Pros and Cons of a Limited Liability Partnership
Like any type of business structure, a Limited Liability Partnership has its pros and cons.
- Personal Asset Protection
- Increased Growth Capacity
- Avoidance of Double Taxation
- Flexible Structure
- Pass-through Taxation
- Financial Disclosures
- Potential Inefficiency
- Extra fees and Paperwork
As the name implies, a limited liability partnership requires at least two members, though there can also be more. It’s a great vehicle for professionals such as attorneys, accountants, architects, and financial advisers to create structure for their client-facing, service-based activities.
LLPs in the United States are actually a recent innovation in the legal and business landscape. In the early 1990s, only a handful of states offered LLPs. By the end of the decade, 40 states offered them. Today the legal business structure is available in most every state, though it is crucial to know that the exact laws vary from state to state.
It was a real estate and oil crisis in Texas during the 80s that spurred the formation of LLPs. The collapse of prices led to loan and savings failures. The investments were not able to pay out the large amounts of assets requested by the damaged parties.
Investors attempted to recoup their losses from the individual lawyers who had advised the ventures. This would have led to a significant number personal and professional bankruptcy cases. LLP laws were passed to protect professionals from this type of liability.
What is a Limited Liability Partnership?
Understanding a limited liability partnership should begin by discussing a general partnership. A general partnership is an agreement between two or more parties. Though it may be formally drafted with a legal contract or informally created with a handshake, it is partly defined by the fact that these partners have created a for-profit entity through their mutual understanding.
The downside of a general partnership is that all the partners become liable for the actions of the others; leaving personal assets at stake. There is nothing separating the partners from the business, and nothing separating them from each other in terms of liability.
This is why many small businesses choose to set up their business as an LLC, or limited liability company. An LLC creates a separation between each individual and the business, thereby reducing each participant’s own liability.
However, some types of businesses, such as accounting, legal and financial planning firms, do not operate like a retail venture or restaurant. These professional, service-based businesses tend to operate with a number of equally qualified individuals working with their own clients. These individuals benefit by combining their practices, sharing an office and other professional resources between them to each grow their respective list of clients.
A limited liability partnership allows these businesses to create a legal structure in which their personal liability is reduced, while also retaining equal investment and responsibility in the business activities.
As a side note, there is another type of partnership called a limited partnership, which should not be confused with a limited liability partnership. In a limited partnership, one partner—referred to as the general partner—has all the decision-making power, while the other partners (referred to as limited partners) have a silent financial stake in the venture. This type of limited partnership is common with investments. For example, one investor might get together several other investors to contribute funds toward a project that they manage.
Pros and Cons of a Limited Liability Partnership
Pros of a Limited Liability Partnership
Personal Asset Protection
An LLP protects the partners from having their personal assets targeted in the event of a lawsuit against the LLP or its partners. It can also protect each and every partner from being held liable and responsible for the actions of the others—or in the exact words of the 1997 Revised Uniform Partnership Act (otherwise abbreviated as RUPA): “a partner is not personally liable, directly or indirectly, by way of contribution or otherwise, for such an obligation solely by reason of being or so acting as a partner.” This also can protect individual partners from the liability of business debts accrued by other members of the LLP, and in many cases, the LLP in general. The partners and the LLP are not the same legal entity.
However, as mentioned above, it is crucial to remember that LLP laws vary from state to state. In some states, this protection against liability only relates to a negligence claim. Breach of contract and intentional tort claims can result in partners being held liable for the actions of other partners in the LLP. In other words, one partner cannot be held responsible for the negligence of another, but they can be held responsible for violating contracts or intentional damage. It’s also important to remember that an LLP arrangement cannot protect a partner from liability in regards to their own professional negligence.
Increased Growth Capacity
As mentioned, each one of the partners in an LLP will often have their own set of clients. In theory, it’s likely that they could manage their own business—but by combining forces with similar professionals, they increase their capacity for growth. The partners can share resources such as office space, expensive software, marketing teams, and other business functions, freeing them up in terms of time and money to focus on doing what they do best.
Another benefit to the LLP structure is that junior partners can free up time for the senior partners by doing more detailed work. This allows senior partners to grow the business both in terms of finding new clients and expanding the scope of work for current clients. Oftentimes these junior partners often have no stake or liability in the partnership, but as they work under their fixed salaries and learn the ropes of the business, they may someday be made a full or senior partner.
