When starting a business, one of your first big decisions is which type of business entity to form. Two of your options are a limited liability company (LLC) and a partnership.
What are the differences between the two? For one thing, LLC formation is more of a process, but there’s much more to know. This guide lays out all you need to know about LLCs and partnerships to help you make an informed decision.
What Is an LLC?
An LLC is a popular business structure for startup companies due to its many benefits. An LLC provides personal liability protection, for example, so your assets are not at risk if your business is sued or cannot pay its debts.
Also, an LLC is a “pass-through entity” in taxes, meaning that the LLC itself is not taxed. Instead, income passes through the company to the LLC owners or members, who report it on their tax returns. The income, again, is also subject to self-employment taxes.
LLCs also offer flexibility in management, as there are few requirements regarding organizational structure.
What Is a Partnership?
A partnership is a more informal business structure with two or more owners. If you and at least one other person start a business that you haven’t officially filed with the state, it’s automatically considered a partnership by default.
Similar to an LLC operating agreement, a partnership agreement is not legally required, but it’s in your best interest to draw one up. Partnership agreements specify how ownership, profits, and losses will be divided.
The agreement also details the protocol to resolve disputes and the steps involved if a partner leaves the business or if a new partner is added. We highly recommend consulting with an attorney when creating a partnership agreement.
A partnership is not considered a legal entity separate from the owners and, thus, is not taxed. Instead, income passes through the company to the partnership owners, who report it on their tax returns.
Partners file their income taxes on a Schedule C form, and the IRS also requires partnerships to file form 1065, or the Return of Partnership Income. This form is only for reporting since partnerships aren’t taxed.
K-1 partnership forms will be attached to the form for each partner to complete, which detail their portion of the business’s income.
Additionally, the Tax Cuts and Jobs Act offers eligible partners a 20% pass-through tax deduction, which allows them to deduct up to 20% of their share of the business’s income.
How Does an LLC Compare with a Partnership?
There are a few key aspects to pay attention to when comparing an LLC with a partnership, including:
- The formality of the entity formation process
- The internal documents detailing business operations and practices
- If there are state statutes that regulate an entity’s operations and practices
- The entity’s taxation process
1. Entity Formation Process
If you decide to start a partnership, you and your partner (or partners) are not required to go through a regulated business formation process with the state. This means that there is no necessary paperwork to file!
Conversely, if you choose to form an LLC, the process is more formalized and requires you to file articles of organization to register your business with the state.
2. Internal Agreements
Generally, an operating agreement serves much the same purpose as a partnership agreement. Therefore, though it’s not legally required, LLCs should create an operating agreement. Similarly, partnership agreements aren’t needed, but it’s in every partnership’s best interest to have one.
Both an operating agreement and a partnership agreement should cover and specify at least the following information:
- The business entity’s ownership
- Profit allocation
- Management roles and responsibilities
- The process of adding or removing an owner
- The procedure to resolve disputes and disagreements among owners
3. By Default: State-Regulated Business Operations
Having an operating or partnership agreement in place can save businesses a lot of time and frustration should any issues arise. However, if a dispute does occur, LLCs proceed differently than partnerships.
For instance, if an LLC does not have an operating agreement, then the business must abide by its state’s default LLC regulations.
On the other hand, partnerships are an informal business structure without state-instituted default regulations. This means that if a partnership does not have a partnership agreement, any disputes between owners would need to be sorted out by the partners or in court.
4. Entity Taxation Process
An LLC and a partnership business entity are generally taxed similarly. Both qualify for pass-through taxation. This means that the business’s income is not taxed and is instead reported on the owners’ tax returns.
However, LLCs can choose to be taxed as a corporation instead by filing the appropriate form with the IRS. There are two different types of corporations that an LLC can elect to be taxed as, and the type you choose determines which filing you will need to complete.
An LLC taxed as a C-corporation or C-Corp will have its profits taxed at the current corporation tax rate. As of late 2022, this is 21%, substantially lower than the typical individual tax rate.
C-Corp shareholders don’t have to pay self-employment taxes. But they are required to pay taxes on their distributions, and for an LLC, this includes all members. Therefore, entities taxed as C-Corps are subject to double taxation.
To be taxed as a C-Corp, file Form 8832: Entity Classification Election with the IRS.
An S-corporation, or S-Corp, is also subject to pass-through taxation. This means that a company’s income is not taxed and instead gets handed off to the owners. In this situation, the tax rate is the same for individual taxpayers.
Entities classified as an S-Corp file taxes using the IRS’s Form 1120-S, which declares each shareholder’s income, losses, and dividends. Like a C-Corp, shareholders of an S-Corp aren’t required to file and pay self-employment taxes.
It’s vital to note that additional bookkeeping and payroll expenses are involved in running a business classified as an S-Corp. The main issue is that the tax benefits should outweigh the additional costs; otherwise, S-Corp status makes little financial sense.
For the most part, S-Corp status is only advantageous for businesses with at least $10,000 in annual member distributions and which pay members via a salary. This enables the business owners to be taxed as employees, meaning they can avoid self-employment taxes.
For your LLC to be taxed as an S-Corp, file Form 2553: Election by a Small Business Corporation with the IRS.
Do I Need to Fill Out Both Forms?
It’s important to note that you do not need to file the Entity Classification Election form to file Form 2553. Instead, you only need to fill out the form corresponding to how you want your LLC to be taxed.
The Main Difference Between LLCs and Partnerships
The most significant difference between a limited liability company and a partnership lies within an LLC’s name: liability.
Again, an LLC is legally distinct from its owners. Therefore, owners’ assets are safeguarded from potential business obligations and debt.
Conversely, partnerships are not considered separate legal entities and do not offer liability protection. Therefore, if a partnership goes into debt or gets sued, the owner’s assets, including their home, are at risk.
Liability protection is the primary reason many business owners opt to form an LLC instead of a partnership, even if there are only two owners.
To Sum it Up
As you can see, LLCs have a lot of similarities with partnerships. But the crucial distinction pertains to personal liability protection, which is provided under an LLC but not a partnership.
When choosing your business entity type, it’s wise to consult with an attorney or tax advisor to ensure you choose the entity that will give you and your business the best chance of success.