In California, business partners have multiple options when forming a business, with a California General Partnership and a California Limited Liability Company (LLC) being among the most popular. Each of these structures comes with its own set of advantages and disadvantages, and this article aims to shed light on the differences between a General Partnership and an LLC, including aspects of liability protection, tax implications, management structure, and the overall process of formation. By understanding these distinctions, business partners can make a more informed decision that best aligns with their business goals and needs in the State of California.

The focus of this article is to find the best business structures for businesses with two or more General Partners or LLC owners. If you are interested in a comparison of a California LLC vs Partnership to find the best business structures for just one business owner, a previous examination of Sole Proprietorship vs California LLC will be more on point than this article.

Executive Summary: Putting the Conclusion First for Busy Business Owners

Operating a business as a General Partnership in California is only a reasonable choice for business owners who do not have (or plan to have) employees, and are not concerned with personal liability or protecting their personal assets from business risks.

A California LLC is a business entity worth considering for business owners who want the ability to reduce their tax liabilities while limiting their personal liability and protecting their personal assets to the maximum extent possible in California.

For a comprehensive, personalized approach to selecting and forming your California LLC or California General Partnership, trust the experienced corporate attorneys at San Diego Corporate Law. Our team has the expertise to guide you through every step of the process, ensuring your California business is structured to provide maximum asset protection and tax efficiency. Contact us today for a consultation.

A Business Structure Introduction to General Partnerships vs LLCs in California

What is a General Partnership in California?

A California General Partnership is a business structure where two or more individuals or business entities come together to conduct a business for profit. In this arrangement, all business owners share equally in the rights and responsibilities of running the business, including profits, losses, and decision-making as established in either a verbal or written partnership agreement, with strong preference given to the partnership agreement being in a writing signed by all General Partners.

In a California General Partnership, each General Partner is personally liable for the business, meaning each General Partner has joint and several liability for all debts, liabilities, obligations, and legal judgments against the California General Partnership. This means that if the business incurs a debt or is faced with a lawsuit, the personal assets of each General Partner are at risk.

California General Partnerships are easily formed and relatively informal to operate, with no specific filing requirements with the California Secretary of State in most instances, although most partners choose to formalize their agreement with the filing of a Statement of Partnership Authority and a written General Partnership Agreement.

What is a Limited Liability Company (LLC) in California?

A California limited liability company (LLC) is a separate legal entity from its owners (referred to as members), providing some degree of personal asset protection like a California Corporation or California S-Corp. This means that the personal assets of a member are typically shielded from claims against the business. However, a member is still personally liable for their own actions, which liability cannot be shielded by any business entity in California.

In addition to liability protection, another major advantage of a California LLC is the flexibility in choosing how the California LLC is taxed. A California LLC with only one member (referred to as a Sole-Member California LLC) can opt to be taxed as a sole proprietorship (formally, an LLC disregarded for tax purposes), an S Corporation, or a corporation, depending on the circumstances and needs of the business. A California LLC with two or more members may opt to be taxed as a partnership, an S Corporation, or a corporation, depending on the circumstances and needs of the business. A California LLC may be governed by either a verbal or written operating agreement, with strong preference given to a written operating agreement signed by all members.

Since we are comparing a California General Partnership to a California LLC, and by definition, California General Partnerships must have two or more business owners, we will focus on Multi-Member California LLCs, leaving the comparison of Sole-Member California LLCs to a comparison with California Sole Proprietorships found by clicking this link because a California Sole Proprietorship must only have one business owner.

Forming a California LLC involves more paperwork and ongoing regulatory requirements than a California Partnership, mostly in the form of initial and biennial filings with the California Secretary of State, however, despite the complexity of formation and operation, the benefits of limited liability and potential tax efficiency make California LLC an attractive choice for some business owners in California.

Personal Liability in a General Partnership vs LLC in California

In this section, we compare the personal liability aspects between General Partnerships and LLCs in California. We will discuss how these two types of business entities handle personal liability for business debts and legal claims, which is crucial for business owners who are considering which legal structure to choose for their business.

