Partnerships and limited companies have some elements in common: Neither is incorporated, and both can have multiple owners. But there also are key distinctions, the biggest of which relates to how much personal responsibility the owners bear for the debts of the company. Other differences arise in ownership structure and taxation.
By definition, a partnership is an unincorporated company owned by two or more people. The owners are called partners. Each partner's share of ownership is spelled out in a partnership agreement. Depending on where the business operates, a partnership may be required to register with the state.
Limited companies are formed under state law. Different states have different requirements, but in general, a limited company can be owned by a single person, by multiple people or even by multiple corporations and other limited companies. Owners are called members, and their ownership interest is described in a document called the articles of organization. States usually authorize multiple kinds of limited companies, depending on what the firm does. These include limited liability companies and limited liability partnerships.
Responsibility for Business Debts
The most important distinction between partnerships and limited companies has to do with who ultimately is responsible for the debts of the business. In a partnership, at least one of the owners is personally liable for those debts. That means that if the business can't pay its debts, the creditors can try to get their money back by suing an owner or trying to seize the owner's personal assets, such as homes, cars and bank accounts.
- In a general partnership, all partners are fully liable for the business's debts.
- In a limited partnership, only some partners are personally liable. These are the general partners. Other partners, known as limited partners, are not personally responsible for business debts. However, limited partners generally don't play an active role in running the business.
The "limited" in a limited company refers to liability. Responsibility for debts lies with the company itself, so none of the owners is personally liable. Their potential losses are limited to what they've invested in the company, but no more.
Owners of a limited company can still be held responsible for business debts under certain circumstances. Examples include an owner personally guaranteeing a debt, committing fraud or mixing his personal finances with those of the business.
How They're Taxed
Partnerships are what the federal tax code refers to as pass-through entities. That means the business doesn't pay income tax on its profits. Instead, the profits "pass through" the company to the partners, who report them as income on their personal tax returns. The partnership still has to file a tax return, however, to report its profit and identify how much of the profit each owner is responsible for.
Since limited companies are created under state law, the federal tax code doesn't recognize them as a distinct kind of business. The IRS recognizes only three kinds of businesses: sole proprietorships, partnerships and corporations. What that means for limited companies:
- A limited company owned by a single person will be treated as a sole proprietorship for federal tax purposes. Sole proprietorships are pass-through entities like partnerships.
- A limited company with two or more owners will be treated as a partnership.
- Any limited company can choose to be taxed like a corporation. That means the company will pay corporate income taxes on its profits, and any profits distributed to the owners will be taxed as personal income.