If you do not know what a limited partnership is, you are not alone.
Many people never even hear the term, much less know when it is applicable.
It comes up once in a while, and there may be times where you need to have your lawyer explain it to your business partner or someone else to make an essential step of sealing your partnership agreement together as partners.
Partnership vs. LLC: What are the Differences?
The main difference between a limited partnership and an LLC is in the tax treatment.
The partners in a Limited Partnership always report their share of income on their personal tax returns, just like any other business owner would.
However, the members of an LLC only report their share of the profits or losses on a separate K-1 for that LLC.
What Is an LLC?
LLC is short for Limited Liability Company. It is a fairly new business vehicle and is structured in some ways like a corporation.
However, you cannot make an LLC into a corporation by simply filing articles of incorporation with your state, as you can do with a C-Corp or S-Corp.
The advantage to an LLC over other types of businesses is in the personal liability protection of business owners.
That means if the company gets sued, the individual members of an LLC are not personally on the line for any debts or lawsuits.
They can lose all their personal assets without affecting the business itself.
What Is a Limited Partnership?
A limited liability partnership (LP) is a partnership in which one or more partners are not involved in the day-to-day operations.
In other words, it’s not a general partnership where all of the partners are equally responsible for everything that happens within their business.
It requires at least two people: limited partners and general partners.
Partnership and LLC Formation
For both an LLC and an LP, you must establish the business by filing articles of organization with your state where the business will be based.
You then have to post a listing in a local newspaper announcing that you are now doing business within their limits.
This is called publication for public notice, and it’s quite important because most states require that anyone who did not see this notice in the newspaper for three consecutive weeks has the right to file a claim against your business.
The time period can vary from state to state, with most states requiring publication within 45 days of filing organization or LLC formation articles.
In fact, even if you live in a state that does not require public notice by publishing in a newspaper, it is still a good idea to do this anyway.
This proves up once and for all that you are doing business in this state.
Forming a Partnership
A limited partnership is formed by filing a Certificate of Limited Partnership (LP) with your Secretary of State.
- A general partner must file the certificate. All documents about the partnership, such as an operating agreement or any other contracts between partners, should be filed.
- The main point is this: you have to be very careful in forming a partnership because it is much more complex than setting up an LLC. For example, take the issue of ownership in the business.
- Ownership for an LLC can be quite simple.
You use a membership interest to indicate that one member has ownership over another member within your company. But with partnerships, you may have to follow a more complex structure.
The main thing they have to determine is how the profits and losses will be divided up between the partners, with one partner perhaps having more risk than another.
Forming a limited liability company (LLC)
On the other hand, you don’t have to worry about any of that with an LLC.
- You basically file your articles of organization and then create your operating agreement. This is a contract between all company members that clearly states how profits and losses will be divided for tax purposes.
- If there aren’t any profits within one year, most states do not require that you pay taxes on your losses.
- The LLC itself is considered a separate entity from its business owners, and as such, it cannot be held liable for debts or lawsuits incurred by the partners in the business.
This is what makes an LLC different than a partnership; with an S-Corp or C-Corp, all members of these business entities are liable for all debts, taxes, and lawsuits.
Pros and Cons of an LLC vs. LP
As always, there are pros and cons to each type of entity.
Pros of LLC
- Pass-through taxation
- Limited liability protection
- Flexible management business structures (for S-Corp and C-Corp)
- Lower state filing fees
- No mandatory meetings
Cons of an LLC:
- Income taxes are still due when there is no income (can be remedied in most cases by having members pay themselves a salary or receiving income from other sources such as real estate investments)
- LLC fees are higher than with other entities
- Many states require that you publish a public notice in the newspaper for these businesses, which can be more expensive than forming an LP or corporation.
- A completely separate entity from owners: owners cannot use their personal assets to reduce business liabilities; losses cannot be used to offset personal income.
Pros of an LP
- Partnership type entity, i.e., no formal LLC filings required (only filing your articles of organization with the state)
- No mandatory meetings
- Simple paperwork structure
- Can elect to be taxed as a corporation instead of an S or C Corp (S and C Corps are more complex while LPs are considered a “flow-through entity” where income is passed directly to the partners.)
Cons of an LP:
- Limited liability protection is not as strong as with an LLC
- Not every state allows limited partnerships (these states are typically the same ones that do not require public notice by newspaper publication). For instance, my home state of California does not allow for a limited partnership to be filed, thus limiting me from using that entity type as an angel investor or for any other business I may start in the future.
- LP fees are higher than with C-Corp, S-Corp, and LLCs
Which is cheaper to form?
Another thing to consider when choosing between an LLC or LP is the filing fees required by your state and any other entities you are considering for your business.
For instance, if you are going to be operating in California, you will have to pay around $800-1000 just to get started.
- The fees for forming an LLC aren’t that much more than LP fees, about $300-$400 for filing your articles of organization (plus you only have to do this one time).
- You will also pay a little bit more in terms of setup costs with an S or C-Corp. But remember that an LLC is considered a flow-through entity rather than a separate entity from its owners, so any losses or income gets passed directly to you.
