While these structures are both formal commercial entities in the American business landscape, there are many significant differences between the LLC and the LP. How do you decide which one is the right choice for your business?
We get quite a few questions from our readers regarding whether the LLC or the LP is the correct structure for their businesses, so we decided to write this article as a means of helping you with this decision. If you’re wondering whether the limited liability company or the limited partnership is the right entity for your business, you’ve come to the right place!
What Is an LLC?
The limited liability company is a business owned and operated by one or more people, who are often referred to as “members” of the LLC. The limited liability company is a hybrid business structure that combines the casual flexibility of sole proprietorships and general partnerships with the limited liability protection of a corporation.
The main reason for the LLC’s popularity is because it provides personal asset protection, which means that creditors can only pursue your business assets in a lawsuit against your company, while your car, house, and personal bank accounts remain protected.
In addition, many entrepreneurs save a considerable amount of money on taxes thanks to the LLC’s “pass-through” taxation, which has the LLC owners claim business profits or losses on their personal returns, and there is no corporate-level taxation.
What Is a Limited Partnership?
A limited partnership (LP) is an American business entity that needs to have at least two owners, and those owners must operate the business using an unbalanced partnership model, in which one owner is known as the general partner and one owner operates as the limited partner.
The LP is a good choice for companies with ownership groups that don’t want to share equally in the responsibilities of operating the business. The general partner is a much more hands-on position, as this person is intimately involved with the daily operations of the company. The limited partner is far less involved with the day-to-day details, and is often referred to as a silent partner due to their less visible involvement with the business. (Learn more about being a general partner vs limited partner on UpCounsel)
Another interesting aspect of this uneven partnership model is that the limited partner has no liability for the company’s debts or other obligations beyond the amount of investment they’ve made into the business.
Because of this aspect, the limited partner is often a passive investor who only wants to invest money into the company in exchange for a small amount of control regarding the major decisions of the business.
Similarities of the Limited Partnership and the LLC
Limited liability companies are far more common than limited partnerships, but these two business entities share some of the same characteristics, starting with the taxation methods.
Both the LLC and the LP are pass-through entities for tax purposes, which means that the company’s profits and losses pass through the business structure itself, and are instead claimed by the individual owners on their personal tax returns. There is no corporate-level tax paid with these business structures, which is a significant difference from corporations, which typically pay taxes on both the corporate level and the individual level.
When compared to corporations, both the limited partnership and the limited liability company are quite flexible structures. Corporations have highly specific rules and regulations regarding management and ownership, but LPs and LLCs have much more flexibility in these areas that allow owners to set up their own managerial frameworks.
Advantages of the Limited Partnership
The most significant advantage of the limited partnership compared to an LLC is that it is far easier to attract investors to an LP.
Both the LLC and the LP are unattractive entities for venture capitalists because you can’t invest VC in a pass-through company, but for other types of investments, the limited partnership has distinct advantages. Namely, the role of the limited partner is a great way to encourage investments into your business without giving up much control over operations.
Another advantage is that the limited partnership is more consistent regarding legal issues than the LLC is. The LLC as a business entity wasn’t widely accepted in all 50 states until the 1990s. Because of this, there isn’t much legal precedent for how courts should treat LLCs, and each state can have its own rules and regulations as well. In contrast, the LP is an older business type with more consistency with regard to legal precedent.
The limited partnership also provides its owners with many opportunities for tax deductions that are not available to LLC owners. With a limited partnership, you can deduct health insurance costs, 401(k) expenses, pension plan contributions, and more. You can’t deduct any of these costs if you’re operating a limited liability company.
Finally, we get to one of the major advantages of serving as a limited partner, which is the lack of self-employment taxes for this type of partner. The limited partner is not required to pay the 15.3% tax rate that is the combined employer and employee portions of both Social Security and Medicare, but the general partner and all LLC owners do pay this tax.
Advantages of the Limited Liability Company
LLCs have some major advantages over the limited partnership as well, starting with the fact that in a limited liability company, every owner has their personal liability limited by the LLC business structure, but in a limited partnership, only the limited partner receives this protection. For the general partner, operating an LP has plenty of risk involved.
In addition, a limited partnership needs at least two owners to function (a limited partner and a general partner), but a limited liability company can be operated by one person on their own. In general, there’s even more ownership flexibility for LLCs than there is for LPs.
Speaking of ownership flexibility, the LP can’t operate without a limited partner and a general partner. If the limited partner decides that they want to become a general partner, the LP’s business structure may not allow this transition to take place. With an LLC, you’re allowed to adjust ownership shares and responsibilities as much as you’d like to.
Businesses That Use the Limited Partnership Entity
The limited partnership is far more common in certain industries than it is in others. The types of businesses that typically use limited partnerships include entities like law firms, accounting firms, and financial investment companies.
Limited partnerships are especially popular for real estate companies, to the point where the term real estate limited partnership (RELP) is rather common. The reason for the RELP’s popularity is because this type of business allows experienced development firms or property managers to take the reins as the general partner, while attracting investments in the form of limited partners.
The LP is also quite popular for family businesses to be able to reduce their estate tax and gift tax responsibilities.
By forming a limited partnership for your family, you can pass down your assets from one generation to the next by using the gift tax exemption for LPs. In fact, this is such a popular route that this form of limited partnership is often referred to as the family limited partnership (FLP).
The limited liability company is a much more common business entity than the limited partnership, but there are still some business types that use the LP quite frequently. If you operate a real estate business or family-owned company ― or if you simply find the limited partner/general partner dynamic to be appealing ― a limited partnership might be the best entity for your business.
One final note we’ll make is that the limited liability company is usually easier to form than the limited partnership is, and therefore while we think it’s perfectly acceptable to form your own LLC, we don’t typically recommend that you DIY an LP formation. However, if you don’t want to spend the money on a lawyer to form your limited partnership, we suggest hiring either BizFilings or LegalZoom to form your LP.
We hope this article helped you deepen your understanding of the differences between limited partnerships and limited liability companies, and we appreciate you taking the time to learn more about the American business landscape!