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 partnership (LLP) and a limited liability company (LLC).
What differences between the two? For one thing, only certain types of businesses can be LLPs. This guide lays out all you need to know about LLPs and LLCs to help you make an informed decision.
What Is an LLP?
An LLP is a partnership between two or more partners in which all partners have limited liability protection. LLPs are for businesses owned by professionals who require states licensing, such as attorneys and physicians.
Also, LLPs are only available in some states, which could pose a problem for LLPs looking to expand into those states. Also, all states have different definitions of who is a licensed professional.
LLPs are similar to professional limited liability companies (PLLCs); LLCs are also intended for licensed professionals. The difference is that PLLCs have all the benefits of an LLC, while LLPs are a type of partnership.
LLPs are “pass-through entities,” meaning the income from the business passes through to the partners to be reported on their tax returns on Schedule C. Income is also subject to self-employment taxes. However, the LLP is not taxed.
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.
Differences Between an LLP and an LLC
There are several key differences between an LLP and an LLC.
1. Personal Liability Protection
In an LLC, all members have personal liability protection from the company’s financial obligations. In an LLP, however, partners are personally liable for their actions, such as malpractice cases. Therefore, they are not personally responsible for the actions of their partners.
States have different rules about personal liability protection for LLP partners. For example, in some states, all partners are personally liable for the company’s debts. Other states require that partners have liability insurance.
Liability insurance for LLPs is a good idea whether or not it’s required.
Members or managers can manage LLCs. In a member-managed LLC, members handle all management duties. In a manager-managed LLC, non-member employees oversee operations and management duties.
Note that with a manager-managed LLC, a member can be a manager, but only in cooperation with another manager who is not a member.
Member-managed LLCs generally work best for LLCs with few members, all of whom can take an active role in day-to-day operations. Conversely, manager-managed LLCs are best for LLCs with multiple members, some of whom want to be “silent” or passive members and not involved in day-to-day operations.
Most LLCs are member-managed, as they are small businesses that cannot afford a management team.
Some states require that when you register your LLC with the state, you declare whether your LLC will be member- or manager-managed, so be aware that you may need to make this decision before you file.
LLC management is more clearly defined in the operating agreement.
Most states do not require an operating agreement, but it’s a very important document. It defines the members’ ownership percentages and profit allocations and should also include the following:
- Each member’s rights and responsibilities
- Management structure and roles
- Voting rights of each member
- Rules for meetings and voting
- What happens when a member sells their interest, becomes disabled, or dies
You can find operating agreement templates online, but it’s best to have them drawn up or reviewed by an attorney. The language of an operating agreement is crucial and can often help determine how member disputes will be resolved.
In an LLP, management duties are equally divided between partners. Management roles and the ownership structure are detailed in a partnership agreement, which is very similar to an operating agreement.
As stated above, LLCs and LLPs are both pass-through entities, and income passes through to the members and partners to be reported on their tax returns.
However, LLCs are unique because they can elect to be taxed as a corporation if the members decide it makes financial sense. This is done by filing an election form with the IRS. In addition, you can choose to be taxed as a C-Corp or an S-Corp.
C-Corp status means income is taxed at the current rate for corporations (21% as of late 2022), which is lower than the usual individual taxpayer rate. But keep in mind that C-Corp shareholders – who are members in the case of an LLC – must also pay taxes on their distributions. This is called double taxation.
However, members are subject to self-employment tax in an LLC taxed by default as a sole proprietorship or partnership. Once such LLC switches to being taxed as a corporation, self-employment taxes no longer apply.
Similarly, self-employment taxes do not apply to members with S-Corp status, which is the main advantage of electing S-Corp status.
With S-Corp status, members are generally paid as company employees, which means more accounting and payroll expenses. Therefore, S-Corp status is only beneficial when the self-employment tax savings are more significant than those additional expenses.
As you can see, LLPs and LLCs have many similarities and key differences. But, crucially, LLPs are only for licensed professionals and are only allowed in some states.
When choosing your business entity, it’s always a good idea to consult your tax advisor and attorney to make the choice that will give you and your business the best chance of success.