Setting up a business requires a lot of decision-making, including figuring out which type of business structure would be most beneficial. For example, one may weigh the benefits of a partnership vs LLC and mull over which option, amongst others, would best align with both short-term and long-term business goals. Knowing the difference between an LLC vs. partnership before starting a business is of the utmost importance. Below you will find the definitions of each business structure (including variations), as well as a discussion of the benefits, liability, and tax arrangements for each.
What Is An LLC?
LLC, short for Limited Liability Company, is a business entity that limits its members’ personal liability. For example, if the LLC is struck with a lawsuit or debt, its owners do not have to use out-of-pocket funds to pay any settlements. LLCs are also considered pass-through entities, meaning that members can claim profits or losses generated by the company on their personal tax returns. For these reasons, LLCs have become an increasingly popular option for entrepreneurs in the last decade, especially as just one person can form them.
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What Is A Partnership?
A partnership is an arrangement where parties, otherwise known as partners, agree to go into business together. While an LLC can be formed by just one entrepreneur, a partnership must be formed by more than one co-owner. The partnership agreement will define each partner’s share of the entity, which can vary but must equal one hundred percent total. For example, a partnership of three co-owners can divide up their shares as 30 – 30 – 40.
Similar to an LLC, a partnership is also considered a pass-through entity. However, the key difference to be aware of for LLC vs. partnership taxes is that a partnership is considered a taxing entity by the IRS, while an LLC is not. Each year, the partnership will file a tax return but will not owe any taxes. The return documents are then used so that each partnership member can report profits and losses individually.
It is worth noting, however, that partnerships entail more than legal entities; they require a level of synergy that’s missing from traditional LLCs. According to Deborah Sweeney, CEO of MyCorporation.com, “All partners in a partnership must share an interest in starting the same business and contributing to the greater good of the startup. Partners must be able to work as a team. They will split costs, share profits, make decisions, and provide support for one another equally.”
Different Partnership Variations
It is important to note that “partnership” is a broad term that encapsulates several different business types. Here is a brief overview of the different partnership variations:
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General Partnerships: A general partnership is when two or more people own and operate a business together. They are joint owners with equal rights to operate anything within the business. Personal liability and obligations that concern the business are shared between the two.
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Limited Partnerships: A limited partnership (LP) is when two or more people own the business but split into two branches of partners, general and limited. As a general partner, you own and operate the business with personal liability. As a limited partner, you invest your money, resources, or properties in the business. However, you do not have the right to make operational decisions. You also do not have personal liability for any business debts.
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Limited Liability Partnerships: A limited liability partnership (LLP) is the same as a general partnership, but they offer partners limited personal liability as the name suggests.
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Limited Liability Limited Partnerships: A limited liability limited partnership (LLLP) is generally the same as a limited partnership. Still, it also gives limited personal liability to both general partners and limited partners.
What Is A Sole Proprietorship?
When individuals run a completely unincorporated business by themselves, the business is a sole proprietorship. Some individuals may choose to run a sole proprietorship because it is the easiest option, as it requires no formal action to form.
To be considered a sole proprietorship, the owner must be the only individual selling goods or services, such as a freelancer. Through the lens of the IRS, there is no differentiation between the tax filings of a sole proprietor and any other type of individual.
LLC vs. Partnership Liability
Now that the difference between a partnership vs. LLC has been defined, it is also important to understand the liability protection for each type of entity. Many entrepreneurs will choose to form an LLC precisely because it will protect them from becoming personally liable in case of a debt or lawsuit. In a partnership, however, each member partner will be held personally liable. Furthermore, each member is held legally responsible for all other member’s actions. Because of this, individuals who wish to form a partnership should be extremely selective when choosing partners. However, this is not to say that those who form an LLC are completely absolved from liability.
In extreme cases, such as when a member commits mismanagement or fraud, an LLC member may be held personally liable. Some may argue that liability protection may be the key distinction and factor to consider when choosing between a general partnership vs. LLC.
