Partnership vs LLC: Everything You Need to Know
The most important difference between partnerships and LLCs is in their liability protection. 11 min read
Updated October 21,2020:
The difference between partnership vs. LLC is important when starting a business. The limited liability company (LLC) is a common business structure. An LLC resembles the partnership business structure in many ways. An LLC pays like a partnership on its income tax.
What Is a Partnership?
A partnership is a business form that has multiple co-owners or termed partners. Partners can have any share of ownership, but the percentages must total 100 percent. The partnership agreement that is created at the time the partnership is formed determines each partner's share. Partnerships register with a state.
Varying depending on the partners' professions and their wishes, there are multiple forms of partnerships. Depending on their ownership stake, the partners each share management equally and the business' profits or losses.
How Are General Partnerships Formed?
A partnership is formed whenever two or more people create a profit-oriented business, even if there isn't an intent or written plan to do so. There is no registration requirement or formal filing that needs to be completed in order to form a partnership. Remember, a partnership is owned by at least two parties. Therefore, a sole business person may not own a partnership.
When forming a general partnership, most attorneys will agree that a written partnership agreement or an Articles of Partnership should be created to legally and unequivocally identify the business relationship between the partners. The agreement should establish each partner's responsibilities, duties, and rights. The creation of this formal agreement will only help to prevent future litigation and disputes between partners.
How Are Limited Partnerships Formed?
A limited liability partnership is considered a blend between a corporation and a partnership. It needs to be an unincorporated business that's owned by two or more members called partners. Beyond the assets that were invested in the partnership, none of the partners may be held personally responsible for the actions of the other parties. The partnership agreement outlines each partner's ownership in the company. Depending on the location of the business, a partnership may need to register with their secretary of state's office.
What Is an LLC?
An LLC is created in a state and its owners are termed members. An LLC submits Articles of Organization (called Certificate of Organization in a few states) to the secretary of state of the state. An operating agreement governs how LLCs function, which states ownership stakes and outlines other potential and contingency procedures.
An LLC Operating Agreement is considered to be the most significant document of the LLC because it draws out the framework and roles of the business. More specifically, this agreement outlines the working and financial relationships between the managers and members of the company. It will define the percentage of ownership by each member and will also answer other critical questions related to the business.
How Are LLCs Formed?
LLCs are usually easier to form than a corporation but are more complex to form than a general partnership. A written operating agreement is not required, but it is strongly encouraged to clearly identify each member's responsibilities, duties, and rights.
The two defining characteristics that separate an LLC from a general partnership includes limited personal liability and pass-through taxation.
- Limited liability: As long as the business is run responsibly, it will benefit from limited liability. Personal assets such as cars, homes, and bank accounts are protected from creditors.
- Pass-through taxation: An LLC is known as a pass-through entity. In this format, net profits or losses from the business are passed to the owner level where they are recognized on the personal tax returns of the members.
To legally operate as an LLC, most states require that a Certificate of Formation be filed with the secretary of state in the state in which the business is being formed. LLCs may be created and owned by one member. Currently, there is no limit to the number of members an LLC may have. However, the Operating Agreement of the LLC may limit the maximum number of members.
What Is the Common Business Structure for New Businesses?
One of the most significant decisions to make when starting a business will be deciding on the legal structure of the organization, and how it impacts the following:
- How much taxes are paid
- The amount of paperwork
- Personal liability
- Ability to raise capital
The most prevalent forms of organization for businesses with more than one owner are general partnerships, limited partnerships, LLCs, corporations, and S corporations. Remember, each legal structure comes with various tax consequences, so it's important to choose the format that lines up with your organizational needs.
Liability for Partnerships and LLCs
The most important difference between partnerships and LLCs is in their liability protection. Each partner is personally liable for the partnership's debts. Furthermore, every partner is personally liable for all other partners' actions. LLCs are created precisely to protect its members from liability (as the term “limited liability” refers to). In an LLC, members are only liable to the degree of their personal investment for the business' debts.
There are several situations where LLC members may have personal liability:
- When there is no obvious separation between the business and the individuals
- If an LLC member(s) personally guarantees a business loan
- If a member commits fraud or other illegal activities that go beyond their member duties
- If a member(s) has mismanaged the LLC
- If a member personally signs for the LLC's debts, to the extent of those debts
What Is the Similarity Between LLC and Partnership?
An LLC has become a popular way to form a business organization. Business owners may limit their liability as a sole proprietor or a partnership by forming an LLC. Much like a corporation, LLCs limit the amount of personal liability to the amount of capital contributed to the business. Like a partnership, they allow pass-through taxation and management flexibility. All states, including the District of Columbia, allow the formation of an LLC.
