When forming a business, you have two basic choices: general partnership or limited liability company (LLC).
Depending on how many partners you have and what your intentions are for the company, one may be better suited to your needs than the other.
The article below provides a brief overview of each type of business entity and highlights the differences between them, along with their benefits and drawbacks.
What Is the Difference Between an LLC & an LLP?
When you form a business, one of the first decisions you have to make is whether or not you will be forming an LLC or a general partnership.
In some cases, you can choose to form both entity types for your company, depending on your needs.
LLC vs. Partnership
- The two main differences between an LLC and a general partnership are liability protection and taxation.
- An LLC provides its partners with limited liability, while members in a partnership do not enjoy this same benefit.
- Additionally, each type of business structure is taxed differently: partnerships are considered “pass-through entities,” so pass-through taxation is applied. While LLCs are subject to corporate income taxes.
- Real estate investors who are interested in holding properties individually instead of through an LLC should look into forming a general partnership. A partnership does not require the same formalities as an LLC, but it does provide protection for its members.
On the other hand, if you are already operating your business as an LLC and want to expand your operations by adding partners, you will need to convert your company’s structure before doing so.
The process for converting LLCs is similar to filing Articles of Organization, though it may vary depending on where you live.
If you choose to form a new entity rather than add partners to your existing one, be sure that all owners agree with the change beforehand.
Advantages and disadvantages
What Are the Benefits of Each Type?
Compared to a corporation, both an LLC and a general partnership offer fewer legal and tax benefits.
This is because both small businesses and large corporations tend to hire lawyers and accountants who can take advantage of the many available corporate structures and tax breaks.
What Are the Drawbacks?
Despite their low cost, general partnerships are not as popular as LLCs because they provide less legal protection for their members.
- In a general partnership, all partners have unlimited liability, meaning each member is personally responsible for any debts of the business or lawsuit up to the full amount of his personal assets. For example, if you have three partners in your business and one is sued for malpractice due to something related to his work at your company, he could potentially lose everything he owns.
- An LLC’s structure limits each member’s liability, which provides greater peace of mind for the members.
- Another drawback of a general partnership is that it can only consist of two or more people. LLCs, on the other hand, can have an unlimited number of partners.
This is beneficial since many small businesses are started by founders with different specialties who want to share ownership and management responsibility equally.
For most small businesses, the LLC is the best choice because of its many benefits.
Once you have decided to form an LLC, your business attorney can file all necessary paperwork.
A good first step is to visit your state government’s Secretary of State or Corporations Division website.
Organizing an LLC
Organizing an LLC, like any other business entity, is a matter of state law.
An LLC may come into existence by filing documents with the designated state agency (in California, this is the Secretary of State).
Compliance with the formation statute will vary depending on your location; if your desired LLC name has already been taken, you may have to go through a formal process called “bulk transfer” to acquire it.
Starting a General Partnership
In New York, forming a partnership is required when two or more persons carry on a business for profit as co-owners.
In other words, you do not need to file anything with the state to start a general partnership; if you have an informal agreement between yourself and one or more people to share profits from your business activities, then you have formed a general partnership.
In order to form a partnership, you have to file a Statement of Partnership Authority with the State.
With an LLC, you must fill out required documents with your state’s business filing office.
General Partnership documents:
- Statement of Partnership Authority
- General partnership agreement
- Articles of organization
- Operating Agreement (optional)
General partnerships liability
General partnerships provide complete liability protection to all partners, regardless of how much money each individual contributed.
In a general partnership, creditors can only go after the business itself for outstanding debts or lawsuits.
The single exception is when a partner takes out a loan using his personal assets as collateral; if he defaults on the note, his creditor has the right to take all of his possessions in order to satisfy part of the debt.
LLCs’ limited liability protection
LLCs offer limited protection to all members except those who actively engage in running the company’s daily operations.
For example, if you form an LLC with your significant other as the only two members and then one day he starts managing it from day to day, his actions will be treated as those of an LLC member and consequently will have the protection of limited liability.
An LLC is not a separate taxable entity from its members, which means all company revenues or losses are passed through to the individual business owners.
While this sounds like it’s just an accounting matter that should have no effect on how much you owe in taxes, there are some subtle differences that can affect your tax liability.
- If you own an LLC with other partners and your share of the business’ profits comes out to $35,000 one year, you will be required to report this income on your annual federal tax return. However, instead of paying taxes at the personal income rate (which could be as high as 39%), you’ll pay taxes at your individual shareholder percentage (which could be as low as 29%) since LLC members are treated as sole proprietors for income tax purposes.
- General partnerships operate under the assumption that all of the partners are jointly and severally liable for business debts. This means that if your partner defaults of his own accord, you will be held responsible for paying off his portions of the debt; conversely, he can also hold you personally accountable for any business losses he experiences.
Records for LLCs and Partnerships
The fact is, either type of business entity can be run with or without written agreement among the members.
However, LLCs are required by state law to keep formal records that show how their members share revenues and vote on important matters.
Although either option carries liability protection benefits, forming an LLC makes sense if more than one person will be involved in running the business daily.
For most small businesses, an LLC provides limited liability protection to each member, which allows for more flexibility when it comes to organizing your company’s ownership structure.
Of course, when deciding between the two, you may want to consult with your accountant or other business advisors.
