Owners of new businesses have several major decisions to make before opening up shop. This includes choosing the right business entity for their goals and needs. The legal structure of your business determines the way you pay taxes, your opportunities for growth, and your day-to-day responsibilities as the business owner. It’s fairly common for businesses with multiple owners to structure themselves as partnerships. But you still have to choose between the two main types of partnerships: general partnership and limited liability partnership (LLP).
Professional businesses, like law firms and accounting firms, often choose the latter option primarily because of the legal protection it offers. While general partnerships bear more similarities to sole proprietorships, limited liability partnerships bear more similarities to the next step up: limited liability company (LLCs).
In this guide, we’ll explain what differentiates LLPs from other business entities, what kind of businesses would benefit most from this structure, and how to legally establish an LLP.
What is a Limited Liability Partnership (LLP)?
LLPs protect each partner/business owner from personal liability for the business’s debts and obligations. Even though the partners may run the business together, legal action against one partner would not automatically bring the other partners (and their personal assets) into the picture.
Limited Liability Partnership: Legal Differences
Businesses with multiple partners that don’t register with their home states become general partnerships by default. The same concept applies to businesses with one owner, which in turn become sole proprietorships.
Unlike LLPs, all partners in general partnerships share the same amount of personal liability for business debts and obligations. Creditors can seize your personal assets if you don’t fulfill your obligations. If an employee suffers emotional or physical harm at work due to one partner’s negligence, the employee can personally sue all the partners at once. Since each partner shares an equal amount of liability, lawyers can come after every partner’s personal assets even though only one partner was involved in the incident at hand.
The dire consequences of these scenarios greatly increases the appeal of LLPs. Partnerships that register with the state and fill out the required paperwork gain personal protection from the business’s debts and obligations. One partner doesn’t have to worry about losing personal assets due to another partner’s negligence. Yes, individual partners can still get personally sued, but not for matters related to debts or obligations.
Though most partnerships opt for general partnerships or LLPs, some choose limited partnerships. This entity has a lot in common with general partnerships, with one notable difference: the ability to classify certain partners as “limited.” Instead of running the company with the general partners, limited partners merely fund the business with personal investments. So, while general partners share the same amount of personal liability for debts and obligations, limited partners can only face personal liability for amounts up to or equal to their investments. For this reason, limited partnerships typically make sense for investors of family-run businesses.
Limited Liability Partnership: Pros and Cons
The basic definition of limited liability partnerships doesn’t fully explain its various advantages. And like every other business entity, LLPs do in fact have their drawbacks. So, let’s go over the pros and cons of LLPs along with which kind of businesses would reap the most benefits from the pros.
Advantages of Limited Liability Partnerships
The biggest advantages of LLPs deal with protection, their tax bills, and the ability to change the hierarchal structure without formalities or documentation:
Personal Liability Protection
Much like LLCs, many owners of LLPs view this entity as “the best of both worlds,” especially in regards to personal protection. You get the biggest benefits of general partnerships, like having no single owners and very little paperwork. But while general partners can get sued for all sorts of business-related issues, limited liability partners can only get sued for issues unrelated to debts and obligations.
For example, while owners of LLPs cannot get sued for failing to pay off loans, they most certainly can get sued for things like medical malpractice, or anything else related to personal negligence. But because you have an LLP, the lawsuit could only target the individual partner who committed the alleged wrongdoing. To clarify, the plaintiff could not go after the other partners’ personal assets (cars, houses, etc.).
Let’s say your business has three partners, and one of them gets sued for an act of negligence. That partner could lose personal assets following the verdict but the other two could not.
Low Tax Bills
The tax code classifies LLPs as “pass-through entities.” Other examples of pass-through entities include LLCs and S-corporations. Their income only gets taxed when they do their income taxes during tax season.
C-corporations, on the other hand, face “double taxation.” First, the business’s entire income gets taxed, and then each owner’s dividend (their portion of the business’s income) gets taxed as well.
Owners of pass-through entities skip, or “pass through” that first tax. They just determine how much money they made, and that money gets taxed according to their income bracket.
Less Formal Procedures
LLPs have very few structural and financial requirements. Every LLP, for instance, can decide how they wish to distribute salaries for each partner. There’s no rule that says only certain types of partners can take home certain percentages of the business’s income. If one partner wants to change something related to management structure or income distribution, he or she can just ask the other partners to vote on the proposed change.
