Which Should I Form - an LLC or a Partnership?
Partnership vs LLC - Differences and Similarities
The limited liability company (LLC) is a popular business legal form, and it has many similarities to the partnership legal form. In fact, an LLC pays income tax as a partnership (more details below). But there are some differences between an LLC and a partnership that you should consider before deciding on which is better for your new business.
Formation of Partnerships and LLCs
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.
A partnership is a type of business with several co-owners, called partners. 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. Unlike a corporation, which typically issues stock, the partners share directly in the profits and losses of the business, depending on their percentage share.
The ownership share of partners can be any percentage, as long as all the percentages add up to 100%. The partners determine partnership share at the time the business is formed, and this determination is part of the partnership agreement.
Like a partnership, an LLC is formed in a specific state. The business files articles of organization (in some states, a certificate of organization) with the state's secretary of state. The LLC owners are called members. Most LLCs function under an operating agreement, which defines member percentages and answers other "what-if" types of questions.
Liability for Partnerships and LLCs
The difference in liability protection is the single biggest difference between partnerships and LLCs. In a partnership, each partner has personal liability for the debts of the partnership. In addition, each partner has personal liability for the actions of all of the other partners.
In contrast, an LLC is set up specifically to provide liability protection to its members (hence the term "limited liability." If the LLC maintains its separation from the personal affairs of the member, LLC members are only liable for the debts of the business entity to the extent of their personal contribution.
There are some circumstances under which LLC members can have personal liability:
- If there is no clear separation between the business and the individuals
- If one or more members personally guarantee a business loan
- If a member engages in fraud or illegal activities goes beyond the scope of the duties of a member
- If one or more members has mismanaged the affairs of the LLC.
Members of an LLC are also liable for specific debts of the LLC if they personally sign to be responsible for those debts. For example, if an LLC purchases a building, and an LLC member signs too personally guarantee the mortgage, the member is liable for the loan if the LLC can't pay.
Taxes for Partnerships and LLCs
Partnerships and LLCs are "pass-through" taxing entities. That is, the taxes are passed through to the owners (partners or members) on their personal tax returns.
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 generated for 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 with his or her personal tax return.
LLC's are not recognized by the IRS as a taxing entity. So, multiple-member LLCs are taxed in the same way as partnerships, passing through the income or loss to each member's personal tax return. Single-member LLCs are taxed as sole proprietors, filing Schedule C along with their personal tax returns.
Profit and Loss Distribution for Partnerships and LLCs
For both business entities, profits and losses are distributed directly to the owners. Unlike a corporation, there are no stockholders and no stock is offered to owners.
Registration and Record Keeping for Partnerships and LLCs
If a partnership is not registered with a state, there are no specific requirements for keeping records or minutes of meetings. The partnership may function in any way that works for the partners.
Because an LLC is bound by state requirements and it must maintain a strict separation from the members' personal affairs, 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.
LLCs and partnerships formed in a state must make reports to their state periodically. Typically these reports are due either yearly or every other year.
The Limited Liability Partnership: A Special Case
Some states allow partnerships to form a limited liability partnership. In this type of business entity, partners are not exempt from liability for the debts of the partnership, but they may be exempt from liability for actions of other partners. In an LLP, all partners have the same general management responsibilities. Many professionals form LLP's to protect partners from malpractice claims against other partners.
The information in this article and on this site is intended to be general and is not intended to be tax or legal advice. Every situation is different; before making a decision to form a business as a partnership or LLC or another form, talk to an attorney in your state.