Profit and Loss Distribution for Partnerships and LLCs
1) An LLC does not pay taxes on business profits or losses; instead, the LLC’s net business income or loss is “passed-through” to its members’ personal tax returns.
Limited liability companies choose to be taxed as a corporation, sole proprietorship, partnership, S corporation, C corporation, multi-member LLC, or limited partnership.
2) A general partnership has no formal organizational structure in place, although there are some that have informal arrangements between each other for how they will share responsibilities and split the profits.
3) However, it is important to note that even if you do not have an agreement with your partners stating otherwise, courts will generally find that any profits earned by one partner in the course of the business be treated in accordance with what would have been the understanding of normal partners.
So, if you went into business with your spouse and neither one of you ever said anything about how to divide profits and losses, a court will honor an implied partnership agreement that both spouses are considered equal owners.
What Is the Difference Between General Partnership and LLC in Terms of Termination?
- A general partnership terminates when one of the partners withdraws from the business, dies, or becomes insolvent.
- When a partner leaves or dies, a new partner can be added to take his place. However, if a partner were to become insolvent and have no other assets available for creditors to seize, creditors can petition the court for involuntary bankruptcy against that individual.
- LLCs are not considered separate legal entities under state law until they obtain an Employer Identification Number ( EIN ) from the IRS after filing articles of organization with the Secretary of State. This means that LLC owners have no liability protection until this happens. In fact, during this time, LLC members could still be held personally liable for any debts incurred by their company!
What is the difference between a general partnership and a limited partnership?
- General partners are personally liable for all business debts. Limited partners, on the other hand, are only liable to the extent of their investments in the business. If a limited partner invests $5,000 into her friend’s landscaping business and that business incurs debt beyond that amount, the limited partner is not responsible for paying the difference after she maxes out her initial investment.
- A general partnership is a business arrangement where two or more people combine resources to start a new business enterprise. Each person contributes some amount towards making this endeavor work – whether it is time or money or both – but retains control over how these resources are utilized.
- The general partners have unlimited personal liability when it comes to running this company, meaning they are accountable for all debts and liabilities of the business. The agreement can be verbal or written, but it helps if there is documentation showing that you are partners. However, the best way to avoid any doubt about your partnership is by creating a partnership agreement.
- Limited partnerships (LPs) must have one general partner and limited partners. General partners manage the company and assume unlimited liability, while limited partners only contribute capital and share in the profits of the company.
LPs do not allow for corporate tax treatment; instead, an LP pays taxes on its income at the individual owner level.
Limited partners cannot participate in management decisions, nor can they appoint new members to their governing body.
If no agreement exists between the unincorporated association’s members, then the rules of a partnership do not apply to them.
What Are Some Examples?
General partnership example
A general partnership would be suited for any business that has at least two co-owners involved in all aspects of its operations.
For example, if you plan to start an accounting firm with your friend, you both could serve as equal partners and actively participate in writing up new deals, hiring employees, writing reports, setting office policies, etc.
Since there are at most only two of you, a general partnership would provide the protection you need to shield your personal assets from any possible lawsuits.
An LLC would be appropriate for a business with multiple founders who want to take on passive roles and let the other owners handle day-to-day operations.
For example, say your brother is an established doctor looking for someone to invest in his new medical practice.
You could be that investor by providing funding for the company in exchange for an ownership stake but leave all managerial decision-making to him.
In this scenario, you would form an LLC since you only plan to take on a passive role and don’t want unlimited liability.
When Would I Need an LLP?
Limited Liability Partnership (LLP) is designed specifically for professionals such as attorneys, doctors, and accountants who want to operate their businesses as partnerships.
This structure allows the partners too, among other things, pool resources together into one tax return (which can be advantageous for small businesses), distribute profits based on each partner’s ownership percentage (instead of splitting them equally like in a general partnership), and choose how any business losses will affect each individual partner.
What Should I Know Before I Make My Decision?
The main thing you should consider before forming either an LLC or a general partnership is whether or not your company will be involved in any risks that could result in costly lawsuits.
If the answer is yes, then you should seriously consider forming an LLC since it will provide you with better legal protection than a general partnership.
Other things to consider:
I. Also, you should consider what type of business structure your partners are comfortable with.
If one partner wants to keep his day-to-day role separate from the company he is investing in while another’s expertise is needed for some aspect of management, an LLC will allow them both to equally share ownership without having them work closely on a day-to-day basis.
II. However, if none of your prospective business partners have any involvement in the legal aspects of running a partnership business and simply want to invest their time into helping get the operation up and running, then a general partnership would serve that goal more effectively.
It also provides each partner with unlimited liability, which may be desirable for some, especially if they are highly motivated by potential profits.
III. A general partnership also offers greater flexibility than an LLC, which could be beneficial for the members of a young startup that may not yet have clearly defined roles.
These are just some of the things you need to consider before deciding between an LLC and a general partnership. Seeking legal advice is always advised when making this decision.
One important thing to remember when forming either an LLC or a general partnership is that the U.S. government only recognizes them as distinct entities for tax purposes.
So, technically speaking, there is no difference between having your business operate as an LLC or a general partnership.
Both will allow you to write off any losses you incur each year against other income and protect your personal assets if someone ever decides to sue your company.
It’s really up to you and your partners to decide which structure offers the best fit for your specific business needs. Make sure that whatever choice you make works best for all parties involved.