What Are the Governing Laws on Partnerships and LLCs?
The laws governing general partnerships, limited partnerships, and LLCs are mainly interpreted based on previous legal cases. In addition, each state maintains its own statutes regarding LLCs. Consequently, keeping up with and learning the laws that govern LLCs, which are constantly being changed and tweaked, can be a complicated business. Business law mainly focuses on four key aspects:
- Legal liability
When considering or forming an LLC it's important to consult an up-to-date and knowledgeable attorney to assist in the decision-making process.
Taxes for Partnerships and LLCs
LLCs and partnerships are pass-through structures for tax purposes. The owners (members or partners) pay the LLC's/partnerships taxes on their personal tax returns. Every year a partnership files a Form 1065 tax return but owes no tax itself. Each partner receives a Schedule K-1 that shows the partner's annual profits or losses share. The Schedule K-1 is filed with the partner's individual tax return. The IRS does not deem LLCs a taxing entity.
Partnerships and multimember LLCs are taxed in the same fashion, with profit or loss passing to each member's individual tax return. Single-member LLCs file a Schedule C with their individual tax returns and are taxed as sole proprietors. LLCs are able to choose to be taxed as a corporation or an S corporation. The IRS treats partnerships and LLCs similarly.
LLCs are not recognized by the IRS as a business form, but rather LLCs are required on tax returns to be taxed as a corporation, partnership or sole proprietorship. If there is more than one member of the LLC, it can choose to be taxed as a partnership. Partnerships are disregarded entities and don't owe business income tax. Rather, partners report on their individual tax returns business profit or loss correlated with their ownership share of the partnership.
LLC members can create an operating agreement that determines management duties and clarifies how profits are distributed. A general partnership can have a partnership agreement that determines the rights and duties of each partner.
Profit and Loss Distribution for Partnerships and LLCs
In partnerships and LLCs, the profits and losses are passed straight to the owners. Partnerships and LLCs offer no stock and have no stockholders. In both multimember LLCs and general partnerships, the division of profits and losses are similar.
Partners typically regulate profits and losses based on the percentage or value of capital that each individual contributed to the business. Additionally, LLC owners and partnership members have the flexibility to enter into agreements that will distribute profits and losses in such a way that will benefit their own specific business model.
Registration and Record Keeping for Partnerships and LLCs
Compared to corporations, reporting is not as rigorous for partnerships and LLCs. There are no firm requirements for keeping meeting minutes or other records if a partnership isn't registered with a state. The partnership can work in whatever way the partners wish it to. In contrast, LLCs must follow certain state requirements and must be kept firmly distinct from its members personally. LLCs also are required to keep certain records and hold meetings. Either every year or every other, LLCs and partnerships must file reports with their state of formation.
In order to keep LLCs a separate and distinct legal form and keep its members' protection from personal liability, LLC owners need to carefully keep separate records and make sure personal matters are kept distinct from the LLC. Furthermore and most importantly, personal funds should never be intermingled with the LLC's funds.
Limited Liability Company and Partnership — What's the Difference?
When a new business has more than one owner it needs to decide if it wants to be a partnership (general and limited) or limited liability companies (LLCs). General partnerships are when at least two parties voluntarily agree to equally own and share profits, losses, and management duties in a for-profit business.
Limited partnerships are when one or more general partners manages and funds a for-profit business and when at least one limited partner contributes only capital to the partnership structure. Multimember LLCs are unincorporated business entities that mix beneficial points of partnerships and corporations. Uniform laws have been adopted entirely or in part in states and oversee general partnerships, LLCs, and limited partnerships. They generally oversee:
- Legal Liability
General Partnerships are created through both formal and informal ways. These can include:
- In Writing
- By implication through a court due to party conduct (such as combining capital, sharing management duties, and profits/losses)
It is strongly favored to have a general partnership formed through written agreement or articles that lay out the partners' duties and rights, and lower the potential of future litigation between partners.
For partnerships in the bulk of states, a certificate of partnership needs to be formally filed with the appropriate state agency, usually the secretary of state. Like general partnerships, general and limited partners might want to create articles of limited partnership in order to precisely determine requirements and duties in running the business. Compared to corporations, LLCs are less complex to form. However, LLCs need more formal documents than general partnerships. Owners in multimember LLCs need to create an operating agreement that details the rights and duties of the members.