Even though you and your partners can structure your business any way you choose, you should still document each partner’s degree of ownership. This information belongs on your partnership agreement. We’ll go over how to draft your agreement later on.
Disadvantages of Limited Liability Partnerships
The biggest disadvantages of LLPs deal with eligibility, differences in protection from state-to-state, and the lack of formal processes:
Only Certain Businesses are Eligible
Only certain types of businesses can register as limited liability partnerships. But most businesses that don’t fulfill these stringent requirements would probably be better off choosing another business entity, anyway.
Each state has its own requirements for eligibility. Earlier, we mentioned that LLPs make the most sense for professional firms like architects, lawyers, accountants, or real estate agents. Well, in some states, like New York, California and Nevada, do not grant eligibility to any business aside from professional firms. It’s not so much the nature of these businesses but the fact that their owners need occupational licenses that makes them eligible.
Protection Varies From State to State
When we first defined an LLP in this guide, we referenced the definition used by most states. Some states, however, offer different forms or levels of protection. For example, while most states give LLPs protection from debts and obligations, others only offer protection against acts of negligence. In this case, you couldn’t get personally sued for malpractice but you could get personally sued for failing to pay back business partners, and creditors could seize your personal assets.
These differences can make it very complicated for LLPs to do business in multiple states. Some states don’t even recognize LLPs from other states, and might instead view them as general partnerships. You can just imagine the legal chaos that would ensue should an LLP owner from one state get personally sued in another state. For this reason, LLPs may have to consider “upgrading” to another entity before putting their expansion plans into action.
No Hierarchy = Power Struggles
Since LLPs don’t have single leaders or formal hierarchal structures, disagreements between partners can go on and on, wasting precious time in the process. General partnerships have multiple leaders as well but they usually don’t do as much business (or make as much money) as LLPs. In other words, general partnerships have less big decisions to make and therefore have less risk of partners getting into excessively long disagreements.
It’s crucial for owners of LLPs to get along and prioritize the business over their egos. If this sounds difficult (which it should), you might want to consider another business entity that leaves certain decisions in the hands of one person.
How to Form a Limited Liability Partnership
Since eligibility requirements vary from state to state, the same concept applies to the registration process. The following general steps, however, apply to all 50 states. So, once you get through these, you can move on to state-specific requirements:
Check Your Eligibility
You should not even consider forming an LLP without checking your state’s eligibility requirements. This business entity may very well have the strictest requirements of them all, so you can’t just assume that your business fits your state’s criteria. If you look at requirements online but still have some doubts, contact your state directly to obtain 100% certainty.
Choose Your LLP’s Name
Names of LLPs must meet two requirements: First, your name cannot closely resemble another business in your state. You can check your desired name’s availability by visiting your Secretary of State’s Office’s business database.
Second, your business’s name must end with “Limited Liability Partnership” or “LLP” (i.e. “Rizzoli and Isles, LLP”).
Choose Your Registered Agent
Your registered agent, or “resident agent” receives legal documents and other official mail on your LLP’s behalf. Business owners can get extremely busy, so much so that they misplace or forget to open important paperwork. The registered agent can handle these documents with little if any involvement from the business owner. You could even say that the registered agent exists primarily to prevent the business owner from claiming he or she was “too busy” to respond to legal notices.
If you reside in the same state as your business, you can name yourself (the business owner) as registered agent. But remember: appointing yourself would mean that in addition to your other day-to-day responsibilities, you would have to personally respond to virtually all important paperwork. If you don’t want this responsibility, you should give the job to your business attorney. You can change your registered agent as long as you inform the state of the new agent’s identity and home address.
Obtain the Required Licenses and Permits
Almost every type of business must obtain some sort of licenses and permits. Applying for the required documentation essentially represents your first major step towards legitimacy.
At the very least, you’ll need local and state business operating licenses, which allow your business to legally operate in your city and state. Then you have your sales tax permits, which allow you to collect, report and pay sales taxes on your products or services. If you’re not sure which licenses and permits your business requires, contact your city’s business license department and visit your state’s government website.
