Each Friday, I ask my Twitter followers to send me their legal question via private message or email.  I choose one question to respond to anonymously each week.  Below is last week’s chosen question:

“I am starting a business with three friends to develop a video game.  We are confused about the difference between a limited liability company and a partnership.  Can you help us out?”

There are a number of important distinctions between a partnership and a limited liability company (“LLC”).  You should discuss the details of your business’s goals with an attorney, but the following will give you an idea of the main advantages and disadvantages of each type of business.

Liability

The defining characteristic that distinguishes a partnership from an LLC is the LLC members’ limited liability. A partnership is a business operating under its owners’ names (although a trade name might be used).  The partners are personally responsible for the debts of the business. That means they could lose their personal assets, such as a home, car or certain investments to satisfy the partnership’s debts.  Also, if the partnership owns assets, such as a building or vehicles, the individual partners also personally own those assets in proportion to each partner’s contribution to the business, or as arranged in a partnership agreement. If no agreement exist, the statutes dealing with partnerships will apply standard rules.

An LLC, however, is an independent legal entity and owns property, enters contracts, and loans or borrows money separately from the individual members. The members will generally not be liable for the LLC’s debts or obligations. It acts as a “corporate person” and all traditional duties of a business are carried out in the name of the LLC only.  Members must be careful not to “commingle” their personal assets with that of the LLC, or a court might determine that the LLC is merely a “shell” for the members’ personal use and find the members liable for obligations of the business.

Forming the business

Partnerships are formed as soon as two or more individuals begin doing business.  No formal filing is necessary to “start” the business.  However, it is always advisable that a partnership agreement is in place to outline the contributions, distributions, and responsibilities as they relate to each partner.  Further, a business license or fictitious name registration may be appropriate.

An LLC can be owned by one or more people, known as “members.” An LLC is generally created by registering with the state of formation, as well as any states where it is conducting business. Paying a fee is required, although this fee is generally quite low.  An LLC should always have an operating agreement, even if it has only one member, to lend legitimacy to its corporate status. Read more about this HERE

Management

Generally, in a partnership, the partners are responsible for managing the day-to-day business of the company, and each person’s duties should be described in as much detail as possible in the partnership agreement.  Absent an agreement otherwise, all partners have an equal voice in management of the business.  If there are many partners, or regular decision making is required, the partners may distribute management responsibilities by agreement. However, due to the shared liability of partners, each partner may want to retain some control over the business.

LLC members may chose to manage the LLC like partners would, or they can hire non-members to manage daily operations. Members of an LLC can be other businesses, such as a partnership, corporation, or LLC. Also, foreign individuals and businesses can be members of an LLC.   Of course, a non-member manager should be trusted and sufficiently supervised by the members at all times. Regardless of the management style, the most important thing for an LLC is the operating agreement, as it will determine the duties of each member or manager.

Taxes

For tax purposes, a partnership is a “disregarded entity” which means that each member reports business income on their personal tax returns in proportion to their ownership of the business. That avoids what is sometimes referred to as the “double taxation” encountered with corporations – for example, where a corporation is taxed at the corporate level and its shareholders are again taxed on their earnings.  In some instances, members of a partnership may wish to avoid personal income, so the partners should carefully consider tax consequences when forming a partnership.

The LLC generally gives the most flexibility for taxation because the business can elect to be treated in the manner most beneficial for it and its members.  An LLC may elect taxation as a corporation, partnership, or sole proprietorship.

This is just the tip of the iceberg with respect to taxation.  You should speak with a qualified attorney and/or accountant to discuss all of the possible tax consequences.