In recent years, various new legal structures have emerged, including the LLC (Limited Liability Company). That’s good news for small businesses—because let’s face it, not all businesses are the same, and the same corporation structure isn’t right for everyone.
Yet more options bring new questions about which business structure to use. For many entrepreneurs, the process of picking a business structure is uncharted territory.
If you’re a small business owner or service professional, here’s a quick primer on two important legal structures: the LLC and the LLP (Limited Liability Partnership). We’ll explore the key differences and details to help you determine which is better for your business.
Defining the LLC and LLP
Let’s start with some basic definitions:
An LLC is a legal entity that limits the liability of owners from liability found with the company. With the LLC, there are no shares. An LLC does not file separate taxes, either; all company profits flow through to the owners and are taxed at the personal income rate. It’s great for businesses that want liability protection but minimal formality—the LLC is free of much of the legal requirements and red tape that govern corporations, such as director meetings, shareholder requirements, etc.
The LLP is a general partnership where partners enjoy some level of protection from personal liability. Similar to the LLC, the LLP is a hybrid of both the corporation and partnership, to give the greatest advantages of taxation and liability protection. The LLP is not a separate entity for income tax purposes—profits and losses are passed through to the partners.
Differences Across States
It’s important to understand that laws concerning LLPs vary widely state by state. Generally speaking, LLCs can be formed by any business, persons or person, while LLPs may be restricted to licensed professionals such as attorneys, doctors, engineers, architects and accountants.
In California and Nevada, for example, licensed professionals can form an LLP, but cannot form an LLC. For this reason, a large law firm will opt to form an LLP; they are able to operate as an LLP in every state, but wouldn’t be able to operate as an LLC in every state.
You’ll need to check with your state’s Secretary of State office to determine the specific rules for your state. And if you’re anticipating operating in other states down the road, you should look into their rules as well.
Differences in Personal Asset Protection
While both LLCs and LLPs help shield the personal assets of the owners, there are some critical differences. For example:
In the LLC, members are protected from any debt or liabilities of the business. However, members of an LLC are not protected from the liability of another member. If a member in an LLC makes a client error that is legally actionable, then the LLC and all of its members can be held liable.
In the LLP, partners can be protected from the liability of another member. A partner in an LLP is personally liable only for his own negligence (or of someone working under his direct supervision). Note that this is different from a general partnership, in which each partner is liable for the debts and obligations of the business, as well as the malpractice of other partners.
In some states, a partner in an LLP can still be personally liable for a variety of partnership debts, such as obligations owed to lenders and creditors. However, some states regulate that partners are not personally liable for such debts and obligations. As mentioned above, it’s important to understand the laws of your state.
What About Taxes?
Both the LLC and LLP typically do not require the business to pay income taxes on its profits; rather any profit or loss of the business is passed through to the members (LLC) or partners (LLP). By comparison, a corporation pays income taxes on its business earnings, and then if those earnings are distributed to owners, the owners must pay taxes on them again in their personal tax returns.
A single-member LLC is considered a sole proprietorship, and the member must pay self-employment taxes. It’s important to note that while most LLCs opt for pass-through tax treatment, some may choose to be taxed as a corporation. LLPs are treated strictly as partnerships, and profits are passed through to the partners.
The Bottom Line for Your Business
By mixing some of the properties of corporations, partnerships and sole proprietorships, the LLC and LLP can be very advantageous for new companies. Only LLPs give partners legal protection from the actions of another partner. For this reason, the LLP can be better for a group of professionals who plan to actively participate in the company. If you’re forming a business, take a look at your state law to first determine which entity is allowable in your state, as well as the state laws regarding personal liability for each entity.
How does operating as an LLP or an LLC help your business?
Original content written by Nellie Akalp for AMEX Open Forum.