Types of Clients Tested on The Series 65 Exam

Investment advisers serve different types of clients. Some are individuals; others are estates or large charitable trusts. Many advisers provide investment advice to businesses of various sizes and structures. Understanding these structures is crucial for the Series 65 exam, as questions often test knowledge about client types and their implications for liability, taxation, and investment strategies. Let’s start with the sole proprietor, which is both a human being and a business.

Sole Proprietor

Plumbers and hair stylists typically pay for state and municipal licenses. Therefore, they might not want to also pay to set up a corporation or other business structure, which involves legal fees to attorneys and filing-and-renewal fees to the state. It might be tempting to just run the business as a sole proprietor.

Unlike setting up a corporation or other business structure, setting up a sole proprietorship does not require much in terms of time and expense. Unlike a traditional corporation, the business is not taxed. Rather, the income flows to the owner.

The advantages of opening a business as a sole proprietorship include:

• Faster, easier, cheaper setup
• Easy tax preparation
• Income flows directly to the owner

Series 65 Connection: Advisers need to understand that sole proprietors often have simpler financial situations but are more exposed to personal liability. This impacts risk assessment and insurance recommendations.

The trouble with being in business as a sole proprietor is that the owner remains personally liable for the debts and lawsuits against the business. If the sole proprietorship called Harry’s Hot Dogs accidentally sells 1,000 tainted wieners that send sick people to the emergency room, Harry would have a hot mess on his hands. The lawsuits would be filed against Harry personally.

The disadvantages of owning a business as a sole proprietor include:

• Personal liability
• Harder to obtain loans or attract investment capital due to lower financial controls

Partnerships

Many business owners are renegades who do not play well with others. So, they go into business for themselves and run everything as a sole proprietorship in which they control every aspect and answer to no one. We just looked at some pros and cons of that structure.

Another approach is to take on partners. In a partnership, the income or net loss of the business flows directly to the owners. Unlike certain corporations, the business entity itself is not taxed. The percentage of profits and losses flowing through to each of the owners is stated in the partnership agreement.

Series 65 Connection: Exam questions may test knowledge of partnership agreements and tax implications, especially how profits and losses flow directly to owners.

General Partnership

The main difference between general and limited partnerships involves liability. In a general partnership, two or more persons own the business jointly and are subject to creditors and lawsuits personally, just like Harry of Harry’s Hot Dogs. Unless otherwise stated in the agreement, the general partners control the business jointly, equally, with one vote each.

Series 65 Connection: Expect questions about the liability of general partners and how their role affects investment risk.

Limited Partnership

To form a limited partnership, there must be at least one general partner (GP), who has personal liability for debts and lawsuits associated with the business. But a limited partnership then has limited partners (LPs) who maintain limited liability status, meaning they can only lose what they invest into the business.

By “invest into the business,” we mean the money they put in as well as any debts they personally guarantee. A debt that limited partners sign their names to is called a recourse note, meaning that creditors have legal recourse to come after them for the amount they guaranteed personally. A non-recourse note, then, means the creditors have no recourse to collect this debt out of the investor’s personal assets beyond any collateral that might have been pledged.

Series 65 Connection: Test questions may focus on distinguishing recourse vs. non-recourse notes and the liability differences between general and limited partners.

Maybe a test question will ask what a limited partner’s cost basis is equal to, with the right answer something like, “it equals the capital he contributes initially plus the capital agreed to be contributed in the future.”

To maintain the shield of protection, limited partners must stay out of day-to-day management decisions. Nevertheless, the LPs do vote on the big issues of the partnership through partnership democracy. Partnership democracy is used to allow the LPs to have a voice on a limited number of items, such as:

• Dissolving the partnership
• Suing the GP for negligence, breach of fiduciary duty, etc.
• Inspecting certain records

The LPs can get involved with the above without jeopardizing their limited liability status, but not much else.

The General Partner has a fiduciary relationship to the LPs. That means the GP must put the LPs’ needs first. In legal terms, the GP’s fiduciary duty is “two-pronged,” meaning they have a duty of loyalty and a duty of good faith. This duty of loyalty means the GP cannot compete with the partnership. The GP’s duty of good faith means they must do whatever they reasonably can to run the business successfully and in accordance with the LPs’ best interests. The GP can end up getting sued by the LPs if it becomes clear that they are not meeting his duty to the limited partners, through negligence or fraud.

Since the GP has unlimited liability, the general partner is often a corporation rather than a natural person (human being). The corporate structure, as we will see, provides a layer of protection.

Series 65 Connection: Questions often test the fiduciary responsibilities of general partners, emphasizing their duty of loyalty and good faith.

When the limited partnership is liquidated, the senior creditors are paid first, then the unsecured creditors. The next priority is the limited partners, with the general partner last in line.

Series 65 Connection: Liquidation priorities and creditor claims are frequently covered on the exam.

Be sure to know these critical concepts for your upcoming series 65 exam

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