What is the difference between an LLC and a Partnership?
When you decide to start a business, one of the most important steps is determining what kind of business entity you will establish and how you will structure your new company. A Limited Liability Company (LLC) and a partnership are two options that you may consider.
A partnership is a business shared by more than one owner. Owners in a partnership have some personal liability for the business, depending on the type of business created.
An LLC can be owned by one or more people, called members, and provides liability protection. The owner or owners are separate from the business so if the business is sued or targeted by creditors, the owner’s personal assets are safe.
Some other differences include:
Governing Document: A partnership is governed by a partnership agreement while an LLC uses an operating agreement.
Cost: Partnerships are easier and less expensive to establish and maintain than an LLC.
Taxes: While both entities benefit from pass-through taxation, LLCs have more flexibility because the owners can opt to be taxed as either an LLC or an S Corporation. However, partnerships can elect to be taxed S Corps as well.
For more information about the differences between LLCs and partnerships, read this article.
Can an LLC be a Partnership?
An LLC can be a partnership because it can be owned by multiple members. Owners of LLCs have the option to make elections on how they want to be treated by the IRS. A domestic LLC that has at least two members will automatically be labeled as a partnership by the IRS for tax purposes.
Multi-Member LLC vs. Partnership
Multi-member LLCs and Partnerships have many similarities. A few examples are as follows:
- Both are legal business entities
- The business structures involve multiple owners
- Benefit from pass-through taxation
The biggest difference between a multi-member LLC and a partnership is the liability protection that an LLC grants it’s owners. Owners in a partnership are not separate legal entities from their business. Partners in a partnership do not have asset protection and are liable for business risks and debt.
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How LLCs Work
An LLC is its own legal entity separate from the business owner or owners. An LLC must have a registered agent and file articles of organization or a certificate of formation with the state in which they are doing business.
How to Form an LLC
Every state has their own laws regulating the formation of LLCs. Generally, LLCs are required to file articles of organization or a certificate of formation with the Secretary of State. This document will require information about the company like:
- The name of the LLC
- The effective date of the formation of the LLC
- The name and address of the registered agent of the LLC
- The company’s principal office
- The business purpose or sometimes called “general character” of the LLC
- Duration of the business
- The name and address of one member of the LLC
- The name and address of each organizer of the LLC
- Some states require a copy of the name registration certificate
- Signature of the authorized representative
Pros of an LLC
- Limiting Personal Liability for Business Debts: An LLC protects an owner from certain liabilities, which includes business debts. In the event of a claim from a creditor, only business assets are at risk. An owner’s personal property and assets like real estate or personal bank accounts are protected.
- Tax Advantages: An LLC owner does not have to file a separate tax return for the business. LLCs are “pass through entities” so the profits and losses from the business pass through the business to the owner’s personal tax liability. Multi-member LLCs have the option to choose to be taxed as an S Corp if they chose.
- Flexibility: LLCs offer business owners maximum flexibility and the ability to be treated as either a sole proprietorship, partnership, or an S Corporation for tax purposes.
Cons of an LLC
An LLC can be more expensive and complicated to form than a partnership, depending on where you live and your specific circumstances. LLCs require formation documents to be filed with the state, therefore they are subject to more regulation. However, a partnership does require some documentation as well, it varies from state to state.
Even though the business formation of an LLC may provide the owner with liability protections, there are limits to this protection. An LLC owner will still be personally liable in the following situations:
- A lawsuit for due to their own negligence, even if the claim is related to the business.
- Losses due to fire, floods, lawsuits, or economic downturn
LLCs and Taxes
Unless an LLC files certain IRS forms to elect to be taxed differently, an LLC will usually be taxed as a sole proprietorship or a partnership. An LLC is a pass-through entity so profits and losses of the business pass through the company and are filed with the owner’s personal tax return.
Using a Schedule C form, the LLC owner will report their businesses profits, losses, and deductions to the IRS. If there is more than one owner, each owner will file profit and losses with their own personal tax return.
LLCs owners have the option to be taxes like an S Corp. An LLC owner can file Form 2553, Election by a Small Business. If approved, an LLC will now be treated like an S Corp by the IRS for tax purposes.
If you want to find out more information about Form 2553, read this article.