Personal Liability in a General Partnership in California

In this section, we will explore the concept of personal liability as it pertains to General Partnerships in California. Particularly, we will shed light on the potential risks and implications for owners with respect to personal liability as it directly influences the risk to personal assets and financial security for an owner of a California General Partnership for the operation of their business.

Personal Liability in California General Partnerships Generally

In a California General Partnership, each General Partner bears unlimited personal liability for the California General Partnership. Each General Partner has joint and several liability for all debts, liabilities, obligations, and legal judgments associated with the California General Partnership. This means that if the California General Partnership incurs debt or faces a lawsuit, the personal assets of each General Partner (such as their home, vehicles, investments, or personal savings) can be used to settle the debts, liabilities, obligations, or legal judgments against the California General Partnership. The risk associated with this personal liability should be a significant consideration for business owners considering operating as a California General Partnership.

Personal Liability in a California General Partnership with Employees

In a California General Partnership, personal liability extends to the actions of employees as well. The legal principle of respondeat superior (better known as vicarious liability) applies. For a California General Partnership, this means that the California General Partnership, as the employer, is held responsible for the actions of their employees performed within the course of their work duties. However, coupled with the joint and several liability of each General Partner for all debts, liabilities, obligations, and legal judgments associated with the California General Partnership, each General Partner is responsible for the actions of the employees of a California General Partnership.

For example, if an employee of a General Partnership in California does something that leads to a lawsuit, each General Partner may find their personal assets at risk in the ensuing legal proceedings. This risk amplifies based on the number of employees and the nature of the business.

Obtaining adequate insurance coverage can help mitigate the risk to the personal assets of the California General Partnership and each General Partner, however, that mitigation only extends to the limited liability protection of insurable risks and insurance policy limits.

Employment Practices Liability in a California General Partnership with Employees

Employment practices liability is a significant concern for the General Partners of California General Partnerships with employees. This type of liability arises from claims made by employees alleging wrongful treatment. The scope of wrongful treatment may be discrimination (based on sex, race, age, disability, etc.), wrongful termination, harassment, retaliation, as well as countless other employment-related issues.

In the context of a California General Partnership, each General Partner may be held personally liable for any of these claims because any employment practices liability claim against the California General Partnership could potentially lead to a direct impact on the personal assets of each General Partner based upon their joint and several liability for all debts, liabilities, obligations, and legal judgments against the California General Partnership.

Any business owner, including the General Partners of a California General Partnership, should consider securing employment practices liability insurance, a type of coverage that can help protect businesses against potential claims by workers, however, such coverage can be cost-prohibitive for a small business and the protection only extends to the limited liability protection of insurable risks and insurance policy limits.

Personal Liability in an LLC in California

This section focuses on the role of personal liability within the structure of an LLC in California to explore the extent to which personal assets may be shielded from personal liability to provide an overview of the protective measures offered by California LLCs.

Personal Liability in a California LLC Generally

In a California LLC, personal liability is generally limited, which is one of the primary reasons business owners may opt for this structure. A California LLC is legally separate from its members, thereby offering a protective barrier for the personal assets of the members. This means that if the California LLC incurs debts or is sued, typically the personal assets of the members (such as their home, vehicles, investments, or personal savings) are not at risk.

It is important to note, however, that this liability protection is not absolute. A member can still be held personally responsible in certain situations, such as if they provide a personal guaranty for a business loan or commercial lease, if they directly injure someone, or if they engage in fraudulent or reckless behavior.

To maintain this liability protection, California LLCs must adhere to certain formalities and regulations that are not required in a California General Partnership. It is of the utmost importance for California LLCs to meet these obligations to fully benefit from the limited liability protection offered by the California LLC structure.

Personal Liability in an LLC with Employees

Just as with California General Partnerships, a California LLC also extends its liability to the actions of its employees. The principle of respondeat superior (vicarious liability) holds true in this scenario. This means that the California LLC is responsible for the actions of its employees performed in the course of their employment. For example, suppose there is a lawsuit because a third party is injured by an employee driving during the course of their employment, the California LLC might be held responsible as well as the employee who was at fault for the accident.

