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 |
|---|---|
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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.
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.
To form a multimember LLC, you typically need to follow these steps:
- Step 1: Choose a registered agent. A registered agent is a person or business entity authorized to receive legal documents and official communications on behalf of your LLC. You may hire a professional registered agent service or appoint an individual in your company as the registered agent.
- Step 2: File the articles of organization. The articles of organization is a legal document that establishes your LLC with the state and typically includes basic information, such as the LLC name, business purpose, registered agent, management structure, and other details. It may also include details like management structure, duration of the LLC, and specific provisions related to the multi-member nature of the LLC.
- Step 3: Draft an operating agreement. While not always legally required, an operating agreement is a recommended legal document that outlines how the LLC will be managed, operational procedures, such as how decisions will be made, and provisions for profit sharing, distribution of assets upon dissolution of the LLC, and more.
- Step 4: Get an employer identification number (EIN). An EIN is a federal tax identification number that enables your LLC to hire employees, open bank accounts, and obtain credit. See our step-by-step guide on how to apply for an EIN.
If you want help forming your LLC, learn how to form your LLC with LegalZoom.
There are no formal requirements to start a partnership. If you are operating a business while splitting profits and losses with another taxpayer, you are already operating a partnership for tax purposes. However, we strongly recommend taking the following steps before operating your partnership to avoid future problems:
- Step 1: Create a partnership agreement: We highly recommend having a partnership agreement. This agreement sets out the rights, responsibilities, profit-sharing arrangements, decision-making processes, contributions, and exit strategies among partners. It is essential for managing expectations and addressing potential conflicts in the future. Our guide on how to create a business partnership agreement contains a free downloadable template.
- Step 2: Register your partnership: Research the local laws to determine if you need to register your partnership with your city or state. Some states may require registration with the Secretary of State or a similar agency. Registering your partnership ensures its legal recognition and protects your rights and obligations as partners.
- Step 3: Obtain an EIN: As with an LLC, your partnership will need an EIN to file tax returns, open checking accounts, and do many other business activities. Learn how to get an EIN.
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.