One important trait of general partnerships is each partner's equal right to manage the business. Normally every general partner has one vote in all important partnership decisions no matter their personal capital contribution.
A general partnership is typically managed through a partnership agreement that will lay out the rights and regulations of each active member. Consider that an individual member can act for the partnership, holding the other members personally liable for intentional negligence, malpractice, or unpaid debts.
In single-member LLCs, the member owns, manages, and operates the business. Single-owner LLCs can create their own plans and procedures without needing to get others approval but can lose out on the expertise and backgrounds of other owners. An LLC's operating agreement can determine management roles and decision authority when there are two or more members. Depending on what is best for the business, all members might manage the LLC or decision and management authority may be given to certain members.
In an LLC, members create an operating agreement to manage the entity. This document specifies management duties and how financial profits should be distributed.
Profit and Loss Distribution for Partnerships and LLCs
In general partnerships and multimember LLCs, profits and losses are divided up the same way. General and limited partners in a limited partnership generally divide profits and losses depending on the amount or share of the capital contribution of each partner to the partnership. General partners, limited partners, and LLC members have the option to create agreements that divide the profits and losses in a way that is best for their business model.
Liability for Partnerships and LLCs
Generally, the law and liability flow with authority and control. Because of their management power, general partners have unlimited personal liability in general and limited partnerships. As they manage the partnership, general partners are liable both for their own actions and the actions of other general partners (joint and several liability).
Limited partners, similar to corporate shareholders and LLC members, risk the capital they contributed to the limited partnership. However, when a limited partner takes part in the management or makes a personal guarantee on behalf of the business they can be held liable for those.
LLC members are permitted to engage in management while still having limited liability similar to corporate shareholders. LLC members only risk their financial contribution to the LLC and are not liable for its liabilities. LLC owners can still have personal liability if their actions hurt others, they breach their duties to the LLC, or they personally guarantee loans. Business owners ought to think about proper insurance and other liability protection methods to protect individual assets and business resources.
LLC and Partnership
The main differences between partnerships and LLCs are in tax liability, business structure, and members' personal liability for debts and other obligations. LLCs are formed by filing creation documents with the business registrar of the state. An LLC can be owned by one or many people.
A partnership is created immediately when two or more people start together doing business. At least two individuals own a partnership. A partnership cannot be owned by just one person.
Liability for Partnerships and LLCs
An LLC is a sovereign legal being, and as a legal form, the LLC can own property and enter into contracts distinctly from its owners. LLC members normally are not personally liable for any of the LLC's debts or obligations.
A general partnership operates through its owners' names. General partnership partners are personally liable for the partnership's debts and other obligations. If a partnership has assets or owes money, the same goes for the partners.
LLC and Partnership — What's the Difference?
LLCs can raise capital in many ways. An LLC can allow new members by selling members' interests. It can also create new classes of member interests that have different voting rights or profit procedures. Furthermore, investors are certain they will not be personally liable for the LLC's debts. Third parties can usually buy ownership interests in an LLC without disrupting the business' operation.
In contrast, sole proprietorships and partnerships cannot be sold in bulk. Rather, its assets, permits licenses, etc., must be each transferred individually. The transfer also requires new bank accounts, as well as tax identification numbers. LLC's cost more to start than partnerships, as there are initial formation fees, annual state fees, and filing fees. Lower insurance costs offset in part these costs. A sole proprietorship or partnership is able to start and be run without formal documents.
What Is the Difference Between General Partnership and LLC in Terms of Termination?
In terms of termination, a general partnership and LLC operate differently. In a general partnership, the entity cannot exist separately from the owners. In the event of a partner's death, withdrawal from the company, or the inability to operate the business, that partnership must end.
Remaining partners may keep the entity running by formulating a new partnership. However, an LLC is regarded as a separate entity from its partners. To clarify, it survives the removal or death of a member. To terminate an LLC, official documents must specify a reason to end the company or establish an end date.
Liability for Partnerships and LLCs
The most important aspect of LLCs is that its owners have no personal liability for the LLC's debts. In contrast, owners in sole proprietorships and partnerships have personal liability for the business' debts. When the sole proprietorship's or partnership's assets are unable to fulfill the debt, the creditors are able to then reach for the personal bank accounts, houses, etc., of the owners. However, there are certain situations where a member might be liable for an LLC's debts. These include when:
- A member guarantees a debt personally.
- LLC and personal funds are intermingled.
- The LLC has tiny insurance or capitalization.
- The LLC breaks state law (such as by defrauding consumers) or does not pay state taxes.
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