When setting up a business structure, there are many things to consider, especially regarding the type of business structure you want to form. There are financial, administrative, and legal costs involved when deciding on any business entity type.
If your business has at least two owners, you may set it up as either a limited liability company (LLC) or a partnership. While both these business structures have similarities, they also have some differences in how they are operated and taxed and the type of liability protection afforded to owners.
The following guide will closely examine the differences between LLCs and partnerships.
|Limited liability company||A pass-through tax structure combined with limited liability protection.||According to the IRS, LLCs may choose whether they want to be taxed as corporations or partnerships.||In terms of maintenance, an LLC is one of the easiest entity types to maintain due to the minimal amount of formal annual requirements.|
|Partnership||No liability protection as owners are not separate entities from the business.||Partnerships are taxed as pass-through entities.||Partnerships are just as easy to maintain as LLCs.|
|Corporation||Corporations are legal liability entities, so owners of the corporation are not liable for the obligations, debts, or losses brought against the business.||Corporations are subject to double taxation (on the corporate level and on the owners’ personal income) unless they elect S corp status.||Corporations need to hold directors’ and annual shareholders’ meetings, maintain detailed financial records, file a separate corporate income tax return, and fulfill a few more steps in order to remain in good standing.|
What is an LLC?
LLC is an abbreviation for limited liability company. LLCs are considered legal entities. This is a type of business entity that offers personal liability or protection of personal assets for owners. If a lawsuit is brought against the limited liability company, members don’t have to use money out of their pockets to pay settlements.
Instead, LLCs are considered pass-through entities, and members can claim their losses and profits generated by the business on their personal tax returns. Therefore, LLCs are becoming increasingly popular among small business owners and entrepreneurs over the last decade. This is especially since an LLC only needs one person to operate.
- Tax benefits: The losses and profits of an LLC are passed through to the owners so they can report them on their personal income tax returns. Therefore, LLCs do not pay taxes at the corporate level.
- Management flexibility: LLCs are quite flexible in how they can be managed. For one, the members of the LLC can choose to manage the business. Alternatively, they may nominate a manager from outside the business to take care of the day-to-day operations.
- Credibility with lenders: An LLC has much more credibility with clients, suppliers, and lenders when compared to other types of business entities like partnerships or sole proprietorships.
- Membership flexibility: Individuals, corporations, partnerships, and trusts are allowed to own LLCs, and there’s also no limitation on the number of owners an LLC may have.
- Liability protection: If an LLC incurs debt or obligations or has a lawsuit filed against it, the owner’s personal assets cannot be used to pay off creditors.
- Fewer compliance requirements: When forming and maintaining an LLC, far fewer compliance requirements and filings are needed compared to other types of businesses.
- High formation costs: LLCs require far more investment when forming and maintaining the business. Aside from the formation fees, limited liability companies must pay additional ongoing maintenance fees, which include annual reporting and franchise tax fees.
- Transfer of ownership: All LLC owners must consent to onboard new members and any changes in the percentage of ownership of current members. The only way to avoid this is to draw up an operating agreement stating that all members’ prior consent is not needed for the tasks mentioned above.
Read more about LLC types.
What is a partnership?
Partnerships are formal arrangements or agreements between two or more individuals agreeing to operate a business and take shares in its profits. There are various types of partnership agreements, and in this type of business, the partners share liabilities and profits equally. Partnerships also tend to have “silent partners” who invest in the business but are not involved in the company’s day-to-day operations. For example, lawyers and doctors are often motivated to form limited liability partnerships.
- More cash: Since a partnership may have two or more partners, there’s always the option of getting a new partner that can bring cash flow into the business. The individual might have strategic connections that the existing partners may be lacking or they might have the ability to raise more capital for the business and attract potential investors.
- Sharing in the knowledge and experience of partners: New partners don’t just put in the cash flow; they also may have more experience and knowledge to complement your skills and ultimately help grow your business.
- Additional business opportunities: Business partners share in all aspects of the business, including labor. Therefore, partners allow you to be more productive by giving you the flexibility and ease to pursue other business opportunities.
- Savings: In terms of capital expenditures and expenses, a business partner allows you to share the financial burden instead of carrying all of the expenditure squarely on your shoulders.
- Fresh perspective: It’s not uncommon to have blind spots in how we think and conduct business. However, having a new set of eyes can help you spot what you’ve missed.
- Selling complications: You may decide to sell the business in the future; however, if all partners are not on board, it can be a challenge. This is why it is recommended that your partnership agreement includes an exit strategy.
- Loss of autonomy: Running a sole proprietorship differs from running a partnership. This is because, in partnerships, you need to share control of the business with someone else; therefore, important decisions will need to be made jointly and not unilaterally.
- Liability: Partnerships do not offer liability protection or protection of personal assets. Therefore, in the event of company debts, business obligations, or business losses incurred by other partners in the business, it will also affect your personal assets and finances.
At a glance: How is an LLC different from a partnership?
- Limited liability companies (LLCs) are considered separate entities from their owners.
- The partners can pay taxes as a C corporation or an S corporation.
- LLCs also offer protection of personal assets or liability protection to owners meaning that members or owners will never be liable for the company’s debts or obligations of the company to the extent that they have to contribute out of their own pockets.
- LLCs have unlimited lifespans; even if an owner decides to sell their share of the business interest or the owner passes away, the LLC can continue.
