Is an LLC Considered a Partnership?
Is an LLC considered a partnership? That is a common question people have when trying to understand business organization structures.4 min read
Is an LLC considered a partnership? That is a common question people have when trying to understand business organization structures. LLCs have to choose their tax structure and by default the IRS considers an LLC a partnership for tax purposes only.
Different Business Types
A general partnership is a for-profit business owned by two or more people. They're easy to create and partnerships have low start-up costs. Partners can invest money or provide labor or skills for an ownership stake. The tax benefits and its easy set up are two main benefits of a partnership. However, personal liability is also a risk here, just like sole proprietorships. Another potential drawback with partnerships is the issue of partners disagreeing, which could lead to the termination of the partnership. One way to reduce this risk is to create a partnership agreement.
LLCs are a relatively new business type. They are created entirely on local state laws, and the owners must decide how to be taxed — sole proprietorship, partnership, or corporation. LLCs are attractive as they offer flexibility and practical benefits. The biggest benefits are the combined limited liability protection of corporations with the tax benefits of a partnership. One downside is the possible termination of the LLC if an owner leaves or passes away, depending on which state the LLC is located in.
LLC vs Partnership
The processes of forming a partnership and an LLC are similar:
- Both are created after registering with the state where they plan to operate.
- Partnerships have multiple owners, called partners. LLC owners are called members.
- Partners share profits and losses, typically apportioned based on their ownership share.
- With an LLC, the business must file articles of organization with the state, and in some states, you may need to file a certification of organization. Most LLCs utilize an operating agreement, which discusses ownership percentages and "what-if" scenarios and how to handle them.
- In partnerships, partners have personal liability for partnership debts. Each partner is also liable for the acts of other partners. LLCs are the opposite, as they are designed to take away the risk of personal liability for members.
- Unlike a partnership, it's considered a separate legal entity. The LLC can own property or enter into contracts on its behalf.
Members are only liable up to their personal investment share, provided they keep business and personal assets separate. Any member who engages in fraud, personally guarantees a business loan, mismanages the LLC, and/or doesn't maintain a clear break between personal and business assets can be held personally liable.
Partnerships and LLCs are "pass-through" tax entities. Tax responsibility is passed along to owners to claim on their personal income tax returns. A partnership doesn't pay a separate business income tax. However, it does file IRS Form 1065, which is a partnership return but no tax is due there. Schedule K-1s are issued to all partners which shows the amount each partner will claim on their own returns.
An LLC is not recognized as a separate tax entity. This is why multiple-member LLCs are taxed as a partnership by default. And single-member LLCs are taxed as sole proprietorships. Profits and losses are passed along to owners under both LLCs and partnerships.
If a partnership doesn't register with the state, it doesn't have to follow specific rules for record keeping. LLCs are bound by state requirements and regulations, so they must maintain a strict separation of business affairs from personal affairs and there are some requirements to keep detailed records and hold annual meetings.
The management of LLCs and partnerships are similar. Each type of business offers some management-style flexibility and allows owners to divide responsibilities as they so choose.
LLCs typically have operating agreements to help with conflict management and detail how the business will operate. Partnerships typically have partnership agreements. LLCs with multiple members can decide how the management will be shared. Options include either member-managed or manager-managed. With member-managed, each owner has equal responsibilities and rights. With a manager-managed LLC, only designated managers can make decisions for the business. If not specified in the operating agreement, it defaults to a member-managed structure.
Some business types are prohibited from forming an LLC. A number of states allow a business to form an LLP, a limited liability partnership. In an LLP, partners are still personally liable for partnership debts, but they are protected from liability from other partners' actions. They are commonly utilized to protect partners against malpractice claims aimed at other partners.
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