Updated November 12, 2020:

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.

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.

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.

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.

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