- With partnerships, the business debts are the responsibility of every partner in the business.
- Additionally, the business does not have any legal identity aside from the business partners or owners, who become co-owners in the partnership.
- In the case of a business partnership, once a partner sells the ownership interest or dies, the partnership also ends.
Should I start an LLC or partnership?
When deciding which entity type you’re going to form, there are many factors to consider, such as the liability protection offered, tax benefits, etc. While LLCs have their advantages, so do partnerships. You need to carefully consider each entity’s maintenance requirements, management procedures, and ownership structure before deciding which is the right one for you.
Read more about partnerships here.
LLC taxes vs. partnership taxes
In most cases, different structures enjoy different benefits. This is also the case with LLCs and partnerships. So let’s take a closer look at LLC taxes vs. partnership taxes.
- LLCs are normally taxed as partnerships or sole proprietorships unless they file relevant forms from the IRS to elect to be taxed differently.
- Income and expenses of the LLC pass through to the business and are submitted with the owner’s personal or individual tax return since an LLC is considered a pass-through entity.
- The LLC owner is responsible for reporting their business deductions, profits, and losses to the Internal Revenue Service using a Schedule C Form.
- Multiple owners must file the Schedule C Form and their tax returns.
- Another option available to limited liability company owners is the preference to be taxed as an S corporation. In this case, you will need to complete and submit Form 2553.
- After that, the Internal Revenue Service will tax your business as an S corporation for tax purposes, provided your application is approved. LLCs may also be required to pay self-employment taxes.
- Partnerships are not responsible for paying corporate taxes. However, they are required to file a partnership tax return.
- Additionally, partners are required to pay taxes based on their share of profits and losses. They may do so by filing a Schedule K-1 Form, and each partner is responsible for filing their form with their personal tax return.
LLC vs. partnership: Formal requirements
LLCs and partnerships both have varying formation requirements. So let’s take a closer look at that below:
Formal requirements for LLCs
- When setting up an LLC, you must complete and file Articles of Organization and obtain a Certificate of Formation with the Secretary of State where you’re forming your LLC.
- If you plan to conduct business in any state, your business must be registered with each state in which you plan to transact. Also, familiarize yourself with the various state laws to remain compliant.
Formal requirements for partnerships
- Partnerships are created when two or more people form a business together.
- These business types do not require any type of paperwork, and neither is there a need to file any documents with the local government to start operating legally in the state.
- A partnership agreement is required to outline how the business will be operated and clarify all partners’ roles and responsibilities.
LLC vs. partnership: Management
LLCs and partnerships differ in the way in which they are managed. So let’s take a look at that below:
- There are two types of management procedures involved in LLCs. The first is a manager-managed structure, and the next is a member-managed structure. In the manager-managed limited liability company, the owners of the LLC nominate a manager to handle the business’s daily business operations and administrative concerns.
- In the member-managed structure, the owners all share the responsibility of managing the daily operations themselves.
- In the case of a partnership, much of the management duties are shared equally between owners. This is why there’s something called a partnership agreement that outlines each partner’s share of ownership, authority, rights, and roles.
- It’s also imperative to have a legal agreement in writing, even though it’s not compulsory. It simply ensures that all parties are on the same page, which will also help prevent future disputes.
LLC vs. partnership: Ownership structure
The ownership structure of an LLC is different from that of a partnership in certain ways:
- LLC owners are referred to as members. There’s also a lot of flexibility regarding who can startup an LLC.
- Even non-US residents in the United States are allowed to start LLCs.
- Many states also allow groups, corporations, and other LLCs to form an LLC.
- The minimum number of individuals to start an LLC is one.
- However, there is no limit to the number of members an LLC can have; if more than one person is running the business, it may be considered a multi-member LLC.
- LLCs tend to last indefinitely, so as long as an operating agreement outlines how the company will continue if members leave, pass on, or others vote to remove them, the business will still carry on as usual.
- While general partnership owners have a general partner handle the business’s daily operations, limited partners are considered silent partners that may contribute to the finances. Still, they’re not involved in the running of the business.
Before deciding to start a company or partnership, each type of business has its benefits. However, before making your choice, you should always look at limited liability, income tax advantages, and ownership structure. Ultimately, whether you start a partnership or LLC will depend on your business goals, the size of your business, and the flexibility you’re looking for when running your business.
Partnerships do not offer personal liability protection for owners. This means that all partners are personally liable for the business’s debts and the acts of employees and other partners. So you are severely and jointly liable for the company’s debts, and creditors can take action against you by using your personal assets to pay off the business’s debts.
In a partnership, the managing partner is tasked with overseeing the day-to-day operations of the business. This is why it is imperative to have a partnership agreement to specify and outline the responsibilities and duties of the managing partner.
If you’re forming a corporation, limited partnership, limited liability partnership, or limited liability limited partnership, you need to nominate a registered agent. However, sole proprietorships and general partnerships do not need to nominate one as they’re not registered with the state.
In the case of limited liability, the business owners are liable for the debt. However, this is limited to the investment they’ve put into the company. In the case of unlimited liability, the business owners are personally responsible for all or any loss, obligations, and debt that the company incurs.
While every state has its naming requirements and guidelines, the general rules encourage picking a name significantly different from any other registered business. You should also make your name web-friendly, consistent with your brand, and easy to remember.