Decades ago, business owners had few options aside from sole proprietorships, partnerships, and corporations. Today, limited partnerships (LPs) and limited liability companies (LLCs) are two of the most popular entities for small businesses. These entities have many of the same advantages, including flexibility, pass through taxation, limited liability protection, and greater control of management compared to a corporation. Both are also treated like a general partnership by the IRS for tax purposes. For these reasons, it’s easy to confuse the two. Here’s what you should know about the difference between an LP and an LLC.
Limited Liability Companies
A limited liability company, or LLC, is actually a hybrid business entity that combines the best features of a sole proprietorship, partnership, and corporation. Every owner, or member, enjoys limited liability protection similar to that of a corporation shareholder although an LLC is far more flexible. Unlike a corporation, an LLC does not have strict formalities like the requirement to produce annual reports or hold director meetings.
An LLC is a pass-through tax entity. This means each member’s share of business losses and profits are reported on the member’s personal income tax return. An important distinction with forming an LLC is members can choose to distribute profits any way they like without considering each member’s contribution to the company.
Limited partnerships have at least one limited partner and at least one general partner. The general partner is the one who participates in management with 100% liability for any obligations of the business while limited partners cannot participate in the business management but have no liability for the company’s obligations beyond their financial contribution to the business.
The benefit of an LP is it’s an attractive entity for passive investors. Because limited partners have such strong protection, general partners can more easily raise money without worrying about outside investors becoming involved in the business’ management.
Which is the Right Choice?
There are advantages with each option. Both LLC owners and limited partners of an LP enjoy limited liability protection, but limited partners will lose this protection if they choose to actively participate in business management. This makes a limited liability company a more flexible business structure in terms of management.
While both are treated as a pass-through tax entity, the LLC does come out ahead in this area because LLC members can claim tax losses in excess of their capital investment in the business, unlike limited partners.
There are a few advantages to an LP. Not all states have the same tax treatment of limited liability companies as some states limit the types of businesses that can form an LLC while others tax LLCs like corporations. Limited partnerships can also come with additional tax deductions for employees.
Both business entities offer many of the same benefits that are important to any small business, including flexibility and limited liability protection. Despite their similarities, there are distinct differences between the two, however, which means it’s important to consult with an expert such as a corporate services company or an attorney before you make a choice.