The general partnership (GP) and limited liability company (LLC) are two of the most popular business entities for new or small businesses. The reason for their popularity concerns the many advantageous characteristics that each business entity offers the business owners.
Below we discuss the primary attributes of each business entity and company structure. Understanding these attributes will help you make the right decision when you create a business entity.
Formation of the Business Entity
The process of forming a general partnership or GP is very simple. Two or more individuals must carry on some commercial activity with the intention of generating a profit or loss and sharing that profit or loss. The business arises by default. There is no formal filing or official documents required. While it is certainly advisable to have a business partnership agreement to govern the organization of the GP, it is not legally required. A business partnership agreement is the foundation of the GP.
Forming an LLC agreement is slightly more complicated company structure. Creating an LLC requires filing documents (articles of organization) with the state’s secretary of state’s office. The articles of organization contain basic information about the business, including: name, business purpose, duration, business office, organizer, registered agent, and whether the LLC is member-managed or manager-managed. The state may also require the names of the initial members. The office will review the articles and grant a certificate of organization. At this point, the business entity comes into existence. There is no formal requirement to have governing documents for the LLC agreement, known as a “operating agreement”. Having this document, however, is highly advisable. The state generally requires the LLC agreement to grant the certificate of organization and to update the information in the articles if there is a material change. Some states require annual disclosures, such as operational or financial matters.
Control and Ownership
The owners of a partnership are the company partners. They control all aspects of the company’s operations and decision making. The default rule is that all company partners have equal ownership interests and control over the partnership. The company partners may limit the authority of any partner in a partnership agreement. This is another reason for having this organizational document. Third parties are justified, however, in assuming that all partners have authority to act on behalf of the partnership.
An LLC is owned by members. At the time of organization, the LLC chooses whether it will be member-managed (managed equally by all members) or manager-managed (managed by individuals appointed or hired by the members). A member-managed LLC is treated very similarly to a GP. A manager-managed LLC is more similar to a corporation. The members retain voting rights, but all control and operations is vested with the managers.
Personal Liability of Owners
Perhaps the most important distinction between a GP and an LLC agreement concerns the responsibility of business owners for the debt or obligations of the company. The partners in a GP are personally liable for all such responsibilities. This reality is particularly concerning for partners, as each partner may find herself personally liable if the business is held legally liable for the actions of the partnership’s employees.
When you create an LLC, An LLC agreement provides personal liability protection for its members. That is, the LLC entity form protects the personal assets of owners. Creditors of the LLC must look to the assets of the LLC and cannot seek to execute against the personal assets of the LLC owners. This provides a great deal of comfort to members, who do not have to worry about tort liability for the actions of LLC employees.
Tax Election and Compensation
A GP is taxed as partnership. The rules of partnership taxation are quite complicated. In summary, the business partnership is a pass-through tax entity. This means that any profits or losses of the GP pass through the business entity and are attributed to the partners. The partnership entity is not a taxpayer. As a pass through tax entity, the partnership must file an informational tax return indicating how the profits or losses are allocated to the partners. The partners receive a K-1, which indicates their share of company profits or losses. Partners who work in the partnership are not allowed to receive a salary from the partnership. Partners can only be compensated by drawing from company assets or profits. Partners who work in the company will have a dedicated draw that provides compensation in addition to their share of profits or losses as owners. Lastly, partners have a basis in the partnership equal to the value provided to the company in exchange for their partnership interest. Any interest in profits or losses of the partnership increase or diminish the partner’s basis. Any new contributions of capital or received distribution of partnership profits reduces the partner’s basis.
An LLC is a very versatile tax entity. The LLC may choose to be taxed as a partnership or as a corporation. Generally, if the LLC agreement chooses corporate tax status, this means that the LLC will choose to be taxed under Subsection S of the IRC. Subsection S treats the LLC as a pass-through tax entity, similar to a partnership. A notable difference is that the LLC agreement may then compensate employee owners with a salary. The employee owner will receive any profits or losses of the corporation separately from her salary. This provides a major benefit for two reasons. The LLC owner’s share of profits receives a 20% discount or deduction. This means that only 80% of the profits received are taxable. Also, the owners share of profits is not subject to Federal Income Contribution Act (FICA) taxes. To avoid unreasonable tax avoidance, the owner employee must receive what is deemed a reasonable salary for her services to the company. This prevents receiving all compensation as a dividend distribution. The basis rules associated with the S Corp – taxed entity are somewhat different.
LawTrades Knows Business Entities
When selecting, forming your certificate of organization and setting up your business entity or company structure, it pays to work with a knowledge legal professional. The legal experts at LawTrades can help you every step of the way.