LLC vs. Partnership
The most common ways for businesses with two or more owners to structure their operations are as limited liability companies (LLCs) or partnerships. While there are similarities in how the two business structures are taxed, there are notable differences between LLCs and partnerships regarding owner liability and company management.
Both LLCs and partnerships benefit from “pass-through" federal taxation. That is where the business itself is not taxed, and its owners report any profits and losses on their personal income tax return.
However, the partners in a partnership are each responsible for the business' liabilities, while the owners of an LLC can protect their personal assets from creditors. LLCs are more complex to operate than partnerships, and the owners may be held personally liable for the business's debts if the proper legal formalities are not followed.
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What is a Partnership?
A partnership is formed when two or more people or business entities go into business together and share any profits or losses between them. Partnerships are often organized under a partnership agreement, but an agreement is not required. Additionally, states will usually treat partnerships as the default business structure when a business with more than one owner does not register as a different type of entity.
Partnerships are similar to sole proprietorships in that they are pass-through entities that do not exist separately from their owners. That means any money earned by the partnership is passed directly to the partners and treated as ordinary personal income for tax purposes. The partnership itself is not taxed, and its partners avoid the double-taxation of income that occurs when a business is organized as a C-corporation (C-corp).
Since partnerships are not treated as entities separate from the partners, their owners have unlimited liability for business debts. Whereas an investor in a corporation or LLC can't lose more than the money they contributed, partners can lose their homes, cars, and other assets if the partnership can't cover its debts.
Types of Partnerships
Most states will allow three types of business partnerships, which include:
- General Partnerships are businesses where each partner is entitled to an equal share of business income and is liable for any debts or other financial obligations.
- Limited Liability Partnerships (LLPs) are businesses where some partners have limited liability for the business's debts while at least one partner must accept total liability.
- Limited Partnerships must have at least one general partner and one limited partner. The general partners manage the business and are liable for its financial obligations. Still, the limited partners are passive investors who are not involved in day-to-day business operations and are not personally liable for business debts.
What is an LLC?
An LLC is a legal entity that allows its owners to enjoy the benefits of pass-through taxation while not subjecting themselves to the unlimited liability of a partnership. The regulations vary from state to state, but every state allows businesses to register as an LLC. However, when companies operate in multiple states, they may be required to register in each one where they do business.
The owner protections offered by LLCs are not unlimited, and creditors can seek repayment from the individual owners if the company fails to comply with state legal and reporting requirements or the company is used to commit fraud.
Another advantage of organizing your business as an LLC is that there are no restrictions on ownership, which means that in addition to people, LLC ownership can include corporations, other LLCs, and foreign individuals and businesses. But not all types of business can organize as LLCs, and banks and insurance companies are usually barred from registering as an LLC.
While most business owners who organize as LLCs take advantage of pass-through taxation, they usually have the option of being taxed as a C-corp. In that case, the business's income will be subject to the corporate tax when earned by the LLC, and the owners will pay tax on any distributions they receive from the business. The owners of an LLC may choose to be taxed as a corporation if they plan on reinvesting all of the company's income back into the business and do not want to pay personal income taxes on money returned to the company. This reinvestment also takes advantage of the fact C-corps are taxed at a lower rate than most wealthy individuals.
How do You Form an LLC?
When registering an LLC with your secretary of state, you should first choose a business name. After it has been named, you must draw up articles of organization that lay out the obligations of each LLC member and file them with the state.
In addition to the articles of organization, the registration documents usually include such items as the names and addresses of the LLC's owners, its registered agent, and a statement of business purpose. States also require those registering LLCs to pay a filing fee.
Finally, the LLC will usually need a Federal Employer Identification Number (EIN). The IRS does not charge a fee for issuing an EIN, and businesses can apply for one online. If your business already has an EIN, it will need to apply for a new one when its ownership or organizational structure has changed.
Choosing Between an LLC and Partnership Structure
Whether a business with multiple owners should be organized as a partnership or an LLC is not an easy decision to make. Both options have several advantages and disadvantages that should be weighed carefully against the needs of both the business and its co-owners.
One issue that is rarely a factor in the decision is taxing it since both partnerships and LLCs are treated as pass-through or disregarded entities by the IRS. That means the business itself pays no taxes, and the owners will report any income or loss on their income tax returns. Partnerships are also responsible for paying the self-employment tax. In some circumstances, LLC members must also pay the self-employment tax.
Advantages of a Partnership
The main advantage of running a business as a partnership lies in its simplicity. You do not need to file any paperwork with the state, and there is no requirement that you draft a partnership agreement. This also reduces startup and operating costs for partnerships because there is no need to register the business or follow business formalities.
Disadvantages of a Partnership
For most people thinking of running their business as a partnership, the most significant disadvantage is that they will be personally liable for all of its debts and obligations. Since partners are not treated separately from their business, each will have unlimited liability for all financial obligations. Additionally, all business partners may be liable for the partnership's debts if a single member enters into a financial agreement without informing the others.
An added drawback to operating a business as a partnership is that it may be dissolved if one partner dies or leaves the business. When a partnership is dissolved, it must stop all business activities, and its profits and losses must be distributed among the partners. However, a partnership agreement or a dissolution agreement may allow the business to continue operating as a partnership after a partner leaves.
Advantages of an LLC
If the LLC has been properly registered and managed, its owners can generally avoid personal liability for the business's debts. This is one of the most significant advantages of an LLC over a partnership, whose members are liable for business debts.
LLC managers also have flexibility when it comes to how the business's management is structured. The owners can manage an LLC or choose to have non-members manage the company while they only serve as investors who are not involved in day-to-day activities.
Disadvantages of an LLC
To avoid personal exposure to an LLC's liabilities, the business owners must keep records showing it operates separately from its owners. This means that the company must keep its finances entirely separate from those of its owners and maintain records of meeting minutes, annual filings, and critical operational decisions.
Record-keeping and compliance are significant obligations for LLCs because failure to follow the relevant laws and regulations regarding company governance can result in the owners losing their liability protection. The law will stop viewing them as separate entities distinct from their business. As a result, if a court finds an LLC did not follow all of the required business formalities, it will allow creditors and others owed money by the company to seek repayment from the owners.
It is usually a good idea to consult with an attorney when starting an LLC. The attorney will help ensure that the company complies with all relevant state laws and ensure that owners can't be held liable for its debts. There are also fees involved in registering the LLC with the state.
Additional Questions About Partnerships and LLCs? An Attorney Can Help
An experienced local business attorney can help you determine whether a partnership or an LLC is the best way to structure your business. A skilled lawyer will assess your business's operations and finances to decide the structure that best suits the needs of the company, yourself, and your co-owners. Additionally, a business attorney can help draw up the documents necessary to form an LLC or decide whether your partnership needs to draft a partnership agreement.
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