Sole Proprietorship to S-Corp: Choosing What Works for You – Partnerships (Part 2)

In last month’s inaugural Carlson Dash Digest, we began this three-part series with the purpose of helping you determine which entity will work best for the formation of your business by describing some of the requirements for formation, certain tax[1] and liability consequences, and some general pros and cons of each form.   Last month, we explored some of the benefits and detriments of forming and operating your business as a sole proprietorship.  This month, we discuss various partnerships, which may be a better option for you if “more is merrier.”

Partnerships

In Illinois, partnerships are governed by the Illinois Uniform Partnership Act (“UPA”), 805 ILCS 206, et seq., which provides default rules for partnerships absent a specific partnership agreement. Multi-person small businesses often prefer the partnership form as opposed to a Limited Liability Corporation or other corporate forms because partnerships are easier to form, and provide pass-through tax characteristics.

The General Partnership

The General Partnership is the most flexible form of partnership.  In fact, in order to form a general partnership, two or more people simply need to work together to carry on a business for profit.  Though general partnerships often operate under a partnership agreement, it is not a requirement that a partnership agreement be filed with the state, or even that a partnership agreement is in writing.

How is a general partnership managed?  Typically, the general partners are all responsible for the business, and share the assets, liabilities, and profits within the partnership in accordance with the percentage of ownership.  Usually, each partner has equal input into the management of the partnership.  However, under the UPA, a partnership may utilize a statement of partnership authority setting forth the authority of a particular partner to enter into transactions on behalf of a partnership, including those authorized to transfer real property in the name of the partnership.

The IRS and the Illinois Department of Revenue treat general partnerships as “pass-through” entities.  Therefore, the business itself is not taxed.  Instead, the business’s profits or losses are taxed to its individual partners.

Ease of formation and ownership are upsides to a general partnership, but there are downsides.  Though, unlike a sole proprietorship, a general partnership is a separate entity from its general partners, like a sole proprietorship, a general partnership does not shield the partners from any liability.  Each partner is personally liable for the debts of the partnership.  In addition, all partners are jointly and severally liable for the wrongful acts of any other partner.

Another characteristic that makes a general partnership not so desirable is that general partnerships are limited to a small number of owners.  Therefore, if your business has hundreds of owners (or you expect it to), a general partnership is not the best choice.  In addition, disputes between two partners that are equal owners can bring the business to a standstill.  If some partners do not want to remain individually liable, or your business grows too large for the personal liability of a general partnership to be practical, a Limited Liability Partnership may be a better choice for you.

The Limited Liability Partnership

The Limited Liability Partnership, or “LLP,” is, as compared to a general partnership or limited partnership, a “newer” entity in Illinois.  In order to form an LLP, a general partnership must be formed; a Federal EIN obtained; and then a “Statement of Qualification” must be filed with the Secretary of State.

With regard to management, LLPs are as flexible as general partnerships, and, like general partnerships, can be structured in a way that benefits your business through drafting of the partnership agreement.

And, like general partnerships, LLPs are treated by the IRS and Illinois Department of Revenue as “pass-through” entities for tax purposes.  Therefore, only each partner’s individual shares of the business’s profits or losses are taxed.

Is the liability exposure/risk any better with an LLP?  In fact, it is, in some cases.  What makes LLPs so attractive, as compared to general partnerships, is that partners are not individually liable on the debts of the partnership.  The only personal liability that can be assumed in an LLP is for the respective acts or omissions of each of the individual partners themselves, which may explain why LLPs are relatively popular in Illinois.

The Limited Partnership

Limited Partnerships, or “LPs,” are “older” business entities that lost some of their popularity when LLPs became an option in Illinois.  The likely reason?  While there is limited liability for the limited partners in an LP, there is unlimited liability for the general partner, who is in charge of managing the business.  The limited partners typically do not participate in managing the business. In fact, historically, the limited partners would also subject themselves to unlimited liability if they participated in the management of the business.  However, Illinois has adopted the Revised Uniform Limited Partnership Act (“RULPA”), 805 ILCS 210, et seq., which allows the limited partners in an LP to participate in the management of the business without subjecting themselves to unlimited liability.

For tax purposes, LPs are typically treated like general partnerships and LLPs, meaning profits are “passed through” to the partners, who report the income on their personal tax returns.  In addition, the IRS does not require self-employment taxes to be paid on distributions to limited partners, as long as they do not participate in the management of the business.

Why form an LP?  LPs are attractive to passive investors because of the limited liability that goes along with being a limited partner.  It can be easier to market limited partner interests as an investment.  In addition, general partners can raise money without the concern of outside investors managing the business. Finally, unlike a corporation, which allows a shareholder’s stock to be confiscated in a personal lawsuit, an LP has provisions that protect a partner’s interests from being taken away if that partner is sued personally.

We’ve reviewed sole proprietorships and partnerships, but what about corporations?  Next month, we’ll look at the pros and cons of C Corporations, S Corporations, and Limited Liability Companies.  We welcome you to join us.

[1] The tax information provided herein is general in nature and not intended to be a substitute for advice from a provider of your choice with regard to your own tax situation.

This document is intended for informational purposes only and is not legal advice or a substitute for consultation with a licensed legal professional in a particular case or circumstance.

If you need assistance with a related matter, contact us.