However, unlike a California General Partnership, the personal assets of the members of the California LLC are generally shielded from this liability. The California LLC is viewed as a separate legal entity, so any lawsuits or debts incurred by the California LLC do not typically extend to the personal assets of its members. This protection is one of the key benefits that distinguish a California LLC from a California General Partnership.

Nevertheless, this protection is not all-inclusive. In certain situations, such as a direct injury caused by a member (for instance, in the example above, if the member was at fault for an accident while driving during the course of their employment) or if fraudulent or reckless behavior is exhibited, a member can still be held personally responsible.

As with any business, obtaining appropriate insurance coverage can help mitigate risks associated with employee actions, and the protection provided by this insurance still only extends to the limited liability protection of insurable risks and insurance policy limits, but to the extent that such insurance provides incomplete coverage, it should be the business assets of the California LLC and not the assets of the members at risk, which is a tremendous advantage over the lack of liability protection in a California General Partnership.

Employment Practices Liability in a California LLC with Employees

Within a California LLC, employment practices liability relates to claims arising from the employment process. A significant portion of employment practices liability issues revolve around misconduct such as discrimination (based on sex, race, age, disability, etc.), wrongful termination, sexual harassment, and retaliation.

In a California LLC, this liability extends to the actions of its employees under the principle of respondeat superior or vicarious liability. If an employee of the California LLC engages in an act that results in a lawsuit, the California LLC could be held responsible for the actions of its employee, but the personal assets of the members are typically protected.

However, this protection is not always absolute. Situations where direct injury caused by the action or inaction of a member, or fraudulent or reckless behavior, can still result in personal liability for a member.

Employment practices liability insurance may be used to mitigate this risk, but to the extent that the limited liability protection of insurable risks and insurance policy limits do not cover the liability, it should be the business assets of the California LLC and not the assets of the members at risk, which is a giant leap in protection compared to a California General Partnership.

Taxation of General Partnerships vs LLCs in California

In this section, we will compare and contrast the tax obligations for General Partnerships and LLCs in California. Understanding the taxation landscape is important for business owners as it directly impacts their personal income and overall financial health. We will explore the tax implications for each structure, including income tax, self-employment tax, and potential tax advantages, to provide a comprehensive view of how these business entities are taxed in the State of California.

Taxation of a General Partnership in California

General Partnerships in California are subject to partnership taxation at both the federal and within the State of California.

Federal Income Taxation of a General Partnership in California

A General Partnership in California is treated as a “pass-through” entity for federal income tax purposes. This means that the California General Partnership itself does not pay any federal income tax. Instead, each General Partner reports their share of the income or loss of the California General Partnership on their personal tax returns. The share of income, deductions, and credits of each General Partner is reported on Schedule K-1 of the Internal Revenue Service Form 1065 tax return filed annually by the California General Partnership. This Schedule K-1 is issued by the California General Partnership and is filed with the personal federal tax return each General Partner. The income or loss is taxed at the tax rate of each General Partner and not at the California General Partnership level. It is important to note that each General Partner is taxed on their allocated share of the income of the California General Partnership whether or not there is any distribution of net profit to the General Partners.

Federal Self-Employment Taxation of a General Partnership in California

Each General Partner of a California General Partnership is subject to federal self-employment tax on their allocated share of the net profit of the California General Partnership. This tax encompasses both the Social Security and Medicare taxes for individuals who work for themselves. The current self-employment tax rate is 15.3%, with 12.4% going towards Social Security and 2.9% towards Medicare.

One of the unique aspects of the self-employment tax is that the Social Security component is only levied up to a limit that generally increases annually (on the first $160,200 of income for the 2023 tax year), whereas the Medicare component applies to all self-employment income. Additionally, if the net income of a California General Partnership allocated to a General Partner exceeds $200,000 for an individual or $250,000 for joint filers, there is a 0.9% Additional Medicare Tax.

