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Opening a business with two or more partners adds new opinions and ideas to an already tough process. The choice between LLCs and partnerships can have a huge impact long-term.
This article will show you the differences between these two popular options to help you make the best choice for your new startup.
Why Understanding LLCs vs. Partnerships Is So Important
The two most common business structures for two or more partners are a partnership or limited liability company, usually called an LLC. 2020 NSBA data shows that LLCs are far more popular. 35% of small businesses are LLCs, while only 1% are partnerships.
There are many areas where these two corporate structures look the same, like pass-through taxation, but the differences are big. These factors can have long-term impacts on the finances and health of any company.
A partnership is the simplest way to set up a business with two or more partners and there are no paperwork requirements. A general partnership requires an employer identification number, also called an EIN, from the IRS. This makes this structure a quick and easy way to get started.
There are few different partnership options. In a general partnership, the partners have equal rights in making company decisions. Liability is also shared and can directly impact all partners’ personal assets.
In an LP or limited partnership, there are two types of partners. The general partner assumes ownership and has personal liability. Limited partners will invest resources into the business but they don’t make decisions for it. They also don’t have any personal liability.
An LLP, or limited liability partnership, is like an LP, but in this structure the limited partner has a small amount of personal liability.
An LLLP is also like an LP, but in a limited liability limited partnership, both general and limited partners share some personal liability. LLLPs are a great option to protect personal assets, but they are the newest partnership structure, and they’re not an option in every state.
Limited liability companies are an attractive alternative to partnerships. An LLC is often considered the most attractive option for partners because of its approach to taxes, liability, and operations. In an LLC, the owners do not have personal financial liability if someone has an issue with their business.
Quick Tips To Understand LLC vs. Partnership
To better understand how partnership and LLC structures are unique, we’ve outlined three quick areas that could guide your final decision. These can help you determine which is the best fit for your new startup.
1. Learn the liability differences
The primary difference between partnerships vs. LLCs is personal liability.
Some startups begin with clear and obvious risks that will need asset protection. For example, most brick and mortar stores run the risk of slip and fall lawsuits and falls account for 85% of worker’s comp claims.
Other businesses seem low risk, but intellectual property and breach of contract claims have closed companies that started strong. You may want to complete a risk assessment for your industry so that you and your partners have all the information you need to make the best decision and to expect and address potential risks with your choice of corporate structure.
LLCs are the oldest and most reliable way for new business owners to separate their personal assets from company assets.
In a partnership, each partner is legally responsible for other partners’ decisions and actions, and that liability can have an immediate negative impact on the partners. The only partnership type that doesn’t have this level of personal liability is the LLLP.
While LLLPs are growing in popularity, this business structure is new enough that there is unclear legislation in some states and it’s not even an option in others. LLCs are also not an option in every state, but this structure has been around since 1977, so it is the best structure to protect personal assets without filing as a corporation.
2. Dig into the financials
Both partnerships and LLCs enjoy pass-through taxation. This means that the business does not pay taxes but the individual partners do. This helps small businesses avoid double taxation because corporations get taxed twice– once on the income the company earns and again for their stockholder earnings. In a pass-through, profits and losses pass directly to the partners or members.
When you move beyond the basics of LLC and partnership taxation, there are laws in each state, as well as federal tax regulations that can impact your balance sheet. For example, general partnerships are usually not subject to securities laws, but an LP or LLP may be.
This complete guide to how LLC taxes work is a helpful resource if you’re leaning towards the LLC structure. Take a look at IRS resources for partnerships. If you don’t feel like you have a complete understanding of these regulations, speak to a tax professional for help.
3. Check your partners
The number of business partners you plan to have will also impact whether a partnership or LLC is the right choice. Partnerships have limits on the number of partners they can have in some countries. There are also regulations that define who can be a partner.
At the same time, LLCs are free of most of these restrictions. In many states, a corporation, foreign entity, or even another LLC can serve as a member for a new LLC. If you expect your startup to grow quickly or you want to involve a large number of members to offset costs an LLC could be your best bet.
4. Decide what will happen at the end
There are many reasons businesses dissolve partnerships, and many reasons a partner may need to exit in a hurry. When a company is just starting out it can feel wrong to picture the end, but this factor is another clear difference between partnerships and LLCs.
