If you’re starting a new business and will have two or more owners, there are several important factors to consider.
You want to be sure that you consider the business formation type that’s ideal for your company.
Business formation is the legal process of determining how your business will operate.
While there are several different types of business structures available, when you’re running your business with partners, there are certain considerations to explore before deciding on the ideal type.
Here is a comprehensive look at the differences between two of the most common business structures – limited liability company (LLC) and partnership.
What Is a Limited Liability Company?
An LLC is among the most popular business structures, and with good reason.
It’s a structure that’s relatively simple to form and has easy “pass through” taxation, meaning the profits and losses pass through from the company to the owners’ individual tax returns.
An LLC also provides owners with considerable liability protection.
In the case of an adverse court judgment against the company, the owner’s individual assets are protected in most cases.
While most LLCs are small businesses (many are only one employee), there is no legal limit as to how large an LLC can be.
Many people consider an LLC to be a hybrid business structure, with some of the most favorable elements of sole proprietorships and corporations.
The tax structure is the same as in a sole proprietorship while the liability protections are similar to those offered by a corporate legal structure.
The formation process is quite simple but varies slightly from state to state.
What Is a Partnership?
There are multiple partnership types among business structures.
Some have more formal and rigid rules than others.
In general terms, a partnership is when two or more people own a business together.
Here is a look at the four most common types.
General Partnership (GP)
A general partnership is the most basic of all business partnerships.
Forming a general partnership does not require any legal paperwork to form.
However, failing to formalize the terms of the partnership can be risky, especially if disputes arise.
Limited Partnership (LP)
In a limited partnership, one partner is primarily responsible for the daily operations and management of the company.
Other partners, known as limited partners, have a defined role in the company.
Most limited partners bring a particular element to the business, such as finances, space or equipment, or specialized expertise.
Limited Liability Partnership (LLP)
In a limited liability partnership, all partners are at risk for debts and legal judgments against the business.
However, the amount of liability for which they are accountable for the actions of other partners is structurally limited.
Such structures are common among legal, medical, and financial businesses.
Limited Liability Limited Partnership (LLLP)
The LLP is similar to an LLLP but with an extra layer of liability protection.
The LLLP partnership agreement should explicitly lay out the specific liabilities for both the general and limited partners.
This partnership type is available in 28 states.
Understanding the Differences between an LLC and a Partnership
With many choices available for your business structure, it’s crucial to learn the similarities and differences between an LLC and a partnership.
There are distinct variances that can shape the choice and help you determine the proper business type for your company.
Liability Protection
In an LLC, the business is considered a separate legal entity from its owners (who are referred to as members).
That separation helps protect the members if they are sued or cannot pay their debts.
Members’ individual liability, if any, is limited by their individual investments in the company.
In partnerships, there is no distinction between the business and the owners from a legal liability perspective.
In the case of a general partnership, there’s considerable risk to members’ personal assets.
That means the creditors can come after the owners’ homes, cars, and savings.
In a limited partnership, the owners’ personal liability is limited to their investments in the company.
In a limited liability partnership, the rules can vary from state to state.
Each state has rules about how much liability protection the owners have.
In general, partners are protected from liability in cases of negligence or malpractice of other owners.
They may also, depending on state law, be protected from other debts and obligations.
Management and Decision-Making
Management approaches are often dependent on the business structure you choose for your company.
With an LLC, here are two different operational approaches you can choose: member-managed or manager-managed.
When you choose a member-managed structure, owners divide up the company’s managerial duties among themselves.
In a manager-managed structure, the owners hire or appoint a manager to oversee day-to-day responsibilities for running the business.
In this case, members usually do not take on an active role (though a member can be appointed as manager) and instead focus on strategy or higher-level decisions.
It’s important for LLC members to create an operating agreement that spells out the members’ and managers’ roles and responsibilities, rights, and distribution of profits and losses.
While states do not usually ask LLCs to file operating agreements, they may require LLCs to maintain these agreements at the principal place of business.
In a general partnership, usually partners share many of the managerial duties.
Similarly to the LLC operating agreement, a partnership agreement can spell out the roles and responsibilities of each partner, ownership shares, dispute resolution procedures, and rights.
A written agreement helps all partners clearly understand their roles, avoid disputes, and determine how decisions are made.
These agreements should also lay out each partner’s financial obligations, ownership percentages, and conditions for additional partners to enter the business or existing partners to exit.
In a limited partnership, general partners usually manage the business.
Limited partners typically do not play a role in management, because doing so can cause them to lose their liability protection.
Some states allow limited partners to vote on certain issues that relate to certain aspects of the business.
In an LLP, there’s a lot of flexibility in determining the roles of each partner.
Partners may be assigned responsibilities based on their strengths or areas of expertise.
Taxation
Tax issues can be very complex when it comes to your business structure.
Both LLCs and general partnerships are “pass through” entities.
That means tax obligations and liabilities are passed through from the business to the partners or members.
The business itself does not pay income tax.
Owners in both entities must pay Medicare and Social Security self-employment taxes and personal income taxes.
The partnership, while not paying taxes, must file an informational return annually (Schedule K-1, IRS Form 1065).
The form details income, deductions, gains, and losses.
Individual partners use that information to report their share of income or losses on their own returns,
For an LLC, a multi-member entity is taxed as a partnership by default.
Such LLCs also file a Form 1065.
Similarly, members use this information to complete their personal tax returns.
Some states also require LLC owners to pay an annual franchise tax.
An LLC, however, has some tax flexibility that a partnership does not.
With a multi-member LLC, the IRS allows owners to elect to be taxed as an S-Corporation.
In such a case, the LLC is still taxed as a pass-through entity, but only salaries and wages paid to LLC members are required to pay self-employment taxes.
Other profits paid to LLC members as distributions are not subject to Medicare and Social Security taxes.
Note that while some states honor the IRS election, not all states do.
Some require additional filings or disregard the S Corp option altogether.
In a limited partnership, limited partners usually do not pay self-employment taxes on their share of the profits.
In an LLP, partners report their allocation of company earnings on individual tax returns and pay income and self-employment taxes.
Formation and Maintenance Costs
Partnerships and LLCs both have requirements for forming and maintaining the chosen business structure.
The fees for these initial and annual filings will vary greatly from state to state.
An LLC will file articles of incorporation in most states and is required to appoint a registered agent, who will receive any legal forms or summons on behalf of the business.
In some cases, they will hold annual meetings and record minutes, especially among multi-member LLCs.
LLCs will also need to file annual reports on activity, ownership, and contact information.
A general partnership does not typically have to file annual reports but LPs and LLPs may need to file such reports.
Flexibility and Growth Potential
Whenever multiple owners or partners are involved, it can be complicated to grow or scale up a business or make key business decisions.
In either case, having a well-defined partnership or operating agreement in place is essential.
When core decisions need to be made, these guiding documents are crucial to ensuring that there is a smooth process.
When all interested partners have a clear understanding of the steps to take to make these decisions, the business can grow and act on key moves quickly.
Partnerships and LLCs are popular business structures for a reason.
Understanding the nuanced differences can help you make the right decision for your business.
Leave a Reply