Legal Structure Difference: LLC and LLP – Which Is Right For You?
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As an entrepreneur, new business owner, or investor, you understand your market, your customers, and your competition. But for many, the process of picking a business structure is an unfamiliar road to navigate. So what is the legal structure difference of LLP vs LLC?
The question whether to form an LLC or LLP doesn’t have to be complicated once you understand how these two entities are created, who can create them, and what legal protections and tax benefits they offer.
First, let’s start with the basics. An LLC is a Limited Liability Company. It’s a separate legal entity that protects owners from liability found with the company (similar to a corporation), while also offering the pass-through tax benefits of a sole proprietorship or partnership. The LLC is free of much of the legal requirements and red tape that govern corporations, such as director meetings, shareholder requirements, etc.
The LLP (Limited Liability Partnership) is a general partnership whose partners enjoy some level of protection from personal liability. Similar to the LLC, the LLP is a hybrid of both the corporation and partnership, to give the greatest advantages for taxation and liability protection. The LLP is not a separate entity for income tax purposes and profits and losses are passed through to the partners.
What is an LLC?
An LLC, or Limited Liability Company, is a flexible form of business entity that combines the limited liability protection of a corporation with the simplicity and tax advantages of a partnership. Owners of an LLC are referred to as “members” and the LLC can be owned by individuals, other LLCs, corporations, or even foreign entities.
Unlike shareholders in a corporation, members of an LLC are generally not personally liable for the company’s debts or liabilities. This means that personal assets of the members are usually shielded from business creditors.
What is an LLP?
LLP, or Limited Liability Partnership, is a type of partnership where all partners have limited liability protection. This means that they are protected from the debts and liabilities of the partnership and also from the actions of other partners, to a certain extent.
LLPs are commonly used by professionals such as lawyers, accountants, and architects, where each partner can protect their personal assets from potential negligence or malpractice claims arising from the actions of another partner.
Legal Structure Difference: LLC and LLP
Which is better: the LLC or LLP? To determine what’s better for your company, let’s explore the differences:
State Laws
Before we dive into the differences, it’s critical to understand that laws concerning LLPs vary widely state by state. Generally speaking, LLCs can be formed by any business, persons, or person, while LLPs may be restricted to licensed professionals, such as attorneys, doctors, engineers, architects, and accountants. For example, in California and Nevada, licensed professionals can form an LLP, but cannot form an LLC. This is why a large law firm will opt to form an LLP, as they can operate as an LLP in every state, but would not be able to operate as an LLC in every state.
You’ll need to check with your state’s secretary of state office to determine the specific rules for your state.
Legal Protection
Both the LLC and LLP provide personal asset protection, but there can be crucial differences. For example:
- Members of an LLC are protected from any debt or liabilities of the business. However, members of an LLC are not protected from the liability of another member. If someone in an LLC makes a client error that is legally actionable, then the LLC and all its members can be held liable.
- By contrast, partners in an LLP can be protected from the liability of another member. A partner in an LLP is personally liable only for his or her own negligence (or of someone working under their direct supervision). This is different from a general partnership where each partner is liable for the debts and obligations of the business, as well as the malpractice of other partners.
- In some states, a partner in an LLP can still be personally liable for a variety of partnership debts, such as obligations owned to lenders and creditors. However, some states regulate that partners are not personally liable for such debts and obligations.
Tax Implications
In general, both LLCs and LLPs do not require the business to pay income taxes on its profits; rather any profit or loss of the business is passed through to the members (LLC) or partners (LLP).
By comparison, a corporation pays income taxes on its business earnings and then if those earnings are distributed to owners, the owners must pay taxes on them again in their personal tax return.
A single-member LLC is considered a sole proprietorship and the member must pay self-employment taxes. It’s important to note that while most LLCs opt for pass-through tax treatment, some may choose to be taxed as a Corporation.
LLPs are treated strictly as partnerships and profits are passed through to the partners.
Management Structure
The way each business structure is managed can differ significantly. While LLCs offer an advantage with their flexible management structure — members themselves can manage it or they can appoint external managers — LLPs usually see all partners managing the firm, unless an alternative agreement has been arranged.
Decision Making
Understanding the decision-making process is pivotal in any business structure, as it can dictate the flow and pace of operations, growth strategies, and day-to-day tasks. Both LLCs and LLPs have unique characteristics when it comes to how decisions are made:
- LLCs:
- Operating Agreement: This crucial document usually outlines the decision-making process in detail. It can specify who makes decisions, when they are made, and how members’ opinions are weighed.
- Majority Ownership: Often, those who hold the majority stake in an LLC have a louder voice. This can lead to decisions being driven by a majority vote, although this isn’t always the case.
- Unanimous Decisions: For some critical choices, like amending the operating agreement or adding a new member, many LLCs require a unanimous decision.
- Managers: If the LLC chooses a manager-managed structure, day-to-day decisions might be made by designated managers, whereas significant decisions still lie with members.
- LLPs:
- Equal Say: Typically, every partner in an LLP has an equal voice, which fosters a collaborative decision-making environment.
- Partnership Agreement: This is the LLP’s equivalent to the operating agreement for LLCs. It can lay out exceptions to the equal-say rule or delineate how conflicts in decision-making are resolved.
- Veto Power: Some partnership agreements might grant certain partners the power to veto decisions, especially in areas of their expertise or concern.
- Committee Decisions: Larger LLPs may form committees for specific sectors or decisions. For example, a committee might oversee hiring, while another handles partnerships or expansions.
