Partnerships and multimember limited liability companies (LLCs) are two popular business types for operating a business with multiple owners. While a partnership is easier and less expensive to form, an LLC offers liability protection and has flexibility in choosing how to be taxed:
- A partnership is the default tax classification for any business with two or more owners. While certainly recommended, a formal partnership agreement is not required.
- A multimember LLC is a limited liability company with more than one owner. By default, multimember LLCs are taxed identically to partnerships but have the option to be taxed as an S corporation (S-corp) instead. Even if treated as a partnership for taxes, an LLC provides its owners more liability protection than partnerships.
Advantages of an LLC vs Partnership | Advantages of a Partnership vs LLC |
|---|---|
|
|
Taxation of Multimember LLC vs Partnership
By default, multimember LLCs and partnerships are taxed identically. Both are required to file annual tax returns by filling out Form 1065 and filing it. The allocation of income and deductions are reported to owners on Schedule K-1, which the owners then use to report the business activity on their individual tax returns.
Partnerships and LLCs (without a special election) also share the following tax characteristics:
- Business income is subject to both income tax and self-employment tax on the owner’s individual income tax return.
- Since business losses flow to the owner’s individual tax return, they can be used to offset other sources of income like wages and investment income.
- Liquidation of the business by transferring noncash assets to the owners is generally not a taxable event.
LLCs Electing S-corp Status
The big difference between partnerships vs LLCs for taxation is that LLCs have the option of electing to be treated as an S-corp by filling out Form 2553 and filing it. For a partnership to be treated as an S-corp, they first have to reorganize as an LLC or corporation.
Let’s look at the tax differences between a multimember LLC with an S-election and a partnership.
Multimember LLC With an S-election | Partnership | |
|---|---|---|
Form Filed | Form 1120-S | Form 1065 |
Net Income | Not subject to self-employment tax | Subject to self-employment tax |
Income & Deductions | Must be allocated to owners based on ownership percentage | Can be allocated to partners in any way agreed upon by the partners |
Payment to Owners | Owners receive wages for services performed and must have payroll taxes withheld | Owners receive guaranteed payments for services performed, which are subject to self-employment tax |
Liquidation of Noncash Assets | Treated as the sale of an owner’s interest in the business—usually resulting in taxable gain or loss | Generally does not result in any gain or loss |
Liability Protection of General Partnership vs LLC
A primary reason for forming an LLC instead of a general partnership is liability protection.
- Partners in a general partnership are personally liable for all the debts of the partnership and all the actions of the other partners and their employees.
- An owner of an LLC is usually only liable for their investment in the company. This is true even if the LLC is treated as a partnership for tax purposes.
You can be found personally liable for debts of your LLC if you don’t treat the LLC as separate from your personal finances. It is vital that the funds of the company not be commingled with your personal funds, and if you need guidance in this area, then read our article on how to separate business and personal finances.
Additionally, it is important that customers and vendors are aware they are doing business with an LLC and not you personally. So, you should include LLC anywhere your business name appears like emails, invoices, and business cards.
When To Form a Multimember LLC vs Partnership
When deciding to form a general partnership vs an LLC, the primary considerations are the ease of forming and operating a partnership compared to the tax flexibility and liability protection of an LLC.
Multimember LLC | Partnership | |
|---|---|---|
Ideal for | High-risk industries like construction | Professional services like lawyers and accountants |
Has Employees | ✓ | ✕ |
Income Earned From | Efforts of employees and use of equipment | Partners, in general |
Generally, you should form an LLC if you are concerned about being held liable for the actions of others. Your potential liability increases when you have employees or operate in a high-risk industry. The other major factor is self-employment tax, and an LLC can save you taxes since the business income in excess of your salary is not subject self-employment tax for an LLC with an S-election, but it is in a partnership.
How To Form a Multimember LLC vs Partnership
A partnership is easier to form than an LLC because there are no formal requirements to start a partnership. On the other hand, LLCs must be formed under the laws in the state for which they are operating.
Bottom Line
Most businesses should consider spending the extra time and money to form an LLC instead of a general partnership because of the liability protection and the ability to elect taxation as an S-corp. However, if your business doesn’t plan on having employees and you’re not in a risky industry, then a partnership might work fine.