So, for example, a General Partner may expect to pay the following amounts in self-employment tax in addition to their federal and state income tax liabilities:

$ 20,000 Allocated Net Income x 15.3% = $3,060 Self-Employment Tax

$ 40,000 Allocated Net Income x 15.3% = $6,120 Self-Employment Tax

$ 60,000 Allocated Net Income x 15.3% = $9,180 Self-Employment Tax

$ 80,000 Allocated Net Income x 15.3% = $12,240 Self-Employment Tax

$100,000 Allocated Net Income x 15.3% = $15,300 Self-Employment Tax

$120,000 Allocated Net Income x 15.3% = $18,360 Self-Employment Tax

$140,000 Allocated Net Income x 15.3% = $21,420 Self-Employment Tax

$160,000 Allocated Net Income x 15.3% = $24,480 Self-Employment Tax

These self-employment tax calculations will assume greater significance later in our discussion when we delve into the self-employment tax considerations for California LLCs, as they will be a critical comparison point for understanding the distinct tax implications of choosing a California LLC over a California General Partnership, depending upon how the members elect for the California LLC to be treated for purposes of taxation.

California Income Taxation of a General Partnership in California

Just like federal taxation, a General Partnership in California is also considered a “pass-through” entity for state income tax purposes. This implies that the California General Partnership itself does not incur any state income tax. Instead, the share of the income or loss of the California General Partnership for each General Partner is reported on their individual California tax returns and each General Partner is taxed at their respective personal income tax rate.

The California General Partnership is required to file Form 565, Partnership Return of Income, with the California Franchise Tax Board. The California General Partnership also needs to issue a Schedule K-1 to each General Partner, detailing the share of the income, deductions, and credits of the California General Partnership allocated to each General Partner.

Federal Alternative Minimum Tax for a General Partnership in California

The Federal Alternative Minimum Tax is a tax system that complements the regular income tax for certain taxpayers. This tax does not apply to partnerships like California General Partnerships at the partnership level, but General Partners may be subject to Federal Alternative Minimum Tax on their personal tax returns.

California Alternative Minimum Tax for a General Partnership in California

Similar to the Federal Alternative Minimum Tax Alternative Minimum Tax, California also has an Alternative Minimum Tax system that complements the regular income tax for certain taxpayers. This tax does not apply to partnerships like California General Partnerships at the partnership level, but General Partners may be subject to California Alternative Minimum Tax on their personal tax returns.

Default Taxation of an LLC in California

LLC Taxed as a Partnership

A California LLC with two or more members is taxed as a partnership by default, and this taxation is almost identical to the taxation of a California General Partnership, discussed above with the addition of the California Annual Franchise Tax and California LLC Fee discussed below.

California Annual Franchise Tax for California LLCs

In addition to the tax treatment of a California General Partnership discussed above, the California Annual Franchise Tax is owed annually by every California LLC. The California Annual Franchise Tax is a mandatory fee imposed on all LLCs in California, regardless of their income or activity levels. This tax is set at a flat rate of $800 per year and is payable to the California Franchise Tax Board. Even if the California LLC was not operating or operated at a loss, this tax would still apply.

California LLC Fee

In addition to the tax treatment of a California General Partnership and the addition of the California Annual Franchise Tax discussed above, each California LLC taxed as a partnership is subject to the California LLC Fee. The California LLC Fee is an additional tax based on the gross revenue (not net income!) of a California LLC, calculated on a sliding scale, starting at $900 for businesses with income from $250,000 to $499,999 and increasing to a maximum of $11,790 for businesses with income of $5,000,000 or more. This fee is paid in addition to the California Annual Franchise Tax.

Taxation of an LLC Taxed as an S Corporation in California

A California LLC can elect to be taxed as an S Corporation by filing Form 2553, “Election by a Small Business Corporation” with the Internal Revenue Service. This election changes the federal and California tax treatment of the California LLC.

