductible loss at the basis of the stock plus shareholder debt.
• IRC Sec. 1368, Sec. 301(c) and Sec. 316(a) are the two distribution regimes. C corporation: dividend to the extent of earnings and profits (Sec. 316(a)), then basis (Sec. 301(c)(2)), then gain (Sec. 301(c)(3)(A)). S corporation with no accumulated E and P: tax-free to the extent of basis, then gain (Sec. 1368(b)); with accumulated E and P, the accumulated adjustments account first, then dividend, then Sec. 1368(b) (Sec. 1368(c)).
• IRC Sec. 1372, Sec. 1401 and Sec. 1402(a)(13) carry the owner-compensation consequences: a 2-percent shareholder is treated as a partner for fringe benefits, self-employment tax runs at 12.4 percent plus 2.9 percent, and a limited partner's distributive share as such is excluded from self-employment earnings other than Sec. 707(c) guaranteed payments for services.
• RUPA Sec. 202 forms a general partnership from conduct. Sec. 202(a) reaches two or more persons carrying on as co-owners a business for profit whether or not they intend to form a partnership; Sec. 202(c)(3) makes a profit share a rebuttable presumption and withdraws it for six categories, one being interest or other charge on a loan, expressly even where the amount varies with profits.
• RUPA Sec. 301(1) is the agency rule: a partner's act for apparently carrying on in the ordinary course the partnership's business binds it unless the partner lacked authority and the third party knew or was notified. The exception is conjunctive.
• RUPA Sec. 306 and Sec. 307(d) allocate partner liability.
  • 306(a) joint and several liability in a general partnership.
  • 306(c) a full shield in an LLP, covering contract, tort, or otherwise, for a partner sued solely by reason of partner status.
  • 307(d) an exhaustion gate, plus a judgment against the partner before levying on personal assets.
• RUPA Sec. 401 supplies governance defaults: equal management rights per capita, ordinary course by a majority of the partners, and unanimity for extraordinary acts, amendments, and admitting a partner.
• RUPA Sec. 409 codifies the duties.
  • (a) loyalty and care.
  • (b) the duty to account and hold as trustee any benefit derived in the business, from partnership property, or from a partnership opportunity.
  • (c) a care duty limited to gross negligence, recklessness, willful misconduct, or a knowing violation of law.
• RUPA Sec. 502 and Sec. 503 limit what a partner can sell to the share of profits and losses and the right to receive distributions. A transfer causes no dissociation and no dissolution and gives the transferee no management, information, or inspection rights.
• RUPA Sec. 702 and Sec. 704 govern lingering authority: two years of binding power after dissociation against a party who reasonably believed and had no notice, ended by a filed statement of dissociation operating as constructive notice 90 days after filing.
• RUPA Sec. 801 and Sec. 806 govern dissolution and winding up: notice of a partner's express will to withdraw dissolves a partnership at will (801), and assets go to creditors including partners who are creditors before the partners' net distributable amounts (806), RUPA having eliminated the former UPA's automatic subordination of partner loans.
• ULPA (2001) Sec. 201, Sec. 302, Sec. 303, Sec. 404 and Sec. 406 are the limited partnership provisions.
  • 201 formation when the secretary of state files the certificate.
  • 302 a limited partner has no power as such to act for or bind the LP.
  • 303 a status-based shield surviving participation in management and control, which discarded the older RULPA control rule.
  • 404 general partner liability, and 406 management vested exclusively in the general partners.
• RULLCA Sec. 102(13), Sec. 201, Sec. 304, Sec. 401, Sec. 405, Sec. 406, Sec. 407, Sec. 501, Sec. 502 and Sec. 503 are the LLC provisions.
  • 102(13) an operating agreement that may be oral, in a record, or implied from conduct, and is never filed.
  • 201 formation by a certificate of organization carrying only the name, office address, and agent, with no management-structure disclosure.
  • 304 a shield in which failure to observe formalities is not a ground for member liability.
  • 401 consent of the others to admit a member.
