How you structure your company is vital from a legal and tax perspective. Many new entrepreneurs recognize the usual options, such as a C corporation, S corporation or limited liability company (LLC), but in some cases, certain partnership alternatives can prove more favorable.
Understanding limited partnerships
Limited partnerships (LPs) enjoyed popularity in the 1970s and 1980s―the heyday of tax shelters. Today, they are used mostly in special situations (e.g., films, short-lived projects, and family estate-planning) and have been eclipsed by LLCs. Here are some other key characteristics:
- LPs have at least one general partner who manages the business with full personal liability exposure; one or more limited partners (“silent investors”) have personal liability protection but don’t participate in business management.
- Limited partners are financially exposed only for the invested or committed-to-invest amount in the LP; limited partners are not liable for other partners’ actions or partnership debts.
- LPs are organized under state law, by filing formation documents with the state.
- LPs are required to have a partnership agreement and must publicly disclose their status by having the LP designation in the company name.
LP tax considerations
Tax-wise, an LP’s profits and losses are allocated to limited partners, according to the partnership agreement terms and the relative value of their financial contributions.
- The general partner typically receives a management fee, netted against partnership income.
- Limited partners receive a share only after the general partner has been fully compensated for services on behalf of the business.
- Limited partners are not subject to self-employment tax on their share of net earnings from the partnership: only the LP general partner bears this tax cost.
- LPs are used by some large, publicly-traded investment entities--called master limited partnerships. While they have the legal mantle of a limited partnership, they are taxed more like corporations. LPs can become limited liability limited partnerships (LLLPs), if allowed by the state, to give all partners personal liability protection with respect to debts of the partnership.
Understanding limited liability partnerships and professional limited liability companies
Limited liability partnerships (LLPs) are a relatively new form of business organization. They appeared in the 90s after LLCs became popular and were added to the federal partnership tax return as an entity type. LLPs are similar to LLCs, but with these differences:
- LLPs can only be used for certain types of professional practices (as dictated by state law), such as accountants, attorneys, physicians, architects, licensed masseurs/masseuses, and other disciplines limited to rendering professional services of the licensed owner-partners.
- LLPs can limit partner liability for everything but personal acts. For example, an LLP of attorneys can limit liability on a lawsuit arising from a third party, but not for personal malpractice.
- LLPs can shield innocent partners from malpractice by an offending partner. For example, if Partner B has a malpractice claim brought against him, the personal assets of Partner A wouldn’t be at risk, unless Partner A was supervising or directing the actions by Partner B that gave rise to the claim.
- LLPs represent a vast number of professional practices that formerly were operating as general partnerships. As new professional practices are formed, state law may require the business to become a professional limited liability company (PLLC), rather than an LLP.
- A PLLC can include one or more professionals (an LLP must have at least two partners), but the PLLC business type is not available in every state.
Forming an LLP
Forming an LLP is easy—simply create your new professional practice as an LLP or convert your existing professional partnership into an LLP:
- File a single form with the LLP’s state—some states also require legal notice of the new LLP published in newspapers.
- There must be two or more partners in order to become an LLP. A converting partnership retains its original partnership agreement, and the LLP is governed by state law on partnerships.
- New professional practices that want limited liability status may be required by state law to form as a professional limited liability company (PLLC).
LLP tax considerations
LLP partners are taxed on their share of LLP profits and losses. While the IRS has failed to definitively explain the extent to which partners are subject to self-employment tax, they are likely not exempt. While they have some limited liability protection, they owe self-employment on their share of LLP net earnings.
Professional corporations, an alternative to LLPs and PLLCs
Professionals, such as doctors and lawyers, also have the opportunity to form a professional corporation (PC) instead of an LLP or PLLC. If you plan to consider whether to form a PC, consider the following:
- In the past, qualified retirement plans for PCs offered more favorable terms than did other entities. Today the rules for qualified retirement plans have been standardized across entities.
- Partners can now borrow from their retirement accounts just as PC owners do.
- Like LLPs and PLLCs, PCs do not insulate an owner’s personal assets from malpractice claims. A partnership that is not engaged in a professional practice can opt to become a limited liability company (LLC).