File Your Certificate of Limited Liability Partnership
As the name denotes, all registered business entities must register with their home states in order to do business. The following documents are essentially applications for the business’s legal status. Corporations have their articles of incorporation, LLCs have their articles of organization, and LLPs have their certificate of limited liability partnership.
Required information includes your business’s name, address, the names of each owner, and your registered agent’s address. The fee depends on your state, but you can expect to pay anywhere from $50 to $100.
Draft Your Partnership Agreement
Most states do not legally require LLPs to draft partnership agreements. But since partnerships have no rules for hierarchal structure, you need this document to clarify each owner’s responsibilities. Your partnership agreement will also explain the level of personal protection you have in your state.
Purchase Required Insurance Plans
In addition to state-required plans like workers compensation, you may have to purchase professional liability insurance, a.k.a. malpractice insurance. Professional liability insurance covers financial losses due to your business’s negligence or malpractice. Common policy holders include doctors, lawyers, real estate agents, accountants, and IT (Information Technology) professionals.
Some states also require doctors and lawyers to have professional liability insurance. But anyone who provides professional advice or services should consider this coverage. We all make mistakes, right?
Comply with Federal Regulations
All registered business entities must have an employer identification number (EIN). This number allows the IRS to tax your business as an LLC. There’s no charge, and you can complete the application on the IRS website in just a few minutes.
Should You Upgrade To An LLC?
The only real difference between LLPs and LLCs is ownership and management structure. In an LLP, all partners can manage the business together. LLCs can either manage the business in this same manner or choose what’s known as “manager management.”
In this structure, the owners hire or appoint specific people to manage the business. Manager management wouldn’t make sense for LLPs, since the whole point of being a “partner” is to help manage the business. And remember, most LLPs are firms (law firms, accounting firms, etc.). A lawyer wouldn’t start a partnership if he or she didn’t intend to practice law anymore.
What are Articles of Organization?
If you intend to form an LLC, you must file articles of organization to your home state’s business filing agency and pay the required fee. Usually just two to three pages in length, articles of organization include general information about your business.
What’s Included in the Articles of Organization
Each state has its own variation of the document with its own minor details. But regardless of your business’s location, you will need the following general information at the very least:
- Your LLC’s name
- Your LLC’s address
- Business purpose: The level of specificity for this section varies from state to state. You’ll probably just have to provide an overview of your products or services. Some states might ask for more detail, while others allow you to simply choose “for all legal purposes” as your description.
- Start date: It’s possible to have already begun selling your products or services even though you have not earned the status of an LLC. If so, contact your state’s business filing agency and explain the situation. Some businesses leave this section blank to denote that they will start doing business once the document is approved by the state.
- Name and address of the registered agent: This person or company must have an address in your business’s home state and be able to receive standard mail during normal business hours.
- Name and signature of the organizer: This refers to the individual responsible for filing the actual document. You can choose to hire someone to file or leave it up to one of the business owners.
Some states also have separate articles of organization for professional LLCs (LLCs owned by licensed professionals like doctors, lawyers, accountants, etc.) If your state does not have this separate form, you must specify this categorization somewhere in your articles of organization.
What to Do After Filing Your Articles of Organization
The legal journey of establishing an LLC technically ends after receiving approval for your articles of organization. Maintaining your status as an LLC, however, involves at least two more tasks.
LLCs must report their revenues and earnings annually to the IRS and pay an annual fee. This report states your LLC’s income, financial activities, and the names of the owners.
Aside from these annual obligations, the only other step (though it’s not legally required) is to draft your operating agreement. This is basically the LLC’s version of the aforementioned partnership agreement:
Draft Your Operating Agreement
This legal contract outlines the responsibilities of each owner along with the amount of money each owner has invested and the executive chain of command. You could even say that after their articles of organization, the operating agreement is an LLC’s most important document. For that reason, it’s recommended to draft the document with the help of your business lawyer. You should also go into significant detail when explaining the organization’s structure.
LLP vs LLC
There are very few general differences between LLPs and LLCs. But each state has its own legal requirements for both entities. In order to ascertain which entity would be best for your goals, check your state’s requirements and speak to your accountant. And don’t worry about devoting too much time to the decision-making process. The actual establishment of your entity won’t take long at all. For now, just focus on ensuring you are indeed making the right choice.