- Thus, it’s the owners who pay taxes rather than the company itself, which is a lot less paperwork for you.
- This can be an important factor if your business becomes wildly successful (think Facebook) because then there will most likely be more legal issues and tax implications. The more legal issues you find yourself facing, the more expensive it will be to deal with them.
The main thing to keep in mind is that there are a lot of factors that play into choosing between an LLC and an LP.
It’s definitely not as cut and dry as saying one is better than the other.
You really have to consider what’s most important to you as the owner of your business and which type will be able to accommodate those needs while balancing costs with any other selected entity types.
Debt and Legal Liability
In your business, you should also consider the types of debt and legal liability associated with these two entities.
For instance, in California as an LLC or LP, you may be liable for any debts incurred by the company, meaning that if a creditor is winning a judgment against your company, they could come after both you and your personal assets to pay off that debt.
- If you form an S or C-Corp, on the other hand, any debts your business incurs will not directly affect you or your personal assets.
- As a general rule of thumb, if you have a lot of personal assets (e.g., house, cars, etc.), then you may want to consider putting your business in an LLC or LP so that if any partnership debts come up, you won’t be personally responsible for paying them.
If, on the other hand, you don’t have much personal property, then it might not be worth worrying about and could actually end up costing you more (in terms of fees) to form an entity that offers limited liability protection.
As an owner of a C-Corp, you have to file your personal income taxes separately from your business.
As an owner of either an S or LP, however, since you are considered a “partner” in the company rather than the actual owner, any profits and losses will be passed directly on to you in terms of tax liability.
This is good if your business sees high profits but could also be detrimental if they experience large losses.
Rules of Paying Taxes:
I. Not having to deal with filing your personal income taxes separately can save you some time and headaches in the long run, which might make it worth paying the extra fees to form an S or C-Corp.
II. As I mentioned earlier, LLC is considered a flow-through entity, meaning that the profits pass through to you, and the losses are passed on to your personal tax liability.
To compare this, if there were an LLC or LP with large income tax burdens associated with it, then in principle, the owner would have to pay taxes again when those profits are passed back to him in his personal tax return.
III. If you need to be able to pay yourself a large amount of money in the future, whether it’s from business profits or otherwise, then having the funds pass through directly to your personal income could help you avoid costly taxes.
IV. If you don’t foresee yourself making any significant deposits into future retirement accounts (e.g., putting your money into IRAs or 401k), then it may be better to form an LLC or LP and have those funds pass through directly to you.
Records for LLCs and Partnerships
When forming a partnership or limited liability company, the state government typically requires you to submit certain documents showing how your business is structured.
These records include:
- Articles of organization (LLCs) or Certificate of formation and Operating agreement, which define the rights and responsibilities for each member/manager of the company
- Bylaws (LLCs) or operating agreements, which outline rules and regulations for how the partnership will be managed
- Membership certificate that lists all partners, their percentage of interest in the company, and any events or circumstances that would pass ownership to another party.
There may also be additional documents required depending on your specific state requirements.
As an S or C-Corp, you will only have to submit a Certificate of formation detailing the company’s name and registered agent information.
Other than that, there won’t be any need for any other documentation showing how your business is structured.
Why would someone want a partnership instead of an LLC?
Some people prefer partnerships because they feel a sense of getting to know each other before making a commitment.
If you decide that it’s not working out, then at least there isn’t any negative impact on your business reputation (i.e., an LLC).
Regardless of what type of entity you choose for your business, make sure the state in which you are registering it can recognize the type of entity you want.
Know in advance how to change your business structure and whether or not it will be easy to revoke that liability status.
Is an LLC the same as a corporation?
No. If you form an entity to protect personal assets from lawsuits and creditors, then it is considered a limited liability company or “LLC.”
Otherwise, if your business has stockholders with voting rights on future investments and management decisions for the company, then it is usually considered a C-Corp.
Can an S-Corp also be a C-Corp?
Yes, it’s relatively easy to convert from S to C status; however, this is not recommended.
It can take up to 5 years for the conversion process, and you will have to pay fines when you change back or forth in the future.
If you want your business entity to be a C-Corp, then start out with the C status.
What happens if my business fails?
With an LLC or LP, the loss is passed on to your personal income and assets.
This can cause potentially devastating tax consequences for you in the future; however, it also allows you to continue to live off of your existing savings account without having to liquidate all of your other assets first.
Can I change my Limited Liability Company into a Partnership?
Yes, depending on the specific state in which you are incorporating.
It requires that you dissolve your existing LLC, file new articles of organization with the state government, and assign all ownership to other people in the partnership through a “certificate” signed by all parties.
A Certificate of Formation is required for any new LLC.
Partnerships and limited liability companies, in general, are less complicated to form (instantaneous) as opposed to a corporation but often need more maintenance (annual reports are required).
In addition, partnerships and LLCs may be subject to additional taxes depending on the type of entity.
Be advised that each state has different laws regarding the formation and maintenance of these entities, so make sure you are well informed before making a decision.