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.
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.
Which is better: the LLC or LLP? To determine what’s better for your company, let’s explore the differences:
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.
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.
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.
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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