In my last column, which explored sole proprietorships and general partnerships, I tried to demonstrate that in some cases, the law can be your friend. These are the two easiest business models to form, the ones often begun without any legal complexities. But the ease of formation also means that, along with no legal requirements to form the business, you also get zero legal protection.
Here, I’ll discuss limited partnerships (LPs) and limited liability companies (LLCs), the advantages and disadvantages of both types of business structures, and whether or not they are appropriate fits for consultants.
Limited partnerships: Safe, but not smart
A limited partnership is a safe bet, at least for the limited partners. There’s still a general partner on the hook for everything unless the terms state otherwise. This is fair because only the general partner gets to make business decisions. The liabilities and responsibilities of each limited partner must be carefully spelled out and the document executed legally.
You must also file a 1065 Schedule K-1 form with the Internal Revenue Service, which lets the IRS know how much of the LP's income or losses should be reported by each partner.
But a limited partnership also requires a general partner who’s accountable for everything that doesn’t fall under the responsibilities of the other partners. The general partner's liabilities are limited by some complex legal language, but it's important to remember that any tiny mistake in all the agreements can invalidate the partnership.
The major disadvantage of being a limited partner under this business structure is that you can't participate in the management of the business—that's completely in the hands of the general partner, which is also one of his or her major protections in an LP.
A special case of the LP is the family limited partnership (FLP). As you may suspect from the name, every partner is a member of the same family under this scenario. If you have or anticipate having a big estate, then an FLP may make sense for you, but this isn't generally a good business structure for a consultancy. It’s more appropriate for a business that has, or probably will have, a lot of assets, such as farmland, buildings, or a large stock portfolio.
In general, a limited partnership has few advantages for a consulting business. Like a corporation, an LP requires a lot of legal paperwork and must be approved by the government. If you don't do everything just right, your LP may be disallowed. The mere approval of an LP's legal structure, however, doesn't guarantee that it was set up in the best way to benefit the limited partners.
LLCs miss out on tax advantages
The limited liability company (LLC) is a hybrid of the limited partnership and a corporation. Like many hybrids, LLCs are showing strong initial growth, but it's important to remember that mules are also a hybrid. While there are some benefits, I believe an LLC is a loser for most people.
One major advantage of an LLC is that the members can be part of the management of the business. Like the limited partners in an LP, LLC owners have their assets protected to the extent that only those monies and assets they invested in the LLC are at risk under normal circumstances. And depending on the precise laws in your state, it may cost less to start and maintain an LLC. If you don't need the tax breaks of a true corporate structure, then an LLC may be a good idea.
But consultants would be unwise to operate an LLC if they are in business alone. Individuals can form an LLC in many but not all states, but the IRS doesn't recognize a single-member LLC. Thus, a single-member LLC gets the asset protection of a corporation but none of the tax advantages.
Another major problem with the LLC structure is that it’s new. When it comes to the law, the most important thing is precedent. Most judges will follow precedents rather than do what they call "making new law" by going against earlier judges' interpretations of the law.
All the other business forms mentioned have centuries of precedents defining just how they must operate. LLCs are new, and it's sometimes difficult to predict just what will happen when a legal question concerning an LLC goes before a judge. That alone makes an LLC risky in my opinion, especially when a corporation is often a better choice.
If you have a question or suggestion for John McCormick, e-mail him at email@example.com. If you have a general comment, e-mail TechRepublic.