  • 405 two distribution solvency tests, and 406 a consent track and a recipient track barred after two years.
  • 407 member-managed by default, with majority for the ordinary course and unanimity outside it.
  • 501 a member is not a co-owner of company property, 502 the transferable interest is the distribution right only, and 503 a charging order is a lien on distributions only.
• MBCA Sec. 2.02, Sec. 2.04, Sec. 2.05, Sec. 2.06 and Sec. 3.01 cover formation.
  • 2.02(a) mandatory articles of name, number of authorized shares, initial registered office and agent, and each incorporator.
  • 2.02(b) a permissive purpose clause, against a default of any lawful business under 3.01.
  • 2.04 joint and several liability for persons purporting to act for a corporation knowing there was no incorporation.
  • 2.05 officers appointed at the organizational meeting, and 2.06 bylaws that are private and unfiled.
• MBCA Sec. 6.22(b) and Sec. 6.27 cover shareholder liability and transfer restrictions.
  • 6.22(b) no shareholder liability except by reason of the shareholder's own acts or conduct, a default rule that does not abolish equitable veil piercing.
  • 6.27, authorization. A restriction may be imposed by the articles, the bylaws, or an agreement, for any reasonable purpose, and the authorized types expressly include a right of first refusal.
  • 6.27, enforcement. The restriction binds a holder or a transferee only if it is noted conspicuously on the certificate or in the required information statement, or if that person has knowledge of it.
• MBCA Sec. 6.40(c) and Sec. 8.33(a) limit distributions.
  • 6.40(c) the equity insolvency test, plus a balance-sheet test measuring assets against total liabilities plus the preferential rights on dissolution of senior shares.
  • 8.33(a) director liability for the excess only, and only where the plaintiff establishes noncompliance with Sec. 8.30, with contribution from other liable directors and recoupment from knowing shareholders.
• MBCA Sec. 7.28 makes cumulative voting an opt-in in the articles. Each share then carries as many votes as there are directors to be elected, and the shares guaranteeing a given number of seats are [(directors desired x shares voting) / (total directors to be elected + 1)] + 1.
• MBCA Sec. 8.30 and Sec. 8.31 separate the standard of conduct from the standard of liability.
  • 8.30(a) and (b) good faith, a reasonable belief in the corporation's best interests, and like-position care.
  • 8.31(a) no money damages absent bad faith, a belief the director did not hold, a failure to be appropriately informed, a lack of objectivity, or another enumerated failure.
  • Liability exists unless the articles limit it.
• MBCA Sec. 8.61(b), Sec. 8.62 and Sec. 8.63 are the conflicting-interest safe harbors. Sec. 8.61(b) forecloses a challenge resting on the director's interest where any one of three things is true.
  • Qualified-director action under Sec. 8.62, which requires a majority, but no fewer than two, of the qualified directors who voted, after required disclosure, deliberating without any other director present.
  • Shareholder action under Sec. 8.63.
  • Fairness to the corporation.
• MBCA Sec. 14.05(b) and Sec. 14.07(d) handle post-dissolution claims: dissolution preserves claims, and a shareholder is exposed to the lesser of the pro rata share of the claim or the assets received, capped in the aggregate at the total received.
• The common law supplies three doctrines with no statutory home.
  • Promoter liability keeps the promoter liable through adoption, denies ratification for want of a principal in existence, and releases the promoter only by novation.
  • Veil piercing needs both a unity of interest and ownership and fraud or injustice, with no single factor dispositive.
  • The corporate opportunity doctrine runs on line-of-business and interest-or-expectancy, and yields disgorgement through a constructive trust rather than damages.

How PocketCPA uses these sources

Every lesson is written in original words and cites the paragraph each rule comes from. No standard's text is reproduced. How lessons and questions are written and checked is set out in our methodology.

See also

• Sources for every REG topic
• Free REG sample questions
• The CPA exam glossary