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Small Business Tips

LLC or LLP? Choosing The Right Business Entity

Stephen Fishman
Tax expert and contributor MileIQ

You really need to think about your legal organization when entering into a business with someone. There are several options including a Limited Liability Corporation or a limited liability partnership. Let's go over the pros and cons of these options. 

What's the difference between an LLC or LLP?

There are several options for your business entity with two people. Today, few business owners want to be in partnerships. That's because these have unlimited personal liability for business debts and other liabilities. Corporations provide their shareholders with limited liability. But, these can be expensive and a hassle to maintain.

The LLC is the most popular legal form for small businesses. Yet, many states also offer the option of the limited liability partnership (LLP). It's important to understand the difference between the two.

LLC: A useful hybrid entity

The LLC is a useful hybrid: a cross between a partnership and corporation. It's like a corporation because its owners must file papers with their state's business filing office to create the LLC. It also exists as a separate legal entity.

An LLC is like a partnership because owners jointly own and manage the business. They also share in the profits. I recommend writing an LLC operating agreement laying out how you'll govern the LLC. If you don't prepare an operating agreement, the default provisions of your state's LLC laws will apply. Not every state requires these written operating agreements.

The IRS taxes a multi-member LLC the same as a partnership. For tax purposes, an LLC is a pass-through entity. That is, it ordinarily pays no taxes itself. Instead, the profits, losses, deductions, and tax credits of the business are passed through the business to the owner's individual tax returns.

The owners pay income tax on their ownership shares on their individual returns, at their individual income tax rates. This is if the business has a profit.

If the business incurs a loss, it's shared among the owners. They can deduct the loss from other income on their individual returns, subject to certain limitations.

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Dividing profits and losses

LLCs have great flexibility on how to divide profits and losses among the owners. For example, one owner could get 75% of the profits and the other 25%, even though they are each equal owners of the LLC. Yet, there are limits on how creative LLCs can get. The IRS may disregard an allocation of profits or losses if it's done only to avoid taxes.

LLCs must file an annual tax form with the IRS. Use Form 1065, U.S. Return of Partnership Income to do this. The LLC must also provide each member with an IRS Schedule K-1, Partner's Share of Income, Deductions, Credits, etc. This lists the member's share of LLC income and expenses.

The members must then file IRS Schedule E, Supplemental Income and Loss, with their individual income tax returns. This shows the income or losses from all the LLCs in which they own an interest.

When to choose LLC

You want the limited liability and flexibility of a corporation but also want pass-through income status. You'll have to maintain more records than with a sole proprietorship, though.

LLP: Partnerships with a twist

LLPs are similar to partnerships except for one crucial advantage. An LLP limits the partners' liability for malpractice claims. In some states, an LLP limits debts incurred by the partnership. States may also call an LLP a "registered limited liability partnership."

You may use an LLP in some states because state laws prohibit you from forming an LLC. States limit certain occupations to LLP status. Typically, this applies to those in the medical, legal and accounting fields.

In some states, engineers, veterinarians, and acupuncturists are also allowed to form LLPs. Not all categories of licensed professionals can form an LLP, though. Check your state's requirements to see if you can form an LLP.

At least two partners are needed to form an LLP, and the partners must usually be licensed in the same or related professions. In most states, creating an LLP requires registration with the state government, annual filings, and administrative fees.

When to Choose LLP:

You should choose an LLP if you want LLC benefits but your state doesn't allow your profession to use them. If your state allows both legal entities, carefully check your state's laws for liability protections.

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