LLC is a Corporation or Partnership: Everything You Need to Know
Many small business owners who are thinking of registering their entity may wonder whether an LLC is a corporation or a partnership. 3 min read
Many small business owners who are thinking of registering their entity may wonder whether an LLC is a corporation or a partnership. While a limited liability company (LLC) shares common features with both corporations and partnerships, it is not classified as either.
What Is a Partnership?
Both partnerships and LLCs are formed at the state level and follow a similar process. A partnership is co-owned by several owners, referred to as partners. While corporations issue stock, partnerships and LLCs allow owners to share directly in the business's profits and losses based on their percentage share. Partners and LLC members can be assigned any percentage share as long as the total of all shares equals 100 percent. The percentage shares are determined when the business is formed and documented in the official partnership agreement.
Both partnerships and LLCs are subject to pass-through taxation, in which profits and losses are reported on the owners' individual tax return. This allows these entities to avoid the double taxation that affects corporations. Like LLCs and unlike corporations, partnerships do not have formal meeting requirements.
While LLCs offer limited liability protection, in a partnership each owner is legally responsible for the actions of the other partner as well as those of the business.
What Is an LLC?
An LLC is formed by filing documents called articles of organization with the secretary of state office. Owners of an LLC are referred to as members. The LLC members can create an operating agreement that defines ownership percentages and the details of the day-to-day operations of the business.
Many new businesses opt to form as an LLC because it offers beneficial taxation, limited liability protection, and few formal requirements. However, an LLC may have trouble attracting investors because it cannot issue stock certificates. LLCs can elect whether they want to be taxed as a partnership, corporation, or sole proprietorship. However, some types of businesses, such as banks, cannot form an LLC. In addition, in some states, the LLC is dissolved if a member leaves or dies.
Liability: Partnerships vs. LLCs
As mentioned above, liability protection is the primary difference between these two business entities. With a partnership, each partner has full liability for the debts of the business as well as for the other partner's actions. This means that if the business is sued, the partners' personal assets could be seized to pay a legal judgment.
An LLC protects your personal assets in this instance by offering limited liability. This means that you are only responsible for business debts up to the amount of your investment in the business. When you are a member of an LLC, personal liability exists only in specific circumstances:
- If clear separation between the individual and the business is not maintained
- If the member in question personally guarantees a loan for the business
- If the member engages in illegal activity or fraud in the course of running the business
- If the member has mismanaged the LLC's affairs
LLC and Partnership Taxation
As described above, both LLCs and partnerships are subject to pass-through taxation. Both entities file an information tax return annually using IRS Form 1065. The business must also generate a Schedule K-1 for each partner or member to show his or her share of profits and losses. This form is filed with each stakeholder's individual tax return.
Unlike a partnership, however, an LLC can also opt to be taxed as a C or S corporation. This allows you to choose the most advantageous form of taxation depending on your business. If your LLC members have high taxable income, they will pay a higher individual tax rate than the corporate rate. Choosing to be taxed as a corporation prevents LLC income from being included in your personal taxes. This allows you to keep some profits within the business and therefore not subject to personal income tax.
Despite this benefit, having your LLC taxed as a corporation means its profits will be taxed at the corporate level when they are earned and again at each member's individual level when they are distributed. Your tax attorney or CPA can help you explore various business tax scenarios to determine which election is most beneficial.
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