Federal Income Taxation of an LLC Taxed as an S Corporation in California

A California LLC taxed as an S Corporation does not pay income taxes at the corporate level under the federal rules. Instead, it operates as a pass-through entity where the income, deductions, and credits pass through to the member. The member then reports that net income or net loss of the California LLC taxed as an S Corporation on their individual tax returns at their individual income tax rates. For federal income tax purposes, and negating income tax deductions from the payment of employment taxes, the federal income tax paid by a General Partner of a California General Partnership is taxed equivalently to the income taxes paid by a member of a California LLC taxed as an S Corporation for purposes of federal income taxation.

Restrictions on who may be a member of a California LLC taxed as an S Corporation are in place to maintain its S Corporation tax status. A California LLC taxed as an S Corporation is limited to one hundred members. These members must be United States citizens or permanent residents of the United States. Further, other LLCs, corporations, partnerships, and certain trusts cannot own a membership interest or membership units in a California LLC taxed as an S Corporation. There can only be one class of membership interest or membership units, meaning that all members have the same rights to profits and assets.

Despite the restrictions, S Corporation taxation of a California LLC is often the preferred choice of taxation for many California LLCs.

Federal Self-Employment Taxation of an LLC taxed as an S Corporation in California

California LLCs taxed as S Corporations are not subject to self-employment taxes. Yes, you read that correctly. Read that again if necessary.

One of the major advantages of a California LLC taxed as an S Corporation is the ability to eliminate self-employment taxes. This is because a member who is also an employee of the California LLC taxed as an S Corporation is required to pay themselves a reasonable salary, which is subject to standard payroll taxes, but not self-employment taxes.

The term “reasonable salary” is not explicitly defined by the Internal Revenue Service, but guidelines suggest it should reflect the market rate for similar services provided in the industry. This salary is considered an expense for the California LLC taxed as an S Corporation and is, therefore, deducted from its income.

The employer and employee contributions to standard employment taxes are the same 15.3% as self-employment taxes paid by General Partners of a California General Partnership, but the benefit of replacing self-employment taxes with standard employment taxes paid only on a reasonable salary to a member who is also an employee of the California LLC taxed as an S Corporation, and any remaining income of the limited liability company after the payment of reasonable salary can be distributed to the members without being subjected to self-employment taxes. This could mean significant tax savings for the members of a California LLC taxed as an S Corporation.

There are a few different methods of determining what is a reasonable salary, and these should be discussed with a tax advisor. However, drawing upon the self-employment tax calculations provided in the Federal Self-Employment Taxation for a General Partner in a California General Partnership, above, see the following table and compare the savings between the self-employment tax of a General Partner and a member California LLCs taxed as an S Corporation:

$12,000 Reasonable Salary on $20,000 Allocated Net Income x 15.3% = $1,836 Standard Employment Tax (Savings of $1,224 Compared to Self-Employment Tax)

$24,000 Reasonable Salary on $40,000 Allocated Net Income x 15.3% = $3,672 Standard Employment Tax (Savings of $2,448 Compared to Self-Employment Tax)

$36,000 Reasonable Salary on $60,000 Allocated Net Income x 15.3% = $5,508 Standard Employment Tax (Savings of $3,672 Compared to Self-Employment Tax)

$48,000 Reasonable Salary on $80,000 Allocated Net Income x 15.3% = $7,344 Standard Employment Tax (Savings of $4,896 Compared to Self-Employment Tax)

$60,000 Reasonable Salary on $100,000 Allocated Net Income x 15.3% = $9,180 Standard Employment Tax (Savings of $6,120 Compared to Self-Employment Tax)

$60,000 Reasonable Salary on $120,000 Allocated Net Income x 15.3% = $9,180 Standard Employment Tax (Savings of $9,180 Compared to Self-Employment Tax)

$60,000 Reasonable Salary on $140,000 Allocated Net Income x 15.3% = $9,180 Standard Employment Tax (Savings of $12,240 Compared to Self-Employment Tax)

$60,000 Reasonable Salary on $160,000 Allocated Net Income x 15.3% = $9,180 Standard Employment Tax (Savings of $15,300 Compared to Self-Employment Tax)

A tax advisor should be consulted regarding setting a reasonable salary, although for many business owners, $60,000 could be deemed a maximum reasonable salary.

