LLC or LP: What’s Best for Your Business?
Understanding the relative benefits and limitations of an LLC and an LP is important when determining which type of entity would be best suited for your company.
Limited liability companies (LLCs) and limited partnerships (LPs) are two of the most popular business entities. If there are two or more owners and the parties have decided they do not want to use a Corporation, then they can choose between these two business formation options.
Factors in making a choice
Following are some of the factors you need to evaluate when deciding whether an LLC or an LP would work best for your business.
When an LLC is the better choice
In general, an LLC might be better if one or more of the following apply:
- You want all owners to have limitation of liability for company debts
- All owners will participate in managing the company
- You want the option of electing to be taxed as a corporation such as a S Corporation
When an LP is the better choice
An LP might be better if any of the following apply:
- You want passive investors who you do not want to participate in management decisions
- You already have an LLC that will serve as the general partner
- You are not particularly concerned about the personal liability of the general partner
- You want to avoid the California LLC gross receipts tax
The Internal Revenue Service (IRS) treats both LLCs and LPs the same for tax purposes upon formation. that is, formation is generally tax free, with some exceptions.
However, operationally, an LLC has the option of electing to be taxed as if it were a corporation. Limited partnership tax treatment doesn’t allow for such an election.
If partnership taxation is desired, there is no tax advantage to either type of entity. But if you want your company taxed as a corporation, you will need to organize the company as an LLC and then file the necessary IRS forms to elect corporate taxation treatment.
Dont’ forget state taxes. California imposes a LLC gross receipts tax unless the LLC elects to be taxed as an Corporation. California also imposes a state 1.5% income tax on S Corporation net income.
There are differences in how LLCs and LPs are structured and created.
Note: a member of an LLC, as well as a partner in an LP, may be an individual person, a corporation, another LLC, or another partnership.
A person who has an ownership interest in an LLC is called a member. An LLC with two or more members is called a multiple-member LLC. Forming an LLC requires filing Articles of Organization, with the California secretary of state.
Many LLCs also have an Operating Agreement, which set forth the members’ ownership interests, rights, and responsibilities.
A person with an ownership interest in an LP is called a partner. In an LP, there are two types of partners: general partners and limited partners. There can be one or more general partners and one or more limited partners. Both own a certain percentage of the company, but only general partners can engage in operating the business. Limited partners are passive investors who share in profits and losses but have no say in how the business is run. Having passive investors is the main advantage of a limited partnership. Forming an LP is typically done by creating a Partnership Agreement, which spells out the ownership interests, rights, and responsibilities of the general and limited partners. As with an LLC, the LP must file a form with the California Secretary of State. That form is called a LP-1.
California prohibits certain types of businesses from organizing as an LLC. This commonly relates to certain professionals, such as accountants, architects, physicians, attorneys, dentists and certain types of businesses, such as banks and insurance companies.
Limitation of Liability
If a business is organized as a general partnership, all of the partners can be held personally liable for the business’s debts. This means that a partner is risking more than what they contribute to the business.
If the company’s debts are greater than the value of the company’s assets, a creditor can go after the partner’s personal property, such as their personal bank accounts, other investments, cars, and real estate. In fact, a creditor does not have to go after the Partnership’s assets first but can go after the general partners first or at the same time.
A central purpose of both an LLC and an LP is to limit the owners’ personal liability, but they do not provide the same degree of protection.
With an LLC, all of the members obtain limited personal liability. The members may also participate in the management of the business and keep their limitation of liability.
In an LP, only limited partners enjoy limited personal liability. However, this only applies if the limited partner takes no active role in managing the company. A general partner remains personally liable for partnership debts.
Some LPs resolve this problem by forming a separate LLC or a Corporation to be the general partner. But this requires setting up two entities, the LLC and the LP (or Corporation), and incurring the expense of forming and operating each.