When forming a new business, deciding what type of business entity to start is one of the first and most important legal decisions you’ll make. Partnerships are a popular option for businesses with multiple owners. That said, limited liability partnerships (LLPs) can be an especially good choice because they offer legal protections that ordinary partnerships don’t afford.
LLPs are particularly common among professional businesses, such as architecture, law, and accounting firms. Read on to learn more about how limited liability partnerships work and how to form a limited liability partnership as a small business owner.
A limited liability partnership is a business entity structure in which each partner is shielded from personal liability for the business’s debts and obligations. Partners can manage the company together but are protected from personal liability for the actions or negligence of other partners.
The best way to understand a limited liability partnership is to see how it compares to other types of partnerships. If your business is run by two or more people, and you don’t register with the state, by default you have a general partnership.
In a general partnership, all partners manage the business together and are equally liable. Every partner is fully, personally liable for the debts and obligations of the business and for the actions of every other partner. For instance, say Sandy and Jeff run a gardening partnership together. If Sandy damages a customer’s lawn, the customer could sue Sandy and Jeff and come after either’s personal assets.
That’s a lot of liability for every partner to shoulder, so many people opt for a limited liability partnership instead. In a limited liability partnership, partners are not personally liable for the debts and obligations of the business.
Partners in an LLP can certainly lose their investments if the business doesn’t do well, but the personal assets of each partner are safe from creditors. In order to form a limited liability partnership, however, you need to register your business with the state.
With this in mind, it’s important to understand that there’s one other variation on a partnership called a limited partnership. A limited partnership has two types of partners—general and limited. General partners are personally liable for the actions of other partners and for the partnership’s debts. Limited partners invest in the company and are only liable up to the amount of their investments. Limited partnerships are popular among family-owned businesses and real estate developers.
Let’s take a closer look at the biggest benefits of structuring your business as a limited liability partnership.
The main point of a limited liability partnership is to protect each partner from the potential mistakes of the others. There’s no single, general owner of the business—instead, each partner owns his or her share, and they distribute responsibilities accordingly. Your assets aren’t at stake if another partner gets sued for malpractice, for example.
Of course, that protection doesn’t extend to partnership assets, only to personal assets. Therefore, if there’s a lawsuit, then the partnership’s assets get targeted instead of those belonging to individual partners.
For example, if there’s a company called Bob, Bart, and Barry, LLP, the three owners are partners, but still distinct. So, if Barry gets sued for malpractice, or someone raises a claim of negligence against Bart, then Bob’s and Bart’s house and car are still in the clear.
The company might lose some money, and Barry could wind up personally liable for his breach of conduct, but Bob’s and Bart’s own assets remain separate from the business’s.
If you’re an owner of a C-corporation, your income gets double-taxed—once through the corporation and dividends get taxed again on your personal income tax return.
Partners of a limited liability partnership have a more desirable tax situation—their cash only gets taxed once, when they fill out their income taxes. Business income and profits pass through to each partner’s personal tax return. This is called a pass-through entity.
A limited liability partnership is easy to financially structure—and restructure. Partners can come and go, the business can grow and shrink, and even the way a partner’s salary is decided can vary. Should a partner get a percentage of the company’s profits? Of its gross revenue? From one stream, or multiple, or from across the board?
The best way to calculate these will change from business to business, but having the option to change your company’s structure fairly often without altering its business entity type can be a huge help. You can customize the way you want your LLP to be run by drafting a partnership agreement, which we’ll explain in more detail below.
Yes, a limited liability partnership is easy to structure—but it’s flexible in more ways than just finances. As we mentioned, partners can come and go—and carry with them their clients and employees.
Going back to the example of Bob, Bart, and Barry’s limited liability partnership: these three professionals decided to pool together their resources and share employees, as well as office space and supplies. They’re each saving money by working together and making extra by exposing themselves to each other’s profits. Their partnership also deals with a larger number and a wider range of customers, which promotes growth on a bigger scale.
Finally, the management structure of a limited liability partnership is just more streamlined than that of, say, a corporation. Rather than deferring to a board of directors or to stockholders, a limited liability partnership need only hold votes among its partners.
It’s not all positive, though: Limited liability partnerships come with disadvantages as well.
The biggest drawback of a limited liability partnership is that not everyone can register their business as one.
Unfortunately, that’s actually a very large negative. As it turns out, the rules behind who can form limited liability partnerships are quite narrow—though if you don’t fall into the select few eligible groups, then a limited liability partnership probably wouldn’t have been best for your business, anyway.
Limited liability partnerships are generally connected to firms of lawyers, accountants, architects, and similar profession types—and in fact, some states like New York, California, Oregon, and Nevada only allow certain professions to form limited liability partnerships, and no one else. This isn’t just a coincidence, though: These types of professions tend to make the most sense to form limited liability partnerships, whereas other businesses may not.
The laws regarding limited liability change from state to state—both in terms of what kinds of businesses can form a limited liability partnership and what that limited liability actually means vary across the country.
Some states are also stricter than others when it comes to partner liability. Most states recognize partners as protected from obligations in contracts, torts, and more—though some only allow protection against negligence claims—Tennessee and West Virginia are two examples of states where partners in a limited liability partnership are especially exposed.
