What a difference an “L” can make when it comes to setting up your business. How you structure your company is vital from a legal and tax perspective. Most new entrepreneurs know the usual entity options: sole proprietorship, partnership, limited liability company (LLC), S corporation and C corporation. But there are other alternatives that may be suitable for a particular situation. Understanding what these entities are and when they can and should be used can help owners make an informed decision about entity selection.

LPs
No, LPs in a business context are not long-playing vinyl records. LPs, which stand for limited partnerships, are a type of entity that was highly popular in the 1970s and 1980s, the heyday of tax shelters. Today they can be used for just about any commercial activity, but have largely been eclipsed by limited liability companies and newly-formed LPs are usually used only in special situations (e.g., films and other short-lived projects, as well as for family estate planning). There are only about 400,000 limited partnerships in the U.S. today, in contrast to about 1.2 million LLCs.

LPs are entities in which there is at least one general partner (with full personal liability exposure) and one or more limited partners, with personal liability protection. The general partner manages the business; limited partners are “silent investors,” putting up capital and, hopefully, reaping financial rewards. A limited partner cannot participate in the management or control of the business. A limited partner’s financial exposure is the amount he or she invests (the capital account), or has committed to invest, in the LP…nothing more. A limited partner is not liable for the debts and obligations of the partnership or of other partners.

LPs are organized under state law, which is accomplished by filing certain documents with the state. LPs are required to have a partnership agreement. Also, LPs must disclose their status to the public by including the LP designation in the company name.

Tax wise, a limited partnership’s profits and losses are allocated to limited partners according to the terms of the partnership agreement. In the absence of any special allocations, limited partners are allocated profits and losses according to the relative value of their capital contributions. Typically, the business pays the general partner a management fee that is netted against partnership income, so limited partners receive only a share after the general partner has been fully compensated for services on behalf of the business, where applicable.

Limited partners, like other taxpayers, can only deduct losses passed through to them from the partnership to the extent allowed by the tax law. Certain limitations can prevent a current deduction for their share of losses:

• Passive activity loss (PAL) rules. Individuals who own passive activities, which are all rental real estate as well as other businesses in which they do not materially participate, can only deduct losses to the extent of passive activity income (from the LP and/or other passive activities). Since limited partners, by definition, cannot participate (they are barred because of their status from working for the business), they do not materially participate, so any investments are treated as being in passive activities. Losses that cannot be claimed currently because of the PAL rules can be carried forward and used when there is passive income to offset it, or when the interest in the passive activity is sold or otherwise disposed of.
• At-risk rules. Even if there is passive activity income to offset passive losses from the LP, losses can only be claimed to the extent the limited partner’s investments are at risk. These rules are designed to prevent an investor from claiming write-offs even though there is little or no cash invested and no personal liability for debts. “At risk” means that the LP’s money must be at stake; nonrecourse financing cannot be included as part of the LP’s basis for purposes of determining the extent of losses that can be claimed currently. Losses disallowed under the at-risk rules can be carried forward indefinitely and used when at-risk amounts increase.

Limited partners are not subject to self-employment tax (which is Social Security and Medicare taxes) on their share of net earnings from the partnership. Only the general partner in an LP bears this tax cost on his or her share of net earnings from the business (assuming the general partner is an individual and not a corporation).

Note: In many states, LPs can become limited liability limited partnerships (LLLPs) to give all partners, not just the limited partners, personal liability protection with respect to debts of the partnership.

LLPs
Limited liability partnerships (LLPs) are a relatively new form of business organization. They appeared on the scene in the 1990s after the popularity of limited liability companies really took off (they were added to the federal partnership tax return as an entity type in 1998). LLPs are similar in concept to LLCs, but with these differences:

• Type of business. LLPs can only be used for certain types of professional practices (state law delineates the professions). Generally, LLPs are used for the practices of accountants, attorneys, physicians, dentists, architects, veterinarians, licensed masseurs/masseuses, and another other disciplines treated as professions under state law. The business must be limited to rendering professional services of the licensed owner-partners.
• Personal liability. LLPs can limit the liability of partners for all things other than personal acts. For example, an LLP comprised of attorneys can limit the liability of the partners on a lease of the LLP or a lawsuit arising from a third party being injured on the premises. It cannot limit the liability of attorneys for their personal malpractice in the practice of law. Important: Depending on the circumstances and state law, an LLP can shield innocent partners from the consequences of malpractice by an offending partner. A partner’s personal assets are generally at stake in a malpractice action against another partner if the partner was supervising or directing the actions that gave rise to the action.

Formation of an LLP is simple. It essentially is the conversion of an existing professional partnership into an LLP. The transformation is accomplished by filing of a single form with the LLP’s state. (Some states require that legal notice of the new LLP be published in the newspapers.)

There must be two or more partners in order to become an LLP. A converting partnership retains its original partnership agreement. The LLP is governed by state law on partnerships. For new professional practices that want limited liability status, they must form a professional limited liability company (PLLC), as explained later.

Tax wise, partners of LLPs are taxed on their share of LLP profits and losses. Usual partnership tax rules govern this treatment.

While the IRS has failed to definitively explain the extent to which partners are subject to self-employment tax, it is probably true that they are not exempt. Even though they have some limited liability protection, as do limited partners in LPs, they are not treated as limited partners for self-employment tax and, instead, owe this tax on their share of net earnings from the LLP.

Choosing the right entity form
Today, the LP has largely been displaced by the limited liability company as the vehicle of choice for most businesses that want to protect owners from personal liability exposure. LPs continue to be used by a handful of large, publicly-traded investment entities--they are called master limited partnerships. While they have the legal mantle of a limited partnership, they are taxed more like corporations. LPs also continue to be used by families setting up family limited partnerships for estate planning purposes and in other situations described earlier.

LLPs, however, continue to flourish, representing the vast number of professional practices that formally had been general partnerships. As new professional practices are formed, state law may require the business to become a professional limited liability company (PLLC), rather than an LLP. A PLLC can be comprised of one or more professionals (an LLP must have at least two partners). The PLLC option is not available in every state.

Note: An alternative for professionals to LLPs and PLLCs: These practices can opt to become professional corporations (PCs). (In some states, PCs are denoted as SCs--service corporations, or PAs--professional associations.) In the past, PCs were used by some professionals as a way to maximize their retirement savings because qualified retirement plans for PCs offered more favorable terms than for other types of entities used by professionals. Today, however, the rules for qualified retirement plans have been standardized for all types of entities. For example, today partners can borrow from their retirement accounts in the same way in which only owners of PCs had been permitted to do in the past. Like LLPs and PLLCs, PCs do not insulate the owner’s personal assets from malpractice claims.

A partnership that is not engaged in a professional practice can opt to become a limited liability company (LLC). Conversion of a partnership to an LLC is not a taxable event and the new LLC is essentially the same entity as the old partnership before the conversion.

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