Partnerships are formed when two or more individuals agree to serve as co-owners of a business. Like sole proprietorships, there is no legal distinction between the owners of a partnership and their business. Because of this, partnerships are considered pass-through entities, with owners reporting all business earnings and losses on their personal tax returns.
There are two main types of partnerships: general partnerships and limited partnerships. In a general partnership, all members take an active role in the business and assume personal liability for any business-related debts. A limited partnership, however, allows one or more partners to serve as passive investors, funding the business but remaining uninvolved in the day-to-day operations. Limited partners also enjoy personal liability protection as long as they maintain their inactive role.
Forming a Partnership
Since partnerships are not recognized as separate legal entities, there is typically no paperwork involved when forming one. You can form a general partnership with a handshake. However, it is highly recommended that all the details of your agreement be well articulated in a written partnership agreement. This will ensure everyone understands their responsibilities and can prevent time-consuming and costly disputes down the road. At a minimum, a partnership agreement should include:
- The percentage of ownership of each partner
- How profits and losses will be allocated
- Who is authorized to sign contracts and other legal documents on behalf of the company
- How major business decisions will be made
- How disputes will be resolved
- What happens following the death or departure of a partner
The process for forming a limited partnership can be more involved. Some states require you to execute a partnership agreement, file a Certificate of Limited Partnership, obtain a state tax identification number, and secure workers compensation insurance. Because requirements vary by state, be sure to check with your secretary of state’s office or other business services agency for up to date requirements.
A limited liability company (LLC) is a business structure treated as a separate entity from its owners, known as members. Like partnerships, LLCs are taxed as pass-through entities, with all members reporting their profits on their personal tax returns. However, LLCs offer limited liability protection to all members. An LLC may be formed by a single person or be comprised of multiple members.
Forming an LLC
Establishing an LLC requires a few more steps than a general partnership. To form an LLC, you’ll need to complete a number of steps and formally file your business with the state. The process generally requires that you:
- Choose a name. You can check your state’s business entity database to ensure your desired name is not in use. It is also wise to check the federal trademark database and ensure your domain name is free. Your name will need to include “LLC” or “limited liability company.”
- File articles of organization. You will need to file articles of organization with the appropriate state entity, often the secretary of state, and pay the filing fee. This document typically contains basic information about your company, such as the business name, principal location, and the names and contact information of your registered agent and LLC members.
- Create an operating agreement. While typically not required by the state, your operating agreement is a critical document that outlines the rules, procedures, and powers of your LLC and its members.
- Obtain an EIN Number. All multi-member LLCs and any single-member LLCs with employees are required to obtain an employer identification number (EIN) from the IRS.
- Publish a notice of formation. Some states require you to publish your intention to form and operate an LLC in a local newspaper.
- Obtain other required licenses or permits. Your state and locality may require LLCs to secure other licenses or permits, so be sure to check with your filing agency to determine what, if anything, is required of your business.
To help you decide if a partnership or LLC is the best fit for your business, here are the major similarities and differences between them:
The biggest difference between partnerships and LLCs concern liability protection. Because an LLC is considered a separate legal entity from its members, it offers them personal liability protection. This means that in the event of debts or legal actions against the business, each member will be responsible for no more than their initial investment into the business. To ensure this protection, LLC members must keep their personal and business finances strictly separate.
Partnerships, on the other hand, are indistinguishable from their owners for legal purposes. As such, there is no distinction between the owners’ personal and business finances and no personal liability protection.
Despite differing legal status, both partnerships and LLCs are considered pass-through entities by the IRS. Owners of both businesses report their profits on their personal tax returns, with earnings subject only to their personal tax rate. They are also both responsible for paying self-employment taxes.
One important distinction is that unlike partnerships, LLCs have the option to elect corporate status for tax purposes, being taxed as either S or C corporations if this designation is more favorable.
Formation and Maintenance
General partnerships are essentially mutual agreements between business partners and come with very few formal requirements in terms of formation and maintenance unless you choose to form a limited partnership. LLCs, on the other hand, are more involved. To form an LLC, you must file articles of organization. Once you start your business, most states require regular record keeping and reporting to keep an LLC in good standing. The same is often true of limited partnerships.
While similar to general partnerships, limited liability partnerships (LLPs) offer their owners a level of limited liability protection. The degree of liability protection varies by state, with some states offering protection similar to that of corporations and LLCs, some only protecting against other partners’ negligence, and some falling somewhere in between. In general, an LLP will protect your personal assets.
LLPs also have one important difference when compared to limited partnerships. Unlike limited partnerships, which protect silent partners from liability, LLPs have shared management and shared limited liability across all partners. LLPs also enjoy the flexibility to add or remove partners easily, depending on the rules outlined in their formation agreement.
Forming an LLP
Forming an LLP requires a formal written agreement. Some states also require LLPs to file an annual report. The rules about who can form an LLP also vary by state, often limiting the LLP structure to certain industries. For example, law firms and medical practices often form LLPs.
As you determine how to structure your business, there are several questions you can ask yourself to help work through all of your options:
Do You Need Personal Asset Protection?
The question of protecting your personal assets is the most important consideration to make when choosing a business structure. Consider all the possible risks your business can expose you to and how much protection you would like to have against these risks.
How Do You Want the Government to Tax Your Business?
Taxation is another critical factor to consider when making this decision. Both LLCs and partnerships are pass-through structures, with business profits and losses reported on owners’ personal tax returns. However, LLCs provide the option to elect corporate status for tax purposes, leaving a bit more leeway to their owners.
How Much Flexibility Do You Want in Your Business Structure?
Both LLCs and partnerships offer fairly hassle-free business operations compared to other structures. An LLC, however, will require more upfront and ongoing paperwork to remain compliant with state regulations.
Can You Afford Formation and Administration Fees?
Another consideration to make when choosing your business structure is the cost. While partnerships can be formed at no additional administrative fee, in most cases, LLC owners will need to pay to file formation documents and owe fees on an annual or biennial basis to keep their business compliant. These costs vary by state.
How Much Capital Do You Need to Raise?
The type of business structure you choose can have a large impact on your ability to raise capital. As such, it is important to consider the financial needs of your business before deciding. Because of limited liability protection, it may be easier to find investors for an LLC. Limited partnerships provide the option of offering liability-free investment, but require limited partners to remain at arm's length when it comes to management.
Take some time to consider how much money you’ll need to raise, where you are most likely to find investors, and what business type will work best both for you as owners and in terms of attracting the investments you need to get and keep things running.
What Are the Long-Term Goals for Your Business?
While one business structure may seem best for you in the early stages, before deciding, it’s important to think about your long-term goals. Consider whether you plan to remain in your home town or state or hope to expand nationally or even internationally. What level of skill is required and how many additional business partners will you want or need to bring on to help achieve your goals? All of these considerations can help you choose a structure that will grow with you and your business over time.
While LLCs and partnerships have much in common, they also have some critical and fundamental differences. Before deciding how to form your business, take the time to think through the pros and cons of each and how they will help or hurt your business going forward.