Start-Up Costs
The decision to form an LLC or an LLP is not only about understanding the operational distinctions but also about estimating initial costs. State laws greatly influence these costs. Setting up an LLC typically involves a filing fee for the Articles of Organization, which can range from $50 to $500 depending on the state.
In contrast, LLPs, often established by professionals like attorneys or doctors, might face additional costs related to professional licensing or accreditation. Further, some states have publication requirements where the formation of the entity must be announced in local newspapers, adding to the start-up cost.
Annual Requirements
Operational costs don’t end post-establishment. Most states require LLCs to submit an annual or biennial report, often paired with a fee. This report typically updates the state on key business details, such as addresses or management structure.
On the other hand, LLPs, especially those in high-liability professions, may have stricter insurance mandates to maintain their liability protections. This could lead to increased annual costs.
While LLCs in most states face these reporting obligations, some states exempt LLPs, whereas others do not.
Existence
The duration of a business entity’s existence can vary significantly. For LLCs, many states grant perpetual existence, allowing them to operate indefinitely unless dissolved by the members.
The operating agreement, a governing document for an LLC, can specify a particular dissolution date or event. In contrast, LLPs often have a more fragile existence.
The departure, death, or incapacity of a partner can trigger dissolution, unless their agreement contains provisions to manage such scenarios. This fragility necessitates careful planning for continuity in the case of LLPs.
Dissolution Process
The journey to close a business is multifaceted and can be emotionally taxing. Both LLCs and LLPs require a structured approach to dissolution. Initially, the entity must settle any outstanding debts and obligations.
Assets are then distributed amongst members or partners as per the agreed-upon structure. Following this, official paperwork, often termed as “Articles of Dissolution,” must be filed with the state, signaling the business’s end. Failure to follow proper dissolution processes can result in continued tax liabilities or even legal repercussions.
For LLPs, the exit strategy can be even more nuanced, especially when considering professional licenses and ongoing client obligations.
Advantages and Disadvantages of LLP Vs LLC
| LLP (Limited Liability Partnership) | LLC (Limited Liability Company) | |
|---|---|---|
| Advantages | ||
| Protection from fellow partners' liabilities | Flexible management structure | |
| Typically, no double taxation (pass-through) | Pass-through taxation (avoid double taxation) | |
| Each partner's personal assets are protected | Limited liability protection for members | |
| Suitable for professional groups (doctors, lawyers) | Suitable for various business types | |
| Can make decisions with equal say among partners | Can choose to be taxed as a corporation | |
| Disadvantages | ||
| Often restricted to certain professions | Potential self-employment tax implications | |
| Not all states offer the same level of liability protection | Some states might impose additional fees or taxes | |
| Might require extensive insurance coverage | Possible complexities in multi-state operations | |
| Dissolution can occur with partner changes unless specified | Members might not have equal say in decisions unless specified | |
| Unequal profit distribution, unless specified | More r |
Exploring Taxation Differences: LLC vs. LLP
Understanding the nuances in tax treatment for LLCs and LLPs is crucial for making an informed choice about your business structure. Here’s a deep dive into how these entities are taxed and the implications for your business:
- Tax Classification Flexibility for LLCs: One of the most significant advantages of an LLC is its tax classification flexibility. By default, an LLC is taxed as a pass-through entity, meaning profits and losses pass through to members who report them on their personal tax returns. However, an LLC can also elect to be taxed as a corporation, providing potential tax benefits under certain circumstances.
- Self-Employment Tax Considerations: For LLC members, the self-employment tax is a critical consideration. As profits from the LLC are considered earned income, members must pay self-employment taxes, which cover Social Security and Medicare. This can be a significant expense, and planning for it is essential in financial management.
- LLP Tax Treatment: LLPs are always taxed as pass-through entities, meaning individual partners report their share of profits and losses on their personal tax returns. Unlike some LLC members, partners in an LLP are not subject to self-employment tax on their share of profits, potentially offering a tax advantage.
- Deductions and Allowances: Both LLCs and LLPs can benefit from various business deductions, such as operating expenses, employee salaries, and other business-related expenses. Understanding these deductions and how they apply to each entity can significantly impact your tax liability.
- State-Level Tax Considerations: Tax treatment for LLCs and LLPs can vary significantly at the state level. Some states impose additional taxes or fees on these entities, while others offer tax advantages. It’s crucial to understand the state-specific tax implications for your chosen business structure.
- Planning for Tax Efficiency: Effective tax planning is vital for both LLCs and LLPs. This includes understanding the tax implications of business decisions, such as distributions and allocations of profits and losses, and taking advantage of tax-saving strategies tailored to each entity’s structure.
- Professional Tax Advice: Given the complexities of tax laws and their variations by state, consulting with a tax professional is highly recommended. A qualified accountant or tax advisor can provide tailored advice, ensuring compliance and optimizing tax efficiency for your LLC or LLP.
The Bottom Line
By mixing some of the properties of corporations, partnerships, and sole proprietorships, the LLC and LLP offer compelling benefits for new companies. While both entities have distinct tax advantages, only LLPs give partners legal protection from the actions of another partner. For this reason, the LLP is better for a group of professionals who plan to actively participate in the company.
If you’re forming a business, take a look at your state law to first determine which entity is allowable in your state, as well as the state laws regarding personal liability for each entity.
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This article, "Legal Structure Difference: LLC and LLP – Which Is Right For You?" was first published on Small Business Trends