Partnership vs. LLC: Similarities
Strictly in terms of liability, an LLC is the better choice as you and your partners can limit your personal liability. However, you should consider several similarities between partnerships and LLCs before deciding which is best for you.
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Both are initially started by registering with the state in which the company intends to operate.
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Neither is subject to paying taxes. Otherwise known as pass-through taxation, the responsibility for filing a tax return is the job of each member or partner.
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Both partnerships and LLCs distribute profits and losses directly to their owners and partners.
LLC vs. Partnership: Differences
Business partnerships and LLCs have a number of similar aspects to consider; but before choosing which type of business to form, it is important to note the key differences between an LLC vs. a partnership:
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In a partnership, the debts of the business are the responsibility of each partner.
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LLCs award liability protection, meaning members are only liable for the debts of the business entity to the extent of their personal contribution. Typically, members aren’t liable for the company’s debts.
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LLCs may choose to be taxed as a corporation or an S corporation
It is essential to become familiar with your state’s business entity laws before forming a partnership or LLC. Several fees, requirements, and regulations may differ for both. You can acquire this information from the state’s business regulation agency. Here are a few factors that may differ between an LLC and a partnership:
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Taxation: As stated above, both an LLC and a partnership have pass-through taxation. However, taxation may still differ depending on which type of entity you form. It is recommended to also consult a qualified tax advisor before making your decision.
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Registration Fees: With the exception of a sole proprietorship and a general partnership, businesses are required to register with the state. Costs may vary depending on the state and type of business.
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Paperwork: Paperwork required for taxes and registration will also vary depending on the type of business entity.
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Securities Regulations: Similar to shares of stock, limited partnership interests are considered securities and are subject to securities laws. Partnerships will not have to abide by securities laws if they have less than 10 limited partners known to them and live within the same state. In some states, the 10 limited partners are increased to 35.
Terminating A Partnership vs. LLC
There are some key differences when it comes to terminating a partnership or an LLC. A partnership will be forced to end if a partner dies, leaves the company, or can no longer do their duties and run the business. This is because a partnership requires its owners to be there, and there cannot be a partnership without the owners. Any partners who remain will need to create a new partnership, or let the partnership be terminated.
On the other hand, an LLC can exist without its partners. If a partner dies, leaves, or cannot perform their duties it doesn’t mean the LLC is terminated. The only way to terminate an LLC is to file official termination documents, mark an end date of the LLC, and give a reason for the LLC’s termination.
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Sole Proprietorship vs. LLC vs. Partnership: Pros And Cons
Now that we have discussed the differences between an LLC, a partnership, and a sole proprietorship (as well as the differences in liability protection), let us now explore the advantages and disadvantages generally associated with each type of business structure.
Benefits Of An LLC
The formation of LLCs has become increasingly popular in the last decade, most likely due to the numerous advantages this particular type of business entity offers to entrepreneurs. Below is a list of the benefits of an LLC:
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Personal Liability Protection: Without a doubt, the single most compelling reason to start an LLC is the business entity’s ability to protect the owner’s capital. Business owners that file as an LLC are not personally responsible for business debts. As a result, creditors can’t go after each owner’s personal bank account, house, etc. There are, of course, exceptions to the rule, but they are exactly that: exceptions. For the most part, owners are not usually held liable if the LLC runs out of funds.
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Pass-Through Taxation: LLCs do not actually pay taxes, but their members do. As the name suggests, pass-through taxation witnesses a company’s profits and losses transfer directly to subsequent members. Therefore, it is up to the individual members to claim the profits and losses on their personal tax returns.
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No Member Limit: Whereas partnerships limit the number of individuals under a particular business entity, LLCs do not. Likewise, most states don’t restrict ownership, which means individuals, corporations, other LLCs, and foreign entities are often permitted to join an LLC as a member. To that end, an LLC doesn’t have to consist of multiple members—a single member is entirely possible.