The 0.9% Additional Medicare Tax still applies under standard employment taxes; however, this is another way in which a California LLC taxed as an S Corporation can be advantageous. By setting a reasonable salary for a member, it is possible to keep their income below the income thresholds that trigger the Additional Medicare Tax.

California Income Taxation of an LLC Taxed as an S Corporation in California

Income from a California LLC taxed as an S Corporation is passed through to the member who then reports it on their individual income tax returns. This is similar to the federal treatment, with the income being taxed at the individual California income tax rates, ranging from 1% to 13.3%, depending on the income bracket.

California LLC Annual Franchise Tax When Taxed as an S Corporation

California LLCs taxed as S Corporations are subject to a 1.5% franchise tax on their net profit, with a minimum tax of $800 annually paid to the California Franchise Tax Board. This tax is payable regardless of whether the California LLC is active, inactive, operates at a loss, or files a return for a short period of less than 12 months.

No California LLC Fee When Taxed as an S Corporation

When taxed as an S Corporation, a California LLC is not subject to the California LLC Fee, which applies only to California LLCs disregarded for income tax purposes or taxed as partnerships when there are two or more members.

Federal Alternative Minimum Tax for an LLC Taxed as an S Corporation in California

There is no federal Alternative Minimum Tax (AMT) for California LLCs taxed as S Corporations, but AMT may be due for members whose ownership is considered passive depending on other financial factors.

California Alternative Minimum Tax for an LLC Taxed as an S Corporation in California

There is no California Alternative Minimum Tax (AMT) for California LLCs taxed as S Corporations, but AMT may be due for members whose ownership is considered passive depending on other financial factors.

Comparing and Contrasting the Taxation of a California LLC vs California General Partnership

For California income tax purposes, and negating income tax deductions from the payment of employment taxes, the federal income tax paid by a General Partner of a California General Partnership, or member of a California LLC taxed as a partnership, and a member of a California LLC taxed as an S Corporation are equivalent.

The General Partner of a California General Partnership and a member of a California LLC taxed as a partnership are both subject to all business income and self-employment taxes, which can be a significant annual liability.

The franchise tax of $800 plus the California LLC Fee of $900 to $11,790 starting at a gross revenue of $250,000 for a California LLC taxed as a partnership is a cost-prohibitive way to gain liability protection.

However, the annual tax of 1.5% subject to an $800 minimum for a California LLC taxed as an S Corporation is a very reasonable tax liability to pay in exchange for liability protection, especially when the reduction in self-employment tax liability not only exceeds the annual franchise tax but also more than pays all the additional costs of starting and operating a California LLC, allowing the members to earn a higher post-tax income than would be possible as a under partnership taxation of either a California General Partnership or a California LLC taxed as a partnership.

Making a Final Decision Between General Partnership vs LLC in California

Operating a business as a General Partnership in California is only a reasonable choice for business owners who:

1. Do not have (or plan to have) employees; and

2. Are not concerned with personal liability or protecting their personal assets from business risks.

A California LLC is a good business entity of choice for business owners who want to limit their personal liability and protect their personal assets to the maximum extent possible in California.

Whether done at the time of formation or later when the gross revenue and/or net income of the California LLC grows, electing to be taxed as an S Corporation provides all the tax benefits of a California S-Corp with a more flexible management structure and the ability to operate disregarded for tax purposes until S Corporation taxation would provide a tax benefit to the members.

For a comprehensive, personalized approach to selecting and forming your California LLC, trust the experienced corporate attorneys at San Diego Corporate Law to help you compare the benefits of a California LLC vs General Partnership. Our team has the expertise to guide you through every step of the process, ensuring your California LLC is structured to provide maximum asset protection and tax efficiency. Contact us today for a consultation.