When two people agree to form a business together, what would you guess they call it? Naturally, many people use the term “Partnership.” In some instances, Partnership is technically correct, like when two or more attorneys share an office and referrals, or two accountants do the same. However, today the term “Partnership” is misused by many, and it could have an impact on their business.
Today, most individuals form or intend to create a limited liability company (LLC). An LLC is a legal entity separate and apart from its owners, which is different from a partnership. This means that you must be specific about how you refer to your business, what documents you send to the state or federal government, and what agreements govern it.
The purpose of this blog post is to give a little background on what a Partnership is, how many people misuse the term “Partnership,” and how it compares with an LLC.
What Is a Partnership?
A partnership is simply two or more people coming together for business. States and the IRS do not require partners to file or register their companies formally. When at least two people are involved in a business, the IRS automatically classifies it as a partnership for federal tax purposes.
Even though it is not required, most lawyers agree that business partners should create a “Partnership Agreement” to legally define their relationship by outlining each partner’s responsibilities, duties, and rights. Should a disagreement exist between partners, a Partnership Agreement provides a roadmap for the business that can prevent litigation.
Partnerships are one common way to form a business, and they offer flexibility in their management structure. There are also different kinds of partnerships, including General Partnership, Limited Partnership (LP), and Limited Liability Partnership (LLP).
What Is a Limited Liability Company (LLC)?
Similar to a Partnership, an LLC can be formed when two or more individuals come together to create a business. However, there are some key differences. First and foremost, LLC owners are called members, not partners. Members of an LLC must submit Articles of Organization, sometimes called a Certificate of Organization, to their state’s appropriate Department of State or other applicable departments.
Instead of a Partnership Agreement, members of an LLC create an Operating Agreement; don’t call it a partnership agreement. LLC’s are governed by state law, and many states do not require an Operating Agreement. However, most corporate or business attorneys will tell you that it is standard practice is to create one. This is the most significant and the most crucial document associated with an LLC because it outlines how the business operates.
An Operating Agreement governs
- How the business functions,
- States the percentage ownership of each member,
- Decides who manages the business,
- Decides how to bring new members into the fold, and
- It provides answers to other critical questions related to the financial aspects of the business relationship.
This is not an exhaustive list, but I think you get the point.
Choosing a Business Structure
When you form your business, one of the most critical decisions you make will be to decide on the legal structure of your organization. Each type of structure impacts the amount of taxes you pay, the amount of paperwork you need to file, personal liability, and your ability to raise startup capital.
In terms of Partnerships and LLCs, two main characteristics set them apart:
The reason Limited Liability Companies (LLCs) are named as such is that they provide the members with limited liability for company debts, losses, and wrongful acts. When financial challenges occur, “partners” (in a regular partnership) are personally responsible for the debts of the business, and thus, can potentially lose personal assets such as homes, vehicles, and any money in personal bank accounts to the extent not excluded under a state’s laws.
Conversely, members of an LLC (appropriately operated) are protected from the seizure of their personal assets. The personal assets of members are protected in the event of a verdict against the company.
By default, LLCs are taxed as a partnership. The tax burden ‘passes through’ to individual LLC members, who must report profits and losses on their personal return. Members can also choose for their LLC to be taxed as a C-Corp or S-Corp to avoid certain employment taxation. Partnerships generally do not have the same flexibility in taxation, but automatically receive pass-through taxation.
Hiring an Attorney to Set Up Your Business
If you are one of the many people who misidentify or misclassify their business as a partnership, trust us, you are not alone.
The Law Office of Elliott J. Brown offers a wide variety of services for startups and businesses. This includes the preparation of LLC Operating Agreements and Partnership Agreements. Contact us today to learn more about how we can help your LLC or Partnership.