Both LLCs and LLPs offer liability protection to company owners, which is why it’s easy for people to conflate the two. However, even though they both safeguard company owners, the two business structures offer protections against different outcomes. Whether you’re concerned about lawsuits, high taxes, or losing your home in the case of financial default, it’s important to set the record straight before you make the final decision.
What is an LLC?
An LLC is a business structure that declares that the members own the organization. It generally shields members’ personal assets from the business’s debts and liabilities, and allows for flexible management. With an LLC, you have several tax pathways available. That said, liability protection isn’t absolute, members can still be held personally liable if they’ve signed a personal guarantee, engaged in misconduct, or if a court finds the LLC’s corporate veil was pierced due to commingled finances or ignored formalities.
What is an LLP?
An LLP is owned by partners and taxed as a partnership. The structure is designed to protect each partner from their colleague’s errors. This is often the preferred choice for licensed professionals because they offer a simple way to collaborate without opening the door to undue risk. Some states offer the LLP option to all companies, while others restrict the designation to specific industries or professions (think: CPAs, lawyers, doctors).
LLC vs. LLP: Core differences
There are a few main differences to know about the two structures:
- Liability: An LLC focuses largely on financial liability. Should the business take on debt, the members of the LLC won’t risk their personal possessions, like their home or car, in order to cover the costs. An LLP focuses largely on professional liability. Should a fellow partner make a glaring error, the other partners won’t be held at legal fault.
- Availability: LLCs carry very few restrictions: they’re virtually available for every possible company. An LLP needs at least two partners to form, and may be subject to restrictive state laws. While the general business structure of an LLP is recognized in all states, some states restrict the designation to specific industries or professions. California, for example, limits LLPs to the practice of law, public accountancy, architecture, engineering, and land surveying.
- Management structure: In an LLC, the owners can choose to manage the company, or they can appoint a manager to manage the company. In an LLP, only partners can manage the business.
- Taxes: LLCs have multiple tax options available to them, which can make it easier to adjust finances under the same umbrella as demand and goals wane and wax.
Keep in mind that while it is technically possible to convert your business structure mid-year if absolutely necessary, it’s a paperwork hassle to avoid if at all possible.
LLPs vs. LLC taxes
No matter how you slice it, taxes can get messy for both LLCs and LLPs. Every company is different depending on how it’s structured, how much money it makes, and how the members make decisions about how to move forward.
Here are a few things worth noting:
- By default, LLCs are ‘pass-through‘ entities for federal tax purposes. This means the LLC itself doesn’t pay federal income tax, instead, business income and losses pass through to the members, who report their share on their personal tax returns and pay federal income tax on it, even if the money stays in the business.
- LLCs can also elect to be taxed as a C corp or an S corp. Electing C corp status means the business pays federal corporate income tax on its profits, and shareholders pay tax again on any dividends they receive, this is what’s known as double taxation. Electing S corp status keeps the pass-through structure: the entity itself generally doesn’t pay federal income tax, but members still owe federal income tax personally on their share of the profit.
- LLPs can only file taxes as a partnership. This can be limiting, especially if the company hopes to fundraise or go public.
There is plenty of nuance to the above bullet points. For example, both LLPs and S corps are pass-through entities that generally don’t pay federal income tax at the entity level, but partners and members still owe federal tax personally on their share of profit, and how that profit is structured and split differs between the two. S corps can help members reduce self-employment tax exposure on part of their income, but they may not be a good option for the company during a lean year.
While you should always consult a CPA before deciding on one structure over another, usually the tax flexibility for LLCs is the preferred option for business owners. However, it’s important to consider not just the projected demand and risk exposure of your company, but also how fellow LLC members prioritize their assets. For example, a member with considerable personal wealth will have far more to lose than one without.
Why choose an LLP over an LLC?
LLPs are a better choice if you’re:
- Largely concerned with potential malpractice accusations against your fellow partners. If you’re not concerned with tax structure, shareholders, or investment opportunities, you only have to worry about your own actions on the job.
- Favor a more simplistic agreement regarding your shared responsibilities. LLPs bypass the need for an LLC operating agreement, which can get complicated and, at times, even contradictory.
- Forming a partnership with at least two people and you offer a specific professional service, such as physical therapy or legal advice.
Ultimately, the right one comes down to the type of business you’re creating. However, LLCs are usually the more practical choice for most general businesses. LLPs are not just limiting on a face level, in that you may need to be in a certain profession in order to consider even forming one, they can be limiting on a deeper financial and structural level.
For example, LLPs may not be responsible for their partner’s negligence, but they are personally held responsible for their own negligence, which may mean losing personal assets. In addition, some states offer full protection against a partner’s errors, while others may only offer partial protection.
This major distinction is not always well understood at the time of formation, and can result in a good deal of confusion and grief. So whether it’s a lawyer mishandling a case or a doctor incorrectly diagnosing a terminal illness, disputes in an LLP can offer fewer protections than partners realize.
Which one is right for you?
Consider that LLPs may look like a solid starting point: simple agreements, relatively straightforward taxes, and freedom from your fellow partner’s errors. However, they can also introduce more minefields than protections if you’re not careful, and potentially open your personal assets up to loss.
If you have questions, whether it’s about your state’s laws or the best tax structure, the team at Tailor Brands can help you puzzle your way through even the most complex roadblocks, and help you form an LLC if that’s the route you decide to take.
Most entrepreneurs are go-getters, meaning they’re unlikely to let much get in the way of starting a company. However, because the administrative side of companies can be more complex than meets the eye, it’s often the small details that lay a trap for business owners. This is why it’s often imperative to talk to someone who will ask the right questions and offer the right perspective.
Conclusion
While LLCs are the more popular business structure, that doesn’t necessarily make them better in all cases. No matter what type of company you own, it’s important to consult with an expert based on everything from your long-term goals to your individual member concerns.