A limited liability company (LLC) is a popular business legal form, and it has many similarities to the partnership legal form. But there are some differences between an LLC and a partnership that you should consider before deciding on which is better for your business. Keep reading to learn more about the ways LLCs and partnerships are similar and different.
What Is an LLC?
A limited liability company (LLC) is a type of business legal entity that combines the liability protection of a corporation with the operations of a partnership.
An LLC can have one or more owners, called members. Each member has a percentage of the equity (ownership) of the business. The members operate the LLC following an operating agreement. The LLC members can turn over day-to-day management to a hired manager or they can manage the business themselves.
LLCs are sometimes incorrectly called "limited liability corporations," but they are not a type of corporation. An LLC may choose to be taxed as a corporation or S corporation, but it continues to operate as an LLC.
What Is a Partnership?
A partnership is a business relationship between two or more people. Each partner contributes to the business and has a percentage of the total business equity. The partnership operates under a partnership agreement and day-to-day administration may be handled by a managing partner.
Partnership and LLC Formation
The process of forming a partnership and an LLC is similar. Both are formed by registering with the state in which the business wants to operate.
Forming a Partnership
Partnerships are registered with a state, and there can be several different types of partnerships, depending on the profession of the partners and the wishes of the owners for liability protection, management responsibility, and investment. Unlike a corporation, which typically issues stock, the partners share directly in the profits and losses of the business, depending on their percentage interest.
Forming an LLC
If you are thinking of forming a partnership, check with your state's business division (usually in the secretary of state department). Some states don't allow certain types of partnerships.
Debt and Legal Liability
The difference in liability protection is the single biggest difference between partnerships and LLCs. All LLCs have this protection, but only some types of partnerships do.
Liability in Partnerships
In a general partnership, each partner has personal liability for the debts of the partnership because each partner actively participates in managing the business. In addition, each partner has personal liability for the actions of all of the other partners. General partnerships aren't common for this reason.
Liability in LLCs
In contrast, an LLC is set up specifically to provide liability protection to its members, which is why the term "limited liability" is used in the business name. In most circumstances, LLC members are only liable for the debts of the business entity to the extent of their personal investment.
When LLC Members or Partners Can Have Personal Liability
There are some circumstances when LLC members or partners in a limited partnership or limited liability partnership can have personal liability. These cases are examples of "piercing the corporate veil," meaning breaking the separation between the individual and the company, and making the company liable for the actions of one or more of the members. These actions include:
- Combining personal and corporate assets
- Excessive control or misconduct (fraud or activities going beyond the scope of the person's duties as a partner or member
- Mismanaging the affairs of the LLC
Members and partners are also liable for specific debts of the business if they personally sign to be responsible for those debts. For example, if an LLC purchases a building, and an LLC member signs a personal guarantee for the mortgage, the member is liable for the loan if the LLC can't pay.
Partnerships and LLCs are "pass-through" taxing entities, meaning for both types of businesses, the income taxes are passed through to the owners (partners or members) on their personal tax returns.
Taxes for Partners
A partnership files a partnership tax return every year on Form 1065, but no tax is due by the partnership. Instead, a Schedule K-1 is given to each partner, showing the amount of the partner's share of the profits or losses for the year. Then, the partner files this Schedule K-1 as part of their personal tax return.
Taxes for LLC Members
LLCs are not recognized by the IRS as a taxing entity. Single-member LLCs are taxed in the same way as sole proprietors, filing a Schedule C as part of their with their personal tax returns.
Multiple-member LLCs are taxed in the same way as partnerships, passing through the income or loss to each member's personal tax return using the Schedule K-1. LLCs may file an application with the IRS to be taxed as a corporation or an S corporation. In this case, the LLC is still operated as an LLC, not as a corporation. Partnerships don't have this tax option.
Records for LLCs and Partnerships
Unlike corporations, partnerships have no specific state requirements for keeping records of partnership activities or minutes of partner meetings.
An LLC has some requirements to keep records and to hold meetings. Check with your attorney to see what the requirements are for your state.
Frequently Asked Questions (FAQs)
Why would someone want a partnership instead of an LLC?
An LLC may be preferable to a general partnership because the LLC member has limited liability when the general partners don't. Some states allow individuals to form a limited liability partnership. In this type of business entity, all partners are exempt from liability for the debts of the partnership and for actions of other partners. Some professional firms (attorneys and CPAs, for example) prefer the LLP form for this reason.
What's the difference between a limited partnership and a limited liability partnership?
Limited partnerships have one person with unlimited liability; this person usually has day-to-day control over the administration of the business. The rest of the partners have limited liability. A limited liability partnership gives all partners limited liability. In this case, the company hires someone to run the business.
How does an LLC or partnership compare to a corporation?
The most important difference in these types of businesses is in ownership and how their ownership is taxed. Owners of corporations are shareholders who receive shares of ownership and they may receive (and be taxed on) dividends based on those shares.
LLC members and partners in partnerships, however, are considered self-employed. This means they are subject to self-employment taxes (Social Security and Medicare taxes) on their income from their business. Because they don't receive paychecks or withhold taxes, they may need to make quarterly estimated tax payments that include both income taxes and self-employment taxes.