Before we delve into a discussion, we should make it clear there is no such thing as an LLC partnership. These are two different business entity forms that are similar in many aspects, yet are not the same. There exist a limited liability partnership as an LLC and partnership hybrid but it’s a subject for the other article. Here, though, we are going to look into LLCs and partnerships as separate legal entities and how they stack up. So, keep on reading to find out how these legal structures function and how they differ.
Understanding an LLC and a Partnership
For the start, both structures are a great choice for smaller businesses and startups since they are pretty easy to form and operate, with not so many management formalities as well. Hence, both of these business entity types are widely popular in the US. For the sake of truth, it’s worth saying that LLCs are recently taking the lead, and we’ll explain why below.
Coming down to LLC and partnership definitions, a partnership is a sort of agreement between two or more parties sharing the same business interests and seeking to set up a venture for profit. Partnership relations imply that business profits and losses are distributed proportionally to each partner’s contribution to the company equity. Likewise, business partners who are company co-owners could share the business management or appoint a managing partner as the case may be.
A limited liability company, on the other hand, also applies partnership principles in membership relations and business operation while combining them with limited liability protections usually pertinent to corporations. Thus, an LLC is a hybrid legal structure embracing the best of both worlds. Formed by one or several members, LLCs can be managed by either one of those members or by a hired manager. Similar to partnerships, business revenues and losses are shared by the LLC owners pro-rata to their percentage interest.
Partnership vs LLC: Basic Similarities and Differences
While LLCs are a relatively new legal structure created to match fast-changing modern business environment, partnerships have longer history. Looking at LLCs from a historical perspective, this entity type appeared in the 1970s and took the management and operation structure of partnerships to mix it with corporate aspects. For that reason, partnerships and LLCs have many things in common.
Both partnerships and LLCs are state-specific entities, i.e registered in the state of business conduct, and both entities offer a quite simple formation process. To establish a partnership, business owners usually sign a partnership agreement and file it with the state. However, this procedure is rather formal since many states don’t have law requirements for that agreement. Meanwhile, LLCs face stricter rules in this concern. Technically, forming an LLC is as easy as filing the Articles of Organization or Certificate of Organization with the Secretary of State. However, this procedure is compulsory, and without official state registration, an LLC cannot be formed. Besides, some states have restrictions on certain partnership types while LLCs can be established under any state statutes.
Where LLCs and partnerships are also similar is taxation. By default, both entity types are treated by the IRS system as disregarded entities and use pass-through taxation. It means they don’t pay income taxes at a business level. Both business profits and losses are shared by the company owners and are payable under their personal tax returns. In this case, personal tax rates are applied, which might be lower than business income tax rates in that state. Yet, LLCs have an edge over partnerships in this concern by being entitled to choose a corporate status for tax purposes. This allows applying more flexible taxation schemes and makes LLCs suitable for more complex business scenarios as well.
When it comes to business management and operation, both entities allow for their co-owners to manage the company or hire a third-party manager for that. However, to manage the partnership business, you need to be a general partner exposed to unlimited liabilities not only in relation to day-to-day transactions and operations but also in relation to business liabilities and debts. By way of contrast, in LLCs, any registered member could perform managing functions while retaining their personal limited liability protections. To add more, LLCs boast a more organized management structure. They conduct daily operations under an Operating Agreement outlining the rules and internal procedures for many essential and ongoing business issues and situations. At the same time, LLCs have more formalities to meet here. They have to file annual reports, keep records on many business operations, and hold regular meetings to pass crucial decisions and maintain state compliance.
LLC vs Partnership: Liabilities
Liability issues are where the main difference between LLCs and partnerships lies. As the name suggests and as we’ve stated above, LLCs enjoy the limited liability protection of corporations. With partnerships, on the other hand, it’s not that simple.
What sets LLCs apart from many other legal structures is separated business and personal liabilities. Once formed, an LLC functions as an independent legal entity in all concerns. It is the company as a legal person that is held liable for its debts and any legal issues or lawsuits that might arise during LLC operation. And it is business assets and funds that are used for settling those issues. Meanwhile, the LLC members have no personal liability in this concern and their personal assets and property are legally protected from being used for business liability repayments and penalties. It should be noted, however, that there are certain situations when LLC members are exposed to personal liability. This happens when:
- individual owner assets are combined with that of an LLC;
- fraudulent member’s actions or misconduct take place such as breaching the member rights, exceeding their managing authorities, or making decisions that cause any legal or financial problems for business;
- members fail to fulfill their commitments and obligations set forth by the Articles of Association and Operating Agreement;
- members might be held liable for the business debts, should they function as guarantors under loan or credit agreements.
The scope of member liability in partnerships largely depends on the partnership type. Thus, in general partnerships, partners carry liability both for the business activities and for the debts, actions, and misbehavior of other partners. It means their personal assets are at stake, should any business problem arise, no matter if they have any relation to that problem or not. In other words, partners share not only equity contributions and business profits in equal proportions but also any business issues that might occur. To balance this situation, there is a special partnership type called a limited liability partnership, which is more popular in the modern business world. In an LLP, partners still remain responsible for the business debts but they are not liable for the actions of other partners and any claims or sues against them.
LLC vs Partnership: Taxes
LLCs and partnerships both benefit from pass-through taxation transferring income taxes to the business owners. So, there are no state and federal taxes to be paid at a business level, as well as there is no risk of dual taxation like in corporations. There are simply some additional tax forms to be filed by both partners and LLC members along with their personal tax returns, yet no tax payments are to be made under them. Instead, they pay taxes over the part of company profits distributed to them and pay them under their personal tax rates. Such a taxation scheme gives more financial freedom and flexibility not only to the business owners but also to the company. In the meantime, LLC members have an added benefit not accessible for partners. They can pick a corporate tax status for their LLC. In this case, the company can be taxed either as an S-Corp or as a C-Corp without making any changes in the legal structure.