The U.S. has been experiencing a surge in entrepreneurship, with 2021 setting a record 5.4 million applicationsregistered to form a new business, according to the U.S. Census Bureau. That total represents a 23% increase over the 4.4 million applications filed in 2020– amid a pandemic, no less– and 53% over the 3.5 million filed in 2019, per the Bureau.
Among the many decisions to be made when starting a new company is its business structure. If you’re going in with one or more partners, two business structures to consider are a limited partnership (LP) and limited liability company (LLC). Each has different legal, tax, and liability implications that are important to understand before you make the choice.
What Is a Limited Partnership?
A limited partnership (LP) consists of two or more people going into business together, with at least one designated as the general partner and the other(s) a limited partner.
The general partner has most of the power and decision-making authority. However, they also assume unlimited liability, which includes risking personal assets, like a house or car,if the company fails to meet its financial obligations.
A limited partner is basically just an investor, also known as a “silent partner,” who is not involved in business operations and is liable for only the amount they invested in the company.
Forming an LP is administratively easy and relatively inexpensive. According to the U.S. Small Business Administration (SBA), the main requirement is just a partnership agreement that documents who the general and limited partners are, along with their responsibilities. Profits are simply passed through to the partners’ personal tax returns. An LP isn’t even required to register with its state government, unless it plans to use a “fictitious” name, which is anything other than a list of the partners’ surnames.
On the other hand, LPs lack tax benefits (more on that later) and involve unlimited liability for the general partner. That's why many people “steer clear” of them, said Benjamin R. Hanan, an attorney and CPA at Florida-based Shumaker, Loop & Kendrick, LLP.
“There are some states, like Florida, that go a step further to allow a limited partnership to elect limited liability limited partnership status, or what’s known as an LLLP, to provide general partners with liability protection similar to that of LLCs,” he added.
What Is a Limited Liability Company?
A limited liability company (LLC) consists of one or more business owners whose financial liability is limited to the amount each “member” has invested in the business. Personal assets are considered off-limits. According to the IRS, LLC members may include individuals, corporations, other LLCs, and foreign entities, but not banks and insurance companies.
LLCs are governed by the laws of the state in which they’re registered. Generally speaking, if you conduct the majority of your business and have a physical presence in your home state, you must register there. But if you’re, say, a consultant or online business, you can opt to register in another state with better financial benefits, such as no business income or franchise taxes.
Capital for an LLC is also easy to raise through the sale of interests. On the flip side, LLCs are usually more costly to form than an LP and require more administration to operate.
Overall, the SBA notes, LLCs can be a good choice for medium- or higher-risk businesses and owners with significant personal assets they want to protect, since liability is limited to each partner’s business investment.
“LLCs are generally the most flexible business form, particularly in terms of the ability to choose corporation or partnership tax status, even though both LLCs and limited partnerships are flexible in regard to profit distributions – or waterfalls, as they are commonly referred to – for members or partners,” said Jeanne R. Solomon, an attorney at Polsinelli, a law firm with offices in several states.
Tax Implications for LPs and LLCs
Perhaps one of the biggest considerations when selecting your business structure is understanding how you will be taxed.
According to the IRS, when a business entity is created, a determination must be made about how the entity should be treated for U.S. income tax purposes– meaning, as an individual, partnership, or corporation. These are known as entity classification regulations, or “Check the Box” regulations.
LPs and LLCs are typically treated as a “pass-through” entity. This means that income, losses, and credits flow from the business to their owners and members, who report the financials on their individual tax returns. The same holds true for an LLC that elects to be taxed as an individual or, if there are at least two members, a partnership.
However, an LP or LLC can elect to be treated as a corporation, which brings certain tax savings and deductions,but also “double taxation.” Double taxation is when the same income is taxed twice, such as when a corporation pays taxes on its profits and then shareholders pay income tax on any dividends the corporation pays to them from those profits. It may be wise to seek legal and accounting advice to understand the many complexities.
Additional Considerations
A few more points to keep in mind no matter which business structure you choose:
- Registering your business as an LP or LLC costs money. Just as each state has its own statutes around forming a business, they also charge varying fees for making it official. For example, in Massachusetts it costs $500 to file to become an LLC, plus $500 in annual fees. In Colorado, filing costs $50 and annual fees are $10.
- Put in writing “who will be the owners and managers, how they want to divvy up the profits, and how they want to handle sales and transfers,” Solomon noted. “If there is an even number of owners or managers, think about what to do if there’s a deadlock on a key business decision. How are you going to resolve this, and what does that mean for multiple [owners]?”
- Though it’s critical to carefully select your business structure at the beginning, it may be possible to convert to a different business structure as your business grows. Be aware there might be tax consequences for doing so, along with other complications, such as unintended dissolution. For example, the SBA notes that some states require LLCs to dissolve and reform as a new LLC if a partner leaves or a new partner joins. Again, consulting with an expertfirst can be very helpful.
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