Finally, all these complications pile on top of each other when a limited liability partnership wants to work across state lines. Some states with more restrictive laws don’t recognize limited liability partnerships from other states. Others will recognize them, but only if they conform to those states’ rules. In fact, one state might consider a company to be a general partnership instead of a limited liability partnership—which could cause a lot of legal headaches, especially if a partner’s liability is brought into question.
To sum up: not everyone can form a limited liability partnership, not all states define limited liability the same way, and not all states recognize the limited liability partnerships of other states.
So, your business qualifies to register as a limited liability partnership. What’s the drawback to actually practicing as one?
Some say that limited liability partnerships can potentially run less efficiently than other business entity types since there isn’t necessarily a single leader who makes the big decisions. All partners can legally act in a management capacity, which could lead to redundancies, conflicting directions, and wasted resources.
The way around this is simply to communicate clearly and often, but we know that’s easier said than done. If you focus on the partnership side of limited liability partnerships and recognize that inefficiency can and will have a tangible, negative impact on your business, then this downside shouldn’t be too hard to overcome.
Finally, limited liability partnerships often have to pay registration fees and franchise taxes. This drawback might be major or minor—it depends on your business. It also varies from state to state, as you might expect by now.
We’ll go into how exactly you register as a limited liability partnership later on, but for now, just know that you’ll need to pay a yearly registration fee to your secretary of state. This might be a flat rate or a per-partner charge.
You also may need to pay a franchise tax, which limited liability corporations also pay, depending on your state of business.
And, last but not least, some states require that limited liability partnerships maintain a sum of cash on hand as insurance against liability claims.
Owners in a limited liability partnership are not personally responsible for the debts of the business. This is also known as pass-through taxation, meaning the owners report their share of business income and losses on their personal tax returns. This way, they’ll pay their business taxes at their individual tax rate, as opposed to a corporate tax rate.
The reason for this type of taxation is because there are no corporate taxes for limited liability partnerships.
If you’re trying to decide between an LLC and an LLP, there are some key differences to understand.
The exact registration process to form a limited liability partnership varies from state to state. All states, though, will ask you to follow these general steps, so it can be helpful to review these before you get started with the process for your business:
Check out your state’s rules and regulations on limited liability partnerships to see whether your business is eligible or not. As we’ve mentioned, in many states, only business owners in professions that require a state license can establish an LLP.
The states of New York, California, Oregon, and Nevada have particularly narrow restrictions on what sorts of professional services a limited liability partnership can offer. You can refer to your secretary of state’s website for more information. Be sure you can qualify before you spend time applying.
Your business’s name needs to be distinct from the names of other businesses operating in your state—again, you can check your secretary of state office’s business database to make sure your name isn’t taken.
You’ll also need to add in “Limited Liability Partnership” or “LLP” to the end of your name, in order to indicate that you’re operating as such. For example, our old friends Bob, Bart, and Barry had no choice but to label their company “Bob, Bart, and Barry, LLP.”
A registered agent is a person or company that agrees to accept legal papers and other documents on your business’s behalf. You should carefully choose this person because they are responsible for notifying you of any pending lawsuits against your business.
Although you can choose a partner to be a registered agent, it’s usually better to choose a business attorney or registered agent service.
Make sure you’re up to date on your required business licenses and permits, depending on your type of business and the state you operate in. Some states, such as California, regulate businesses heavily, and most companies require a business license. Typically, your county or city’s business division is the best place to obtain more information.
The certificate of limited liability partnership legally allows your LLP to start operating. You must file this certificate with the state. This application usually requires your business’s name, address, the names and contact information for the partners, registered agent’s contact information, and other administrative details. You’ll face a minor filing fee of $50 to $100, as well.
After submitting the information, the state will process your filing and send you a stamped copy back to keep with your business records. Online legal services like LegalZoom, IncFile, and RocketLawyer can also help you register your business as a limited liability partnership.
A partnership agreement, which is optional in most states, but highly recommended, defines each partner’s responsibilities, their roles, and of course, their protected assets. The limited liability partnership agreement also lays out exactly what liability defenses each partner receives, and acts as insurance against personal asset seizing in case of a lawsuit or something similar.
Limited liability partnerships with employees might need to purchase workers compensation insurance on behalf of their team. Business owners in licensed professions might also need to buy malpractice insurance.
By now, you should have met the primary state obligations for formation. On an ongoing basis, you might have to pay an annual franchise tax in some states.
Also, it’s a good idea to open a business bank account and business credit card that you use exclusively for business purposes. This will help to preserve your limited liability protection.
In addition to your state’s requirements, the federal government also regulates business entities. For example, you’ll need to apply for your federal employer identification number (EIN) through the IRS. You might also have to pay federal payroll taxes if you employ workers.
Limited liability partnerships combine the flexibility for businesses with multiple owners, along with the legal protection for each owner’s personal assets.
If you’re entering into business with multiple owners, and especially if you’re in a licensed profession, you should seriously consider an LLP business structure. Following the steps outlined above should help you launch your LLP in no time.
Priyanka Prakash is a senior contributing writer at Fundera.
Priyanka specializes in small business finance, credit, law, and insurance, helping businesses owners navigate complicated concepts and decisions. Since earning her law degree from the University of Washington, Priyanka has spent half a decade writing on small business financial and legal concerns. Prior to joining Fundera, Priyanka was managing editor at a small business resource site and in-house counsel at a Y Combinator tech startup.