The limited liability company (LLC) and limited liability partnership (LLP) business structures have some characteristics in common, but they differ in several ways. This article will share how these structures might impact business owners from legal, tax, and administrative perspectives.
Let’s begin with some basic information about the two business entity types.
A limited liability company is a legal business entity that protects owners (“members”) and their personal assets from the company's liabilities. In that respect, it’s similar to a corporation. However, unlike a C Corporation, an LLC is not treated as a separate tax-paying entity. The government taxes an LLC on a pass-through basis, like a sole proprietorship or partnership. An LLC’s business compliance requirements are far less extensive than those of a C Corporation. For example, they do not have to have a Board of Directors, bylaws, and shareholder or director meetings.
A limited liability partnership (LLP) is a general partnership whose owners (“partners”) enjoy a level of protection from personal liability. The LLP is a blend of the corporation and partnership structures, giving it some potential taxation and liability protection advantages. An LLP is not a separate entity for income tax purposes, so its profits and losses pass through to the partners. Business compliance requirements for LLPs are minimal.
State Laws Governing LLCs and LLPs
While states, for the most part, have similar laws for limited liability companies in their jurisdictions, their stance on LLPs can vary widely. Very few restrictions exist for who can form an LLC. But LLPs typically come with some rules about who may own them. Usually, only licensed professionals in specific industries — such as attorneys, engineers, physicians, accountants, and architects — may form an LLP. And in some states (like California), licensed professionals can create an LLP but not an LLC. Because the rules vary, business owners should check with their state’s secretary of state office to determine their eligibility.
Legal Protection for Business Owners
Both the LLC and LLP offer personal asset protection for entrepreneurs. However, the way — and extent to which — that protection applies differs.
LLC Member Liability
An LLC protects members from the debts and liabilities of the business. However, if any member of the LLC makes an error or causes legally actionable harm, then all company members can be held liable.
LLP Partner Liability
An LLP can protect individual partners from the liabilities of other partners. Each partner is liable only for their personal negligence or wrongdoing (or of someone working under their direct supervision). This can give peace of mind not available in a general partnership in which each partner is liable for the debts and obligations of the business — including the malpractice of other partners.
Note that some states’ laws will hold a partner in an LLP personally liable for various partnership debts, such as money owed to creditors and lenders.
Pass-Through Income Tax Treatment
Generally, in an LLC or LLP, the business entity does not pay federal income taxes on its profits. Instead, the company’s profit or loss passes through to the owners’ tax returns and is subject to tax at the applicable individual income tax rate. In comparison, a C Corporation pays income taxes at the corporate tax rate on its earnings. And any profits the business owners receive must be reported as earnings. Business owners pay personal income tax on them. This is known as “double taxation” because the income paid as distributions is taxed at the corporate and individual levels.
It’s essential for business owners to check with their state or talk with a tax advisor to determine their exact tax obligations. While many states use the same tax approach that the federal government does for LLPs and LLCs, some handle things differently. Also, some states impose a “franchise tax” or “annual tax” on LLCs and LLPs.
Because LLCs and LLPs are pass-through tax entities, LLC members and LLP partners must pay self-employment tax (2.9 percent Medicare tax and 12.4 percent Social Security tax) on their share of business profits.
If an LLC meets the IRS eligibility requirements, its members may decide to elect S Corporation tax treatment so that owners working in the business go on the company payroll. Then, only the wages and salaries earned by the LLC members are subject to Medicare and Social Security taxes (known as FICA on paychecks). With S Corp tax treatment, income that owners take as profit distributions are subject to income tax but not FICA.
LLPs are always taxed as a pass-through entity and do not have the option of electing S Corporation taxation.
An LLC has two options for how its managed:
- Member-managed LLC – Managed by its owners.
- Manager-managed LLC – Managed by one or more managers, which maybe people the company has hired or LLC members.
An LLC operating agreement is critical for documenting LLC members’ and managers’ roles, decision-making authority, and responsibilities.
The LLP structure gives partners flexibility in their management roles. Partners can receive authority and responsibilities based on their financial investment in the business or according to their professional strengths and expertise. To make sure all partners agree to and understand how to manage the company and the roles and responsibilities of each partner, the LLP should have a written LLP partnership agreement in place.
Requirements to Form and Maintain the Entity
Starting an LLC or LLP
To form an LLC or LLP, the business owners must file any registration paperwork (e.g., Articles of Organization, Certificate of Limited Liability Partnership) the state requires and pay the associated filing fees.
Other startup tasks to ensure the company may legally operate include:
- Designate a registered agent to accept legal notifications (e.g., subpoenas, lawsuit notices, court summonses) and certain government correspondence (e.g., notifications of upcoming filing deadlines) on behalf of the business.
- Obtain an EIN (employer identification number).
- Open a business bank account.
- Obtain any required business and professional licenses and permits.
Compared to corporations, LLCs and LLPs have relatively minimal ongoing business compliance requirements to fulfill. These may vary by state and according to the company’s LLC operating agreement or LLP partnership agreement.
Possible ongoing compliance tasks:
- File an annual report with the state.
- Hold an annual member or partner meeting and record minutes.
- Maintain an operating agreement or partnership agreement at the company’s principal office.
- Report and pay estimated income taxes every quarter.
- Always maintain a registered agent.
- Renew licenses and permit.
- Notify the state of any significant changes to the business entity (such as changing the business name, adding new members or partners, moving to a new location, etc..)
Resources for Deciding Which Business Structure is Right for You
Whether you’re considering the LLC, LLP, or some other entity type for your business, you have a lot to think about! The one you choose will have legal, financial, and administrative impacts on your company and you as a business owner.
It’s helpful to reach out to reputable licensed professionals (such as an attorney, tax advisor, and accountant) to help you understand the potential risks and rewards of the different business structures. Also, remember that SCORE’s cadre of volunteer mentors has knowledge and insight about virtually every industry and all aspects of starting and growing a business.