What is the Difference between Partnerships and Limited Liability Companies?
Suppose you’re starting a new business with one or more other owners, but you don’t want it to be a corporation. For accounting and business purposes, you can choose to create a partnership or a limited liability company, which are the main alternatives to the corporate form of business.
A partnership is also called a firm. You don’t see this term used to refer to a corporation or limited liability company nearly as often as you see it refer to a partnership. The term firm connotes an association of a group of individuals working together in a business or professional practice.
Compared with the relatively rigid structure of corporations, the partnership and limited liability company forms of legal entities allow the division of management authority, profit sharing, and ownership rights among the owners to be very flexible. Here are the key features of these two legal structures:
- Partnerships: Partnerships avoid the double-taxation feature that corporations are subject to. Partnerships also differ from corporations with respect to owners’ liability. A partnership’s owners fall into two categories:
- General partners are subject to unlimited liability. If a business can’t pay its debts, its creditors can reach into general partners’ personal assets. General partners have the authority and responsibility to manage the business. They’re roughly equivalent to the president and other high-level managers of a business corporation. The general partners usually divide authority and responsibility among themselves, and often they elect one member of their group as the senior general partner or elect a small executive committee to make major decisions.
- Limited partners escape the unlimited liability that the general partners have hanging around their necks. Limited partners are not responsible, as individuals, for the liabilities of the partnership entity. These junior partners have ownership rights to the business’s profit, but they don’t generally participate in the high-level management of the business. A partnership must have one or more general partners; not all partners can be limited partners.
Many large partnerships copy some of the management features of the corporate form — for example, a senior partner who serves as chair of the general partners’ executive committee acts in much the same way as the chair of a corporation’s board of directors.
In most partnerships, an individual partner can’t sell his interest to an outsider without the consent of all the other partners. You can’t just buy your way into a partnership; the other partners have to approve your joining the partnership. In contrast, you can buy stock shares and thereby become part owner of a corporation without the approval of the other stockholders.
- Limited liability company (LLC): The LLC is an alternative type of business entity. An LLC is like a corporation regarding limited liability, and it’s like a partnership regarding the flexibility of dividing profit among the owners. An LLC can elect to be treated either like a partnership or as a corporation for federal income tax purposes. Usually, a tax expert should be consulted on this choice.
The key advantage of the LLC legal form is its flexibility — especially regarding how profit and management authority are determined. For example, an LLC permits the founders of the business to put up, say, only 10 or 20 percent of the money to start a business venture while keeping all management authority in their hands. The other investors share in profit but not necessarily in proportion to their invested capital.
LLCs have a lot more flexibility than corporations, but this flexibility can have a downside. The owners must enter into a very detailed agreement that spells out the division of profit, the division of management authority and responsibility, their rights to withdraw capital, and their responsibilities to contribute new capital as needed. These schemes can get very complicated and difficult to understand, and they may end up requiring a lawyer to untangle them.
If the legal structure of an LLC is too complicated and too far off the beaten path, the business may have difficulty explaining itself to a lender when applying for a loan, and it may have difficulty convincing new shareholders to put capital into the business.
A partnership treats salaries paid to partners (at least to its general partners) as distributions from profit. In other words, profit is determined before the deduction of partners’ salaries. LLCs are more likely to treat salaries paid to owner-managers as an expense (like a corporation). The accounting for compensation and services provided by the owners in an LLC and the partners in a partnership gets rather technical.
The partnership or LLC agreement specifies how to divide profit among the owners. Whereas owners of a corporation receive a share of profit directly proportional to the number of common stock shares they own, a partnership or LLC doesn’t have to divide profit according to how much each owner invested. Invested capital is only one of three factors that generally play into profit allocation in partnerships and LLCs:
- Treasure: Owners may be rewarded according to how much of the treasure — invested capital — they contributed. So if Jane invested twice as much as Joe did, her cut of the profit may be twice as much as Joe’s.
- Time: Owners who invest more time in the business may receive more of the profit. Some partners or owners, for example, may generate more billable hours to clients than others, and the profit-sharing plan reflects this disparity. Some partners or owners may work only part-time, so the profit-sharing plan takes this factor into account.
- Talent: Regardless of capital and time, some partners bring more to the business than others. Maybe they have better business contacts, or they’re better rainmakers (they have a knack for making deals happen), or they’re celebrities whose names alone are worth a special share of the profit. Whatever it is that they do for the business, they contribute much more to the business’s success than their capital or time suggests.
A partnership needs to maintain a separate capital (ownership) account for each partner. The total profit of the entity is allocated into these capital accounts, as spelled out in the partnership agreement. The agreement also specifies how much money each partner can withdraw from his capital account. For example, partners may be limited to withdrawing no more than 80 percent of their anticipated share of profit for the coming year, or they may be allowed to withdraw only a certain amount until they’ve built up their capital accounts.