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Little Paperwork & Inexpensive Filing Costs: Compared to their corporate counterparts, LLCs typically coincide with less paperwork and lower filing costs. That said, LLCs still have more paperwork than partnerships.
Although forming an LLC includes many advantages, some downsides should be considered. For starters, as an LLC member, individuals cannot pay themselves wages. Although filing to form an LLC is relatively easy and inexpensive, some states may charge expensive renewal fees, as well as franchise or capital value taxes. Finally, a distinct benefit of LLC vs. partnership (although some may consider it a negative) is that ownership is spread evenly among members.
Benefits Of A Partnership & Limited Partnership
When two or more members would like to form a business agreement, they may opt to form a partnership. Unlike an LLC, partnerships are not required to complete a formal incorporation process through the government. The following are some advantages enjoyed by members in a partnership:
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Pass-Through Taxation For All Members: Partnerships do not actually pay taxes, which means their members do. Again, pass-through taxation will witness a company’s profits and losses transfer directly to its members. As a result, the individual partners will need to claim the profits and losses on their personal tax returns.
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No Rigid Corporate Structure Necessary: Partnerships don’t follow the same rules as corporations and LLCs, and are subject to much less paperwork and guidelines.
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Members Have the Option To Take On Limited Partnership: Limited partnerships, as their names suggest, subject partners to less liability. There are one or more general partners in a limited partnership and one or more limited partners, which spreads liability across everyone involved.
Arguably, the key difference between a partnership vs. LLC is that members are equally liable for debts and losses made through the business. In this case, creditors can go after each members’ personal assets unless the partnership has any limited partners. This also means that each member is liable for the debts and other actions executed by a partner.
Benefits Of A Sole Proprietorship
If you consider yourself a lone wolf and prefer having complete control over your business, then perhaps a sole proprietorship is a good match. Below are some benefits of a sole proprietorship to consider:
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Privacy: Sole proprietorships are not required to file any formation documents with the government, which means business operations are not subject to public disclosure.
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Complete Control & Flexibility: Sole proprietors are in complete control of their own business. While many investors like the idea of a sole proprietorship, some may not be ready for the responsibility.
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Minimal Reporting Requirements: Businesses represented as a sole proprietorship don’t need to file an annual report with the state or federal governments. In general, this entity is simplified to help new business owners.
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Easier To Organize: This particular business entity has developed a reputation for being some to operate and less costly to organize. In particular, there are no forms to complete and no government fees to pay, to form a business as a sole proprietorship.
Although some individuals may prefer to have complete control and flexibility over their business, acting as a sole proprietor also means being completely and wholly liable for all debts. Because of this, creditors can go after your personal property, in addition to your business assets. It should also be mentioned that creditors are more likely to extend credit for sole proprietors because of unlimited liability, but banks may be more reluctant to provide loans.
LLCs & Partnerships vs. Corporations
The difference between LLCs and partnerships vs. a corporation is the ownership structure. LLCs and partnerships typically have outright owners, while corporations are owned by shareholders. This changes the way the business owners earn income and the way they are taxed. LLC owners and business partners are considered self-employed for tax purposes. This means they do not receive regular paychecks with withheld taxes. These owners must pay quarterly estimated taxes, and report their official earnings when filing taxes.
Corporation owners, on the other hand, are treated more like shareholders. These business owners earn income through dividends based on the shares of the business. The corporation owners are then responsible for reporting these dividends along with their personal income when filing taxes.
A few other differences include the cost to establish LLCs and partnerships vs a corporation. Corporation fees tend to be larger depending on the complexity of the business. Corporations are also structured more formally than LLCs or partnerships, and are subject to stricter regulations in terms of business management.
Summary
Deciding between forming a partnership vs. LLC, or remaining as a sole proprietor, is a critical business decision that will indefinitely affect your organizational, taxation, and liability structures. There is no wrong or right answer; rather, the decision should be made based on which type of business structure provides the best set of advantages for your unique business circumstances and goals.
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