Photo credit: Nguyen Vu Hung (vuhung) via Flickr
Choosing which business entity is right for your business is an important one, and many new businesses with more than one owner consider whether to operate as a partnership or a limited liability company (aka an LLC).
There are two types of partnerships: general partnerships and limited partnerships. General partnerships are formed when two or more parties voluntarily agree to run a for-profit business with which they’ll equally share management responsibilities as well as profits and losses.
The second type of partnership is a limited partnership, which is made up of at least one general partner who finances and manages the business, and one or more limited partners who provide only capital to the company.
Now available in almost all states, the LLC is a relatively-new business entity which has become a popular legal alternative for business owners. Like partnerships, LLCs also have two or more owners, which are called members, but the way that LLCs are set up and maintained is different from partnerships. It’s helpful to look at the differences between partnerships and LLCs in terms of five key areas: formation, management, profit sharing, legal liability and taxation.
#1. Formation
General partnerships are the easiest to form of all business entities, and can be formed in a variety of ways, including via an oral agreement or in writing. Although you are not required to do so, when you form a GP, it’s a good idea to draft a partnership agreement which will spell out each partner’s rights and responsibilities and help avoid litigation later down the line.
The process by which limited partnerships are established is more formal. LPs are required to file a certificate of partnership with the state’s relevant office, which for California, is the Secretary of State’s office. Like GPs, the members of the LP may wish to enter into articles of limited partnership to clarify the partners’ roles and obligations in running the business.
Though it’s not as complicated as forming a corporation, LLCs require more formal documentation than a partnership demands. For a multi-member LLC, the owners must enter into an operating agreement that will clarify each member’s rights and responsibilities. LLCs are also required to file Articles of Incorporation with the relevant office for their particular state.
#2. Profit-Sharing
The way profits and losses are shared in partnerships and limited liability companies are similar. Unless the partners determine otherwise, general partners and members of an LLC typically share equally in both the profits and losses of their business organization.
With a limited partnership, however, the general and limited partners usually share in the profits and losses of the business based on the value or percentage of that partner’s capital contribution to the business. In exchange for giving up management power, for instance, a limited partner is only liable to losing the amount he or she invested in the business. In contrast, a general partner of that business may be held personally liable for the debts of the business.
#3. Management
In a general partnership, each partner has equal management and voting rights, regardless of how much capital they contributed to the business. The partners have a responsibility to each other, and are expected to act in the best interests of the partnership as a whole.
Limited partnerships may have either one general partner or two or more general partners who operate the business on a daily basis. In an LP with two or more general partners, the management framework is similar to that of a general partnership for the general partners, but the limited partners of the business typically do not manage the business whatsoever.
In you’re a single-member LLC, you own, manage and operate your business on your own. Single-member LLCs are popular because they allow one business owner to be treated like an LLC. One benefit of being a single-owner LLC is you don’t have to consult other partners on business strategies and policies. At the same time, however, you may lose out on expertise and knowledge that additional partners might provide.
If your LLC has two or more members, an operating agreement may be used to structure the management roles and decision-making authority of each member. For example, you may decide that all members will share in the management responsibilities of the business or that the decision-making powers will be delegated to only certain members.
#4. Legal Liability
In both general partnerships and limited liability partnerships, the general partners have unlimited personal liability, which means they are personally responsible for the debts of the business. Also, each general partner is jointly and severally liable for the acts of their fellow general partners, which can create problems if one partner proves irresponsible, etc. Conversely, limited partners in an LLP can only lose the amount of capital they contributed to the business.
Members of an LLC are entitled to manage the business while retaining the limited personal liability of shareholders in a corporation. This means that, typically, LLC members are not personally liable for the LLC’s debts or legal liabilities. Only their financial contributions are at risk.
#5. Taxation
Both partnerships and limited liability companies enjoy pass-through taxation, which means that the business itself does not pay income tax. The profits and losses are “passed through” to its partners. Since LLCs enjoy both pass-through taxation and limited liability, they’ve become one of the most popular legal alternatives for business owners.