How Do Partnerships Work
A partnership is formed when two or more people decide to go into business together. There are four different types of partnerships that can be established.
- General Partnership. This is the most basic form of partnership, and it is not an actual business entity. Forming a general partnership does not require filing forms with the state and usually just requires a partnership agreement between parties. Every partner in a general partnership has the power to make big business decisions like signing contracts and taking out loans. Each partner also shares total liability, so everyone is responsible for the business debts and risks.
- Limited Partnership. A limited partnership or LP is a legal business entity that is registered with the state. Limited partnerships are made up of at least one general partner and at least one limited partner. General partners are fully responsible for the business while limited partners provide capital but aren’t active in the daily management of the company. Limited partners are considered silent partners and cannot lose more than they have invested in the company.
- Limited Liability Partnership. This type of partnership, abbreviated to LLP runs like a general partnership. Each partner is an active member; however, a limited liability partnership limits each partners liability for each other’s actions. Each state has their own laws regarding the formation of LLPs and some states do not allow this type of business structure. It is most common to see LLPs used for doctors, lawyers, and accountants.
- Limited Liability Limited Partnership. An LLLP operates like a limited partnership however unlike an LP, an LLLP limits the general partner’s liability. This allows all partners to have liability protection.
How to Form a Partnership
Follow these steps to legally form a partnership:
Step 1: Choose the partnership structure
Before starting a partnership, you will need to decide which structure is right for your business and the other partners. A partnership can be formed as a general partnership, an LP, an LLP, or an LLLP.
Step 2: Partnership Agreement
A partnership agreement needs to be drafted and signed before starting the business. This agreement serves like an LLC’s operating agreement and should include the following information:
- Name and contact information of each partner
- Division of ownership among partners
- Management structure and responsibility of each partner
- Dispute resolution tactics
- Distribution of profits and losses
- Role of family members in the partnership
- How to handle a partner leaving
Here is an article about partnership agreement costs to help you plan.
Step 3: Business Name
A business name is required to file paperwork to establish your partnership. Some states regulate partnership names, so it is important to know your state’s business laws before deciding upon a name. The name must be available to use and not infringe on any registered trademarks.
Step 4: Register the Business
The only type of partnership that does not require to be registered with the state is a general partnership. For an LP, LLP, or an LLLP, the business must be registered to be legally operating company.
Pros of a Partnership
A partnership can be a great option for a small business and provides many benefits to the owners.
- Financial Benefits: A partnership allows business partners to pool their finances and split all costs. Partners will share financial responsibilities reducing risk and startup costs for each party.
- Taxes: Partnerships are taxed as pass-through entities. Each partner will be able to claim their share of the business profits and losses on their personal tax return.
- Shared Responsibility and Labor: Business partners will each share the responsibility of running a business and this includes daily operations and labor. Splitting up responsibilities in the company should allow the business to run more efficiently without either partner taking on too much of a burden.
- Wide Range of Knowledge: Operating a business as a partnership grants the opportunity to have multiple business owners who can bring their own knowledge and expertise to the table.
Cons of a Partnership
Partnerships also have their share of downsides, especially if the business is not profitable or run efficiently. Some common issues that are seen in business partnerships include:
- Conflicts between partners over informal arrangements or a vague partnership agreement
- Each partner yields a lower profit because all profits are split based on share of ownership
- Depending on the structure, partners may be liable for other partner’s actions
- General conflicts that arise from running a business with someone else like difference of opinion or mistakes
Partnerships and Taxes
Partnerships are required to file a partnership tax return but the partnership itself is not responsible for paying any taxes. Each partner is required to pay taxes based on their share of profits or losses. This is done by filing a Schedule K-1. Each partner will file their own Schedule K-1 with their personal tax return.
Limited Partnerships
A limited partnership is one type of structure for a business partnership. This requires that at least one partner act as the general partner while other partners are limited partners.
General Partner: The general partner is responsible for running the company and is liable for all business debts and risks. They general partner makes all the business decisions and runs day to day operations.
Limited Partner: Limited partners are silent partners who invest in the company but are not responsible for debts, liabilities, or decision making. The limited partners share in profits but cannot lose more than they have invested.
Read this article to find out more about LLCs and partnerships and how each entity can benefit you.
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