If you are contemplating starting a business, you've probably heard these abbreviations: LLC, LLP, LP, S Corp and C Corp. In the past, partnerships and corporations were the only formation options available for new business owners. Now, more business formation options are available, and many prospective entrepreneurs are forming limited liability companies (LLCs) and limited partnerships (LPs).
LLCs and LPs are two of the most popular business entities today with advantages that include limited liability, pass-through taxation, management control and flexibility. Both are treated like general partnerships for tax law purposes, yet have the limited liability of corporations. Some businesses even combine the two, having an LLC as the general partner of an LP to mitigate liability issues.
What is a Limited Liability Company?
An LLC is a hybrid business organization that mixes the best of corporations, partnerships, and sole proprietorships. Each owner (also called a member) of an LLC has limited liability like a stockholder of a corporation. LLCs allow any entity, including individuals, partnerships, trusts, estates, corporations, or other LLCs to be owners. They also offer greater flexibility than corporations—like no limits on the number of members—yet they have the tax advantages of a partnership, such as pass-through taxable income and losses.
LLCs do not have to observe the formalities normally imposed upon corporations, such as producing annual reports, holding director meetings, and meeting shareholder requirements. In addition, profit and loss can be allocated differently than ownership or partnership interests. Unlike corporations, which must distribute profits in proportion to each of the shareholder's ownership of shares, LLC members may distribute profits in any manner they want without regard to each member's capital contribution.
LLCs are recognized legal entities in all 50 states and the District of Columbia, and every state now permits one-owner LLCs (though some states tax LLCs like a corporation). Finally, with IRS "check-the-box" regulations, a business that is currently a sole proprietorship can change to an LLC with no federal tax consequences.
What is a Limited Partnership?
An LP has one or more general partners and one or more limited partners. The general partners participate in management and have 100% liability for partnership obligations. Limited partners cannot participate in the management and have no liability for partnership obligations beyond their capital contributions, protecting them against personal liability for the partnership's debts and other obligations. They do, however, receive a share of the profits for their involvement as limited partners.
Many partnerships are formed as LPs because the limited liability is attractive to passive investors. It is often easier to market limited partner interests as an investment and general partners can raise money without involving outside investors in the management of the business. Assets are also protected in an LP. Unlike a corporation, which allows a shareholder's stock to be confiscated in a personal lawsuit, an LP has provisions that protect a partner's interest from being taken away when that partner is sued personally.
The LLC's Positive Flexibility
There are advantages to both LLCs and LPs. As discussed earlier, owners of an LLC and limited partners in an LP have limited liability, although limited partners in an LP lose their limited liability if they actively participate in management. An LLC has a more flexible management structure, so members of an LLC may participate in the management of the business without endangering their limited liability.
Both entities have pass-through taxable income and losses. With pass-through tax treatment, there is no taxation to the business itself; all income, deductions, credits, etc., "pass through" to the individual members or partners and are reported on their individual tax returns. A corporation is taxed once on its income at the entity level, when its revenues are generated or collected, and the shareholders are taxed a second time, individually, when the income is distributed.
Because LLCs and LPs pass through taxable income and loss, both avoid the double tax on income that is inflicted upon corporations, and the owners of LLCs and LPs can claim the losses on their tax returns. An advantage of LLCs, however, is that the owners may claim tax losses in excess of their investments, such as on certain leveraged real estate investments.
Advantages of the Limited Partnership
LPs can provide numerous tax deductions to employees. Even a one-person LP can take health insurance and entertainment deductions, and the general partner is allowed to deduct pension plan and 401(k) expenses. An LP also has a potentially limitless life. If a member of an LLC dies or files bankruptcy, the LLC is dissolved. In an LP, the death or resignation of a limited partner does not cause the dissolution of the LP. However, if a general partner dies or resigns, the LP will be dissolved unless certain conditions are met. For example, the LP may continue if all the remaining general partners and a specified percentage of the limited partners agree, in writing and within a certain time period, to continue the business.
Another disadvantage is that all 50 states are not uniform in their tax treatment of LLCs. Some states, such as California, limit the types of businesses that may operate as an LLC. Other states, such as Texas, tax LLCs like corporations, so there is no state tax advantage. Until a uniform set of rules is agreed upon on a national level, confusion may arise for LLCs engaged directly or indirectly in multi-state operations.
Deciding What's Best for Your Business
Virtually any business can benefit from the LLC or LP format, including limited liability, protection from creditors, pass-through taxation, and flexibility. Determining which entity is best for your business depends on specific considerations, including tax consequences, the nature of the business, management control, and other factors that apply to your particular business.
If you’re ready to start a limited partnership or an LLC, LegalZoom can help. LegalZoom can help you set up an LLC or partnership quickly and affordably. Start by answering a few questions about your business. LegalZoom will assemble your documents and file them directly with the Secretary of State, and you'll receive your completed package by mail.
This article was originally pusblished in July, 2005 and updated February, 2011.
This portion of the site is for informational purposes only. The content is not legal advice. The statements and opinions are the expression of author, not LegalZoom, and have not been evaluated by LegalZoom for accuracy, completeness, or changes in the law.