Key Takeaways

  • Both LLPs and LLCs offer pass-through taxation, but LLCs provide more tax flexibility.
  • LLPs are often used by licensed professionals and are restricted by state laws.
  • LLCs may elect to be taxed as an S corp or C corp, which can offer additional tax-saving strategies.
  • Self-employment tax obligations differ between LLP partners and LLC members.
  • LLCs are typically better for businesses seeking more expansive liability protection and flexible tax classification.

Limited liability partnership tax implications can impact a business owner's decision to set up this type of entity. When determining which business entity formation is best for your organization, make sure you fully understand all the potential tax implications.

Tax Treatment of Limited Liability Partnerships

A limited liability partnership (LLP) is a newer business formation option that is governed by a provision that applies to general partnerships and limited liability companies (LLC) in many states. This provision allows for more personal liability protection for partners in a partnership. However, an LLP isn't a separate business entity. It is treated as a limited or general partnership for tax purposes.

LLP vs LLC Tax Benefits Compared

When comparing LLP vs LLC tax benefits, it's important to note that both structures offer pass-through taxation by default, which means income is not taxed at the entity level. However, there are some key differences in flexibility and how income is treated:

1. Tax Classification Flexibility:

  • LLC: Offers more flexibility in choosing how it is taxed. By default, a single-member LLC is treated as a sole proprietorship, and a multi-member LLC is treated as a partnership. However, LLCs may elect to be taxed as an S corporation or a C corporation by filing IRS Form 8832 or Form 2553.
  • LLP: Is always taxed as a partnership and cannot elect to be taxed as a corporation.

2. Self-Employment Taxes:

  • LLP: General partners are subject to self-employment taxes on their entire share of the business’s income. Limited partners may not be, depending on their involvement.
  • LLC: Members may reduce self-employment tax liability by electing S corporation taxation and paying themselves a reasonable salary while taking the remaining income as distributions, which are not subject to self-employment taxes.

3. State-Level Tax Obligations:

  • LLPs and LLCs may be subject to different registration fees and annual reporting requirements, which can indirectly affect their tax burden. Some states impose a franchise tax or gross receipts tax that applies differently to each entity type.

4. Professional Restrictions:

  • LLPs are typically reserved for licensed professionals such as lawyers, doctors, and accountants. This limits their use for general businesses but offers tailored protections for malpractice claims. These restrictions can affect who qualifies for pass-through benefits under an LLP structure.

5. Profit Distribution and Tax Timing:

  • LLPs typically distribute profits based on the partnership agreement, which can be customized for contributions and effort. Taxes are paid on the allocated share, regardless of whether distributions are made.
  • LLCs have more discretion over how and when profits are distributed, especially if taxed as an S corp or C corp.

Texas First With LLPs

Although many states offer the option for business owners to form LLPs, not all states have provisions in place. Texas was the first state with a statute governing the formation of an LLP. The benefit of forming this type of partnership is the extension of limited liability protection that is granted to limited partners in the business.

A law firm in Texas further explained the liability protection granted to general partners in limited liability partnerships. These partners aren't liable for obligations and debts from misconduct, negligence, or errors committed by an agent, employee, or fellow partner of the business. However, a general partner would be personally liable for the debts and obligations incurred by the partnership.

LLP Not an LLC

Although the names are similar, limited liability partnerships and limited liability companies are not the same. An LLP or standard partnership must register with the state, but that process doesn't modify how the business entity is set up. LLPs also don't have the tax flexibility or structural flexibility of LLCs. For example, an LLC can elect for taxation as a corporation or a partnership, while a partnership cannot modify the way it is taxed. All LLPs are taxed as partnerships. For LLCs, the taxation flexibility is one of the advantages, depending on specific circumstances.

When to Choose an LLP or LLC for Tax Reasons

Choosing between an LLP and LLC often comes down to profession and tax planning:

  • Choose an LLP if: You're a licensed professional (e.g., attorney, CPA, architect) operating in a state where LLPs are permitted and you value shared management with clear liability protections.
  • Choose an LLC if: You want tax flexibility (like electing S corp status), are not a licensed professional, or need a more versatile structure for investing, hiring employees, or holding property.

Pass-Through Taxation

One of the benefits of forming an LLP is pass-through taxation, which means all business losses and income are passed through the company to the partners. The partners then report their shares of the losses and income on their personal tax returns. A partner must include Form 1065, Schedule K with their personal tax return when filing with the IRS.

The income of a general partner is subject to self-employment and income tax. The income or loss of a limited partner is reported as passive income or passive loss. Passive loss can be deducted from other passive loss and income, not from the limited partner's total income.

Registration Fees

One of the requirements of an LLP is to file its annual registration with the secretary of state's office. Failure to file this registration could impact the partners' limited liability protection. The partnership must also pay the required fees, which vary by state. The fee in Texas is $200 per partner. Additionally, Texas requires all LLPs to carry a minimum amount of insurance coverage to cover any obligations or debts stemming from:

  • Malfeasance
  • Negligence
  • Omissions
  • Errors

The minimum coverage for an LLP is Texas is $100,000.

Franchise Tax

In some states, businesses are subject to a special franchise tax. For example, Texas previously imposed a franchise tax on LLCs and corporations but not on LLPs. In 2006, this state tax was replaced by a taxable margin, which is the company's total revenue, less the cost of compensation or goods sold (whichever is less). This new law modified the taxable entity definition, causing LLPs to be included. In Texas, the taxable margin rate is 0.5 percent for retailers and wholesalers, and 1 percent for other types of businesses.

Considerations for Multistate Taxation

If an LLP or LLC operates in multiple states, it must register as a foreign entity in each jurisdiction where it conducts business. This can lead to added administrative complexity and potential tax liabilities in more than one state.

  • LLC Multistate Issues: LLCs may face franchise taxes, gross receipts taxes, or minimum fees depending on the state.
  • LLP Multistate Challenges: LLPs may be limited to professional practices and not allowed in every state, making expansion difficult. Additionally, tax treatment of limited vs. general partners may vary by jurisdiction.

Tax Benefits of a Limited Liability Partnership

A business formed as an LLC doesn't have a separate classification under the IRS. Therefore, the owner(s) of an LLC must elect for taxation as a corporation, partnership, or sole proprietorship. If a business has more than one owner, it cannot be taxed as a sole proprietorship.

When electing for taxation as a corporation, the owner(s) must further specify whether the business will be taxed as a C corporation or an S corporation. In an S corporation, the owners typically receive a salary from the business, and income and losses are passed through the business to be reported on the owners' personal income tax returns. A C corporation is more often a large, publicly held company that must file an annual business tax return.

Frequently Asked Questions

  1. What are the main tax differences between an LLP and LLC?
    An LLC offers more tax classification flexibility, including the option to be taxed as an S or C corporation. LLPs are always taxed as partnerships.
  2. Can an LLP avoid self-employment taxes?
    Some limited partners in an LLP may avoid self-employment taxes if they do not actively participate in the business, but general partners are subject to them.
  3. Is an LLC better for tax benefits than an LLP?
    Generally, yes—especially if you plan to take advantage of S corp election to reduce self-employment taxes or need flexibility in profit distributions.
  4. Can an LLC be used for professional services like law or accounting?
    In some states, no. Professionals may be required to form an LLP or a Professional LLC (PLLC) instead.
  5. Do both LLPs and LLCs offer pass-through taxation?
    Yes, both default to pass-through taxation, meaning profits are taxed on the owners’ personal tax returns, avoiding corporate-level taxation.

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