An LLP offers professionals in a partnership more flexibility than a corporation or LLC. Partners can be added or removed from the LLP, though of course this process will need to follow the procedures outlined in the operating agreement. In most cases, the decision to add partners or forcibly remove them will require some discussion and approval from the existing partners, since they all have an equally vested say in the business.
This flexibility in terms of structure is often very desirable for businesses that specialize in highly specific services like law, accounting, financial planning, or architecture. In these businesses, partners can come and go (though not necessarily frequently), and junior partners have the opportunity to become senior partners. LLPs also allow for partners to easily switch firms or retire. This flexibility is oftentimes why professionals choose LLPs as an official business structure.
Avoidance of Double Taxation
One of the more frustrating parts of a corporate structure—at least for senior management and the majority owners—is the issue of double taxation. Though corporate tax laws have been changed in recent years to favor corporations with a flat 21 percent tax rate, a corporate entity is still subject to an accounting phenomenon known as double taxation. First the business itself is taxed, and then profits are passed on to shareholders and owners—who are then taxed on their personal earnings, revenue, and dividends (if applicable).
By contrast, an LLP (and for that matter an LLC as well) are each considered a pass-through tax entity. This means that the income of the business will be reported on every partner’s personal tax income return on the IRS Form 1065 Schedule K, and they will more than likely pay self-employment tax. This means that the earnings of the firm will only be taxed once, not twice. While that does seem beneficial, this same pass-through tax status can have some drawbacks, as we will see in the next section.
Cons of a Limited Liability Partnership
Limited Tax Strategies
Businesses that reach a certain threshold of revenue will find that pass-through taxation is a double-edged sword. On the one hand, it can help partners avoid having their profits doubly taxed. On the other hand, an LLP can result in some rigidity in terms of tax planning. For example, self-employment tax can vary based on income. For many individuals, it is more beneficial to be taxed at the rate of self-employment income instead of the 21 percent corporate tax. Other individuals may find that a corporate structure can actually lower their personal tax burden. Unfortunately, an LLP cannot benefit from these corporate tax strategies.
Additionally, in some states there are restrictions that prevent an LLP from leveraging tax strategies often used by businesses to reduce their tax burden. One of these strategies involves reallocating profits back into the business and writing them off as an expense for tax purposes or saving them for the following year. The profits of an LLP must be distributed year by year. The issues around this topic are complex and vary state by state, so it’s important to speak with a qualified lawyer or tax strategist to figure out the best plan for your partnership.
Some professionals find that the public disclosure requirements of an LLP are its main disadvantage. In some locations, an LLP will be required to submit financial records of their business activity (such as a balance sheet and a profit and loss statement), and members might be required to provide a personal address as part of the filing process, which could end up as publicly accessible information.
While this might not bother partners in some types of businesses, partners in other lines of work, such as the legal defense field, might feel that their personal address being publicly accessible poses a danger to themselves and/or their family, especially in high-profile or sensitive cases. Even the public accessibility of financial records can be a source of embarrassment or weaken a negotiating position in terms of dealing with clients or finding work at a new partnership.
Some partners who may have other investment activities outside of their legal services (as one example) may find that the public record of the income they report on their tax returns can pose a challenge when trying to network and find investors for a project.
By definition, an LLP requires two members. If it so happens that a firm only has two partners and one of those partners decides to leave, the LLP must dissolve. This would trigger some legal and tax restructuring of the business, in addition to other ancillary expenses such as needing to rebrand marketing materials and letterheads. This can add a degree of fragility to the arrangement, which is best mitigated by partnering with reliable individuals who are committed to the business.
Additionally, in some cases partners may not need to consult the other partners in the firm regarding business decisions. This in turn has the potential to jeopardize all the members of the partnership. An example would be if a partner decides to start working with a client who is destructive or hard to work with. Aside from potentially negative experiences with clients, other decisions that could impact the other partners might relate to business concerns, such as the office space and management of outside contractor. To mitigate these issues, it is best for the partners to create a binding operating agreement.
Extra Fees and Paperwork
In most cases, your state will likely require business partners within an LLP to pay franchise taxes, and of course a filing fee when they send in the paperwork. Thankfully only around half the states in the US actually charge franchise taxes, but it is an important consideration for a business entity to consider. Business types and profits/losses are immaterial in terms of franchise taxes—rather, they are based on the net worth of the company being charged, whether they’re a fast food restaurant, accounting firm, or a law firm specializing in personal injury.
Of course, avoiding extra fees and paperwork will not help general partners in the long run. As long as they avoid creating a separate legal entity, they are exposing themselves to risk. Moreover, many states will require that an LLP be formed for certain types of companies, such as firms that offer professional services. While an LLC might help busiensses avoid these franchise taxes, the state(s) in which they practice will most likely require an LLP, specifically.
