By: Raad Ahmed
It’s time for the third and final installment in our series on the best ownership structures for small businesses. First we looked at limited liability companies (LLCs) vs. sole proprietorships, then we compared corporations to LLCs. In today’s post, we’ll weigh the pros and cons of partnerships vs. LLCs. Since there’s more than one type of partnership, this topic can be broken down even further. Really, the topic of today’s post could be: “general partnerships vs. limited partnerships vs. limited liability partnerships vs. limited liability companies”… but that doesn’t have much of a ring to it.
If you’re in business with another person, you may already be in a general partnership without even knowing it. In a general partnership, each partner agrees to manage and run a company, sharing the day-to-day decisions as well as all profits and losses. It is (in theory, at least) an equitable way to distribute money, risk, and responsibility. Each partner gets one vote in matters affecting the business, regardless of each member’s capital contribution. Unless the partners agree otherwise, profits are divided equally among the members of a general partnership.
It’s simple to set up and maintain a general partnership. Some states require that you obtain a certificate of partnership, but many states do not. It may be advisable to draft a partnership agreement delineating each member’s rights and duties, but even this is not required. If you do write one, you won’t have to file it with the state; these partnership agreements mainly serve as a way of avoiding litigation down the line. Partnerships are not required to adhere to the strict internal formalities that can be imposed on corporations and other business structures. For example, there are no state-mandated meetings in a general partnership, and the record-keeping requirements are not as strict as the requirements for an LLC.
On to the limited partnership. Compared to a general partnership, a limited partnership is somewhat more complex to set up; yet neither one is as complex as an LLC. In most states, if you wish to form a limited partnership, you will be required to file a certificate of partnership with the appropriate state office.
In a limited partnership, the limited partners provide only capital; they do not, by law, manage the business. In addition to these limited partners, a limited partnership (somewhat confusingly) must have at least one general partner. The general partners are the ones who operate the business. Limited partners are expressly prohibited from participating in the management of the company, and they risk being held personally liable for business debts if they violate this rule.
This brings up the issue of liability, always a crucial factor in deciding the structure of your small business. One of the great benefits of a limited partnership is that limited partners risk only their capital contributions to the company; they are not held personally liable for company obligations. General partners, on the other hand, have unlimited personal liability. In fact, when conducting business related to the company, they may be personally liable for the acts of their fellow partners as well. Limited partners generally avoid this type of risk, but it bears emphasizing that a limited partner can become personally liable if he or she crosses over into managing the business, or personally guarantees a business debt.
Similarly, in LLCs (which have been explored extensively in earlier posts in this series), members are generally liable only for their contributions to the company, though it is possible for LLC members to become personally liable as well. In an LLC, any member who mingles personal funds with LLC funds, violates state law, lacks the proper insurance, or personally guarantees a debt can lose the protection of limited liability.
What if all of the investors want to have a hand in managing the company? In this case, the right structure is likely a limited liability partnership, or LLP. Unlike limited partnerships, LLPs have no general partners. Every member of an LLP has limited personal liability for debts incurred by the business. Management duties are not restricted to general partners (because there are no general partners). The fees and paperwork for setting up an LLP are similar to those required for a limited partnership.
Finally, you’ll need to consider the rules under which each type of company is taxed. Partnerships have the same pass-through tax structure as LLCs, meaning that both general and limited partners pay taxes on their portion of the company’s profits on their individual tax returns. Limited partners (in limited partnerships, not LLPs) do not pay self-employment tax, since, as a rule, their income is not earned income, because they do not manage the company. (For more on pass-through taxation and self-employment tax, please see the earlier posts in this series.)
As you can see, there’s no simple way to decide what form your company should take. There are many, many details to keep track of, and the rules often change from state to state. Especially if you’re going into business for the first time, it’s always a good idea to talk things through with a tax or small-business attorney to see what your best options are. Good luck… now go make some money! #partnership #LLC #limited liability companies #corporations