LLC or LP: What's best for your business?

If you and at least one other person have decided to start a business, two of the most popular options are to form either a limited liability company (LLC) or a limited partnership (LP). 

Here are some factors you should evaluate when deciding whether an LLC or an LP would work best for your business.

LLC vs. LP

In general, an LLC might be better if one or more of the following apply:

• You want all owners to enjoy limitation of liability
• All owners will participate in managing the company
• You want the option to be taxed as a corporation

An LP might be better if any of the following apply:

• You want passive investors who cannot 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

Taxation differences

The Internal Revenue Service (IRS) treats both LLCs and LPs the same for tax purposes upon formation. However, 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.

You may also need to consider state taxes. Some states tax LLCs as corporations and do not allow them to be taxed as partnerships. This can result in double taxation, where the corporation is taxed on its profits, and the members are also taxed on their share of the profits.

Organizational differences

There are differences in how LLCs and LPs are structured and created. It should be noted that 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.

• LLC structure. 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 a document, most often called Articles of Organization, with the state agency that regulates business entities. Many LLCs also have an Operating Agreement, which spells out the members' ownership interests, rights, and responsibilities.
• LP structure. 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, some type of state registration is also necessary.

Business entities are created under state law, and states may vary in their filing requirements and registration fees. For this reason, you will want to see if there are any significant differences between registering an LLC and an LP in your state.

Some states prohibit certain types of businesses from organizing as an LLC. This commonly relates to certain professionals, such as accountants, architects, physicians, 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.

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 generally 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 to be the general partner. But this requires setting up two entities, the LLC and the LP, and incurring the expense of forming and operating each.