How to Set Up an LLP
Now that we’ve covered the pros and cons of an LLP, let’s examine the process of setting one up.
Though the exact ins and outs will vary state by state, by and large the general process is the same. You will first need to see if your business is eligible for an LLP business structure. As mentioned, most states offer an LLP arrangement to partners engaged in specific types of professional services, such as legal representation, accounting, architectural design, and financial planning. While some states have fewer restrictions on what types of businesses qualify, states like New York, California, Oregon, and Nevada have particularly narrow definitions.
Next you will need to select a name for your LLP, though this is usually done just by using the last names of the senior partners and adding LLP at the very end. You can check with your local secretary of state to see if the name in question is already taken. You will also want to find a designated agent who will accept legal documents on behalf of your LLP. In some cases, your LLP will be able to handle this task on its own (for example, if it is a legal LLP). However, even legal firms might want to appoint a business attorney as the designated agent of an LLP, especially if they focus on other areas of law.
In many jurisdictions, you will need to apply for a business license. This usually occurs at the county or city level, so check with your local government or small business administration to see what the requirements are, along with any filing fees that may be required. Before your LLP can start business, you’ll need to file a certificate of limited liability partnership with your state. The application for this certificate will usually cost around $100 to $150 and require you to submit the name of your LLP, names of the partners and their contact information, the registered agent’s contact information, and other details.
Once those steps have been accomplished, it’s time to put some serious work into a limited liability partnership agreement, which will spell out the roles and responsibilities of the partners, along with operating procedures in the LLP. This agreement will also spell out what types of liability protection are offered by the LLC. Of course, drafting a business partnership agreement is a complex process and best done by a competent lawyer of a legal firm. This helps ensure that every issue is anticipated and addressed in a contractually binding and guiding way and helps protect the LLP.
LLPs Protect Professional Liability
In many states, an LLP is not a question, but a requirement. An individual rendering their services is free to act under the structure of a sole proprietorship, though that can leave them open to legal and financial risk. For this reason, many individuals who start a business, whatever that business may be, wisely choose to form a limited liability company (LLC). Some individuals who expect larger revenues from their self-run company may even form a corporation and put themselves on a payroll for tax purposes.
Professional in specific fields, generally in the vertical of professional services requiring accreditation or licensure, will need to form an LLP if they decide to team up with similar professionals as general partners to create a separate entity for their company or firm. Like a sole proprietorship, they too (in many cases) could remain as general partners, but this would leave them very open to risk, especially vis-a-vis the performance, business debts, and actions of other partners in the firm. To that end, general partners operating in a professional context together will almost always want to opt for the creation of an LLP.
As mentioned in the introduction, LLPs were created in many states to facilitate the protection of individual professionals in terms of minimizing their personal liability. Accountants, lawyers, financial advisers, and architects tend to engage in work that can affect a large number of people beyond the scope of their professional life, and their decisions can have large-scale effects on a greater economic situation or the health of a business that uses their services.
To that end, it would be possible for one innocent (or even a negligent or faulty) individual to shoulder an impossibly large burden of court-imposed damages. The LLP protects these practicing individuals from having their personal assets targeted. With that threat mitigated, these professionals are free to engage in offering their professional services without fear of repercussion.
Moreover, the structure of an LLP makes it more possible for multiple professionals to enter into a partnership and retain an equal measure of investment in and control of the business. Where it is an option for such professionals to form an LLC or Corporation, in terms of considering an LLP vs LLC, the LLP structure is ideal for businesses in the aforementioned industries where each partner likely has their own roster of clients. By pooling resources with partners and passing on menial tasks to junior partners, these professionals are able to focus on their services and expand their business. Forming an LLP is a win-win for securing personal, professional, and financial security while partnering up to grow your practice.
If you have any questions about LLPs, or are interested in learning if this entity makes sense for your individual situation and goals, schedule a complimentary Strategy Session today. On the call, you and a Senior Advisor will go over the best entity structure for your current and future investing and business. There’s no cost and no obligation, just high-quality guidance from an experienced professional. You can schedule online or by calling 888.871.8535.
3 Steps to Create an Invisible Investor Strategy
The greatest mistake that people make when it comes to asset protection for real estate is not understanding the risks that are waiting out there for them. This eBook reveals the structure you should follow to ensure your hard earned money is protected from frivolous lawsuits and costly tax mistakes.