In a partnership structure, the business is dependent on all of its partners. In most cases, when a partner leaves the business will usually need to close and reform. If a written agreement is not available, the process will follow state regulations. Most states use the Uniform Partnership Act to govern general and limited liability partnership dissolutions.
In an LLC, the operating agreement will cover the process for member withdrawal. This way, the business can continue to move forward.
Commitment is another major factor in financial success. 23% of businesses fail because they don’t have the right team. If you feel that your commitment is stronger than your partners’, an LLC could also be a better option.
Long-Term Strategies for Understanding LLC vs. Partnership
Forming an LLC or partnership doesn’t have to be a quick decision, and many businesses rush into this decision with frustrating results. These strategies will help you build a strong foundation and ensure that you understand which partnership structure is the best fit for your company.
1. Start slow
LLCs have more required fees and paperwork than partnerships. It may also be a good idea to operate your business as a partnership at first, then applying as an LLC later. This way you can assess the risks and rewards as they apply to your state and industry.
During this stage, you’ll also want to keep careful track of your profit and loss statements. Accounting software can help you keep clear and organized records until you’ve made the right decision for business formation.
Many companies will also file as an LLC in one state and operate in another for the financial benefits. This choice will make management processes more complex. LLC owners often need outside help to maintain different state requirements.
Start looking at specific state fees, licenses, and regulations before you begin filling out your paperwork. This research could show you that it’s a smarter move to create a limited liability partnership because of regulations in your industry. It could also point you toward LLC formation in Delaware because of the quick turnarounds in Chancery Court.
If your startup is short on staff, look into business formation services. They have strong experience in details you may not notice early on. These services can also be helpful if you’re on a tight timeline.
2. Nail down a written agreement
In an LLC each member owns a part of the business and maintains it by following an operating agreement. Some LLC members manage the business, while others choose to hire a manager.
Agreements for partnerships are not required, but they are extremely useful. These written documents help when disputes arise or urgent questions come up later on. Many states also have default rules that come into play if partners operate without a written agreement. Because of this most partnerships have a partnership agreement.
These agreements are comprehensive documents that outline basic and in-depth decisions on:
- How the business will run
- Who handles different aspects of the business
- How to make future decisions
These agreements are legally binding. Exact wording is important to protect the partners or members. For example, most agreements outline ownership percentages. It’s also a good idea to outline a profit-and-loss split since these percentages don’t have to be the same.
Once you start working on your agreement you’ll have a clearer picture of the decisions you’ll need to make with your partners. These decisions include:
- Partner contributions
- Partner liabilities
- New partner process
- Non-disclosure and non-compete agreements
This process will also clarify how these choices can impact business outcomes. They will also ensure everyone is clear on what you and your partners will get back from this venture.
Creating a partnership agreement or operating agreement is a lot of work. Some partners may feel that they don’t need to worry about these kinds of details so early on. But it only takes one disagreement or misstep to change the trajectory of a business.
To simplify the process, start with a template. Next, spend some time exploring your options for the sections of the agreement where you have questions or concerns.
For example, meeting procedures might seem like too much fuss for a new LLC with just three partners. At the same time, setting early ground rules for veto possibilities and vote procedures can save time and limit future arguments. This is especially important when you and your partners need to make fast decisions.
Once you and your partners have a general outline you can complete your partnership agreement. LLCs have more legal requirements for operating agreements, business formation, and maintenance. It’s a good idea to hire a lawyer or business formation service to complete your operating agreement.
3. Contact investors
Another important consideration is how you plan to raise funds for your company.
Some businesses are homegrown and plan to stay that way. Most LLPs are groups of professionals like dentists, doctors, or lawyers. But startups with an eye on national or international growth will usually need funding that goes beyond direct sales.
Both LLCs and LLPs can admit members or partners to help inject capital. Their success in this depends on how well the partnership structure protects individual members from personal risk. Corporations tend to be most attractive to investors. It’s more typical for LLCs to transition to an S Corp or C Corp than it is for LPs, LLPs, or general partnerships.
Next Steps
Once you’ve got a clear understanding of the right partnership structure for your business, it’s time to complete the next steps. get into choosing a business name and building your brand for powerful promotion. You’ve built a strong foundation for your business, now it’s time to introduce your new startup to the world.
