LLC or Partnership? Which Is Right For You?

September 25, 2021by Brian Walsh

Whenever there is more than one stakeholder in a business there has to be a way to govern the relationship between the various participants. There has to be a structure outlining the roles and responsibilities of the participants or the business will eventually fall apart.

The larger the number of stakeholders there are the more imperative it is for there to be a structure that everyone understands and agrees with.

This is true whether you are starting a new business with a few friends or are entering into a broader joint venture that includes many different types of stakeholders.

How you decide to structure the business will have a significant impact on its operations as well. One decision you need to make up front, and early on, is whether you will be operating a casual business or something more formal.

Many businesses, although they are serious in nature, are often more casual affairs and don’t require the formal structure of a corporation. In these cases, a partnership or a limited liability company (LLC) is often more appropriate legal structures.

What is a Partnership?

A partnership is like a sole proprietorship, except there are two or more owners rather than one. Partners can be individuals, corporations, or trusts, with ownership shared among the partners on an agreed ratio, including income, debts, and other liabilities.

The partners’ personal assets are at risk since each partner is directly liable for any debts, losses, taxes or financial liabilities that arise from the operation of the partnership.

In addition, each partner is exposed to the activities of other partners that affects the partnership. Income and losses of the partnership are payable at the partners’ level, either pro-rata or by an agreed-upon percentage specified in the partnership agreement.

What is an LLC?

The LLC is a hybrid of formal and informal business structures.  Depending on your choices when you set it up an LLC can have characteristics of a sole proprietorship, or partnership structures and a corporation.

The big draw to an LLC is the liability protection it provides without the complicated overhead associated with corporations. Unlike a Partnership where the partners have unlimited exposure to business liabilities, members of an LLC have no exposure outside of their investment in the business.

Partnership Or LLC

Which Is Right
For Your Circumstance

Due to their ease of setup and maintenance founders often setup new enterprises as a Partnership or a Limited Liability Company (LLC).

However, ease of setup and maintenance is not necessarily the best characteristic to base such an important decision on. There are other issues that should be taken into consideration as well.

Once those issues are taken into consideration the decision becomes a good bit more nuanced.

Each form has advantages for some scenarios and disadvantages for others, forcing a prospective business owner to trade the advantages associated with one structure for those of the other, depending on the specific circumstances.

Exposure to Personal Liability

Discovering that your family assets are vulnerable to being confiscated by a creditor of a business is every owner’s nightmare. Many founders believe they are immune to such attempts, only to find themselves liable for actions taken or not taken by the business.

In a partnership, all partners are personally liable for the partnership’s actions, including repayment of any debts. In other words, lenders, vendors, customers, or employees can sue individual partners for damages and compensation. Failure to repay a bank loan can result in a lien against a partner’s home or bank account.

A customer who slips and falls on company property can sue the business and the individual partners. The Federal Government might pursue each partner for failure to collect and pay FICA taxes. While insurance can mitigate the costs of some perils, individual partners bear other risks.

Shareholders in an LLC do not have personal liability for the acts or omissions of the business unless agreed explicitly in a separate transaction. For example, suppose a shareholder guarantees an LLC’s bank debt repayment. In that case, only the shareholder who agreed to the guarantee is liable.

Shareholders, excluding illegal or blatant disregard of unlawful activities, are not exposed to creditors, customers, employees, or the public authorities. Founders should consider the impact of personal liability on their families and estates. If avoidance of personal liability is a founder(s) primary concern, the LLC would be the better legal structure.

Income Tax Liability

Most legal entities are required to pay federal income taxes on earnings but at different rates. The decision about legal structure can affect thousands, even hundreds of thousands, of dollars over time, complicating an individual’s retirement, gift, and estate planning.

Both forms have the flexibility to assign and distribute profits and losses by any method acceptable to the partners or shareholders.

Partnerships and LLCs taxed as partnerships are “pass-through” entities, meaning that profits and losses are distributed to individual partners in a Partnership or individual shareholders in the LLC. This feature avoids the double taxation that occurs in traditional corporations.

There may be circumstances where paying taxes advantageous such as a desire to retain earnings in the business or implement an IPO. The LLC gives founders greater flexibility to choose or change filing status not possible in a partnership.

An LLC’s ability to change tax treatment is a significant advantage for startup companies, especially those focusing on growing revenues in the early years. For example, ABC LLC elects to be taxed as a partnership until it produces a profit.

Many startups incur losses in their early years due to the heavy expense of “scaling” – growing revenues as quickly as possible. Being taxed as a partnership enables the business to distribute losses pro-rata to shareholders, potentially offsetting other personal revenue. When the business begins to make profits, the company elects a corporation tax treatment.

A drawback of LLC structures is the IRS prohibition of paying a salary or wage to a member if the LLC is treated as a partnership. However, a member may receive a “guaranteed payment” to replace the lost salary:

“Guaranteed payments are those made by a partnership to a partner that are determined without regard to the partnership’s income. A partnership treats guaranteed payments for services, or for the use of capital, as if they were made to a person who is not a partner.

This treatment is for purposes of determining gross income and deductible business expenses only. For other tax purposes, guaranteed payments are treated as a partner’s distributive share of ordinary income. Guaranteed payments are not subject to income tax withholding.”

Possible Future Funding Needs

Companies grow through retaining and reinvesting profits or securing new investments from existing owners. The requirement of personal liability in a partnership is a significant investment obstacle for fundraising. Many partnership agreements restrict the partnership from borrowing money without partner approval; some may limit the entry of new partners.

Where both prohibitions exist, additional fundraising may be impossible. Also, the partnership agreement can limit the continuity of a partnership to a specific date or the occurrence of certain events (the death or bankruptcy of a partner). Even the transfer of partnership interests between partners or partners and their family members may be restricted.

In cases where the sale of additional partnership interests is possible, the partnership is likely to find few investors willing to accept liability for partners or the partnership. Another disadvantage of raising funds through the sale of additional partnership interests is the increased complexity of administration. Each existing partner’s interest is affected, requiring a new calculation each time a partner is added.

LLC investors do not purchase shares but membership units. Membership units represent a percentage of ownership. However, membership units are often referred to as shares because most potential investors are more familiar with stock transactions. LLCs have far fewer restrictions on how they can assign membership units, including different classes of membership units. This makes an LLC a far more flexible structure for investment.

Also, Federal and State securities laws do not have burdensome requirements for sales. Finally, limited liability companies can continue indefinitely in most states, changing, adding, and losing members without affecting the operation of the LLC. These features make the LLC form preferable to a partnership if future funding is likely.

Final Thoughts

While partnerships have centuries of use and benefit from hundreds of legal precedents, LLCs are relatively new business structures. Since individual states regulate them, differences in their features may exist from one locale to another.

One of the more subtle differences between LLCs and Partnerships is that an LLC emphasizes the company in its entirety whereas a partnership places more emphasis on the individual partners. The involvement of a partner in the business can have a substantially greater impact than a member of an LLC. So, knowing your partners, their reliability and trustworthiness is very important.

For founders worrying about losing control of their companies, neither a partnership nor an LLC guarantees that founders will always maintain control. However, there are provisions available to each structure that might protect a founder’s interest.

Before selecting the legal structure for their new business, founders should seek competent legal advice from attorneys experienced with the intricacies of all business structures. The wrong choice can cause significant issues down the road.

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