As you start your new business venture, you may explore different business entities to limit your personal liability. Two options are a limited liability company (LLC) and a limited liability partnership (LLP). Both are simple to set up, but may not be an option for every business in every state.
A limited liability company (LLC) is a separate business entity with one or more owners, known as members. You may create an LLC by filing the appropriate paperwork with your secretary of state. This typically includes filing articles of incorporation, paying a filing fee, and creating an operating agreement. When properly formed, the business is a separate entity from its owners, meaning the LLC owns business property, bank account, and has its own tax identification number.
A limited liability partnership (LLP) is essentially a general partnership with the addition of limited liability for one or more partners. A general partnership is formed whenever two or more people do business together and does not require any legal filings. To create an LLP, you must file additional paperwork with the state. Like an LLC, an LLP is a separate business entity.
Take time to weigh the pros and cons of these two different business structures before forming your business.
Both an LLC and an LLP provide some protection against personal liability, reducing each partner’s or member’s liability to the amount they invested in the business. Generally speaking, an LLC provides the most liability protection. Except for cases of business mismanagement, the members are not personally responsible if the LLC is sued or owes any debt. This serves to protect personal assets like members’ houses, bank accounts, and cars.
After formed, the partners of an LLP may have limited liability like an LLC, but this depends on the state where you filed. In some states, an LLP only provides protection from being responsible for another partner’s negligent acts, but the partners remain personally responsible for the overall debts and obligations of the business. Further, some states require at least one partner to have unlimited personal liability, while other partners are protected.
An LLC can opt to be taxed as a sole proprietorship, partnership, or corporation. In contrast, an LLP must file as a partnership. Filing as a sole proprietor or a partnership means that the income is passed through the business, and the taxes are paid only once as income of the individual. If filed as a corporation, the business first pays tax on its corporate tax return, and the same income is taxed a second time on the personal tax return.
In addition, both LLCs and LLPs can take advantage of the 20% pass-through deduction. This means you can deduct up to 20% of your business profits from your personal tax return. There are some limitations on this complex tax break.
Another difference between the two entities is the process for determining the management structure. As mentioned, an LLC may have only one member, while an LLP must have at least two partners. An LLC is managed according to its operating agreement which is created by the members. This document outlines the financial contributions made by each member, how profits will be distributed, and who is responsible for management decisions.
You may opt to have a member-managed LLC, meaning that all the owners have a say in how the business is run. Alternatively, you may create a manager-managed LLC, where you have passive owners or investors who are not involved in the decision making for the company.
With an LLP, the management structure is determined by the partnership agreement. Like the operating agreement, the partnership agreement details the roles of each partner, their financial contributions, and profit distributions. Here you have the option to specify that one partner is a “silent partner,” meaning that, like in a management-managed LLC, they will receive a share of proceeds but will not participate in decision making for the business.
Take time to weigh the pros and cons of each business structure. It is challenging, as well as costly and time-consuming, to change the business structure after you have made the state filings. Overall, if your main concern is limiting liability or tax flexibility, an LLC is probably your best option. However, take a look at your state tax laws; some states may impose a higher tax on LLCs than LLPs.
In some cases, the decision may be made for you based on the state where you want to file and the type of business. If you are running the business on your own without partners, you cannot form an LLP. Additionally, not every state recognizes LLPs as a business structure. Some states only allow professional businesses, like accounting firms and law offices, to use LLPs. Similarly, some professionals may not be allowed to form an LLC, and must go with an alternate structure like an LLP for protection.