When launching a business in California, choosing the right entity type is crucial. Two popular choices are the California Limited Partnership and the California Limited Liability Company (California LLC). While both offer certain advantages such as limited personal liability and pass-through taxation, there are significant differences between the two. In this article, we compare and contrast California Limited Partnerships and California LLCs, focusing on aspects such as taxation, personal liability protection, governing agreements, and managerial control to guide informed decisions when selecting a business entity for a California business venture.

An Introduction to California Limited Partnerships and California LLCs

California Limited Partnerships and California LLCs are two distinct types of business structures, each with its unique set of rules, benefits, and limitations. In this section, we aim to provide an introduction to both business structures to define terms and provide an overview of each business structure. Understanding the basics of these two business entities will allow more a more detailed analysis later in this article.

What is a California Limited Partnership?

A California Limited Partnership is a business structure where one or more general partners are responsible for the management of the California Limited Partnership. Each general partner has joint and several liability for all the business debts, liabilities, obligations, and legal judgments against the California Limited Partnership.

A California Limited Partnership must also have one or more limited partners who invest in the California Limited Partnership but are not involved in its daily operations. The liability of each limited partner is typically limited to their investment in the California Limited Partnership.

The general partners and limited partners are the owners of the California General Partnership.

California Limited Partnerships are often favored in situations where investors prefer to be passive and allow others to manage the business. California Limited Partnerships are regulated by the California Revised Limited Partnership Act of the California Corporations Code, require filing a Certificate of Limited Partnership with the California Secretary of State, and are governed by a Limited Partnership Agreement between the general partners and limited partners.

What is a California LLC?

A California LLC is a legal business structure that combines the flexibility and simplicity of a California General Partnership with the liability protection of a California Corporation or California S-Corp.

The owners of a California LLC, known as members, enjoy limited liability, meaning they are not personally liable for the business debts, liabilities, obligations, or legal judgments against the California LLC.

A California LLC may be managed by all members or managed by one manager or more than one manager, each of whom may (but need not) be a member.

The California LLC business structure is well-suited for small to mid-sized businesses, as it provides flexibility in terms of management and profit distribution. California LLCs are governed by the California Revised Uniform Limited Liability Company Act of the California Corporations Code, require filing Articles of Organization with the California Secretary of State, and are governed by an Operating Agreement between the members (and managers if the managers are not members).

Taxation of California Limited Partnerships vs California LLCs

The taxation of business entities is often the most important factor that can significantly impact the financial health of a business venture. In this section, we detail how California Limited Partnerships and California LLCs are taxed. Each of the business entities has unique taxation rules which can have varying implications for business owners. Understanding the tax obligations for each business structure is essential in maximizing profitability and ensuring compliance with state and federal income tax and self-employment tax liabilities.

Taxation of a California Limited Partnership

The specifics of tax obligations of a California Limited Partnership are complex. California Limited Partnership have unique tax rules and regulations that require careful understanding. This section is intended to provide clarity with regard to the taxation of a California Limited Partnership and the potential tax benefits and obligations associated with running a California Limited Partnership. However, this article only provides a general understanding of these tax aspects and should not be treated as a complete dissertation on the taxation of California Limited Partnerships.

Federal Income Taxation of a California Limited Partnership

At the federal level, a California Limited Partnership is considered a partnership subject to pass-through taxation for income tax purposes under the United States Internal Revenue Code. This means that the income or loss generated by the California Limited Partnership is passed directly to the general partners and limited partners, who report this income or loss on their individual income tax returns. The California Limited Partnership itself does not pay federal income tax. Instead, a California Limited Partnership must file an annual information return (Internal Revenue Service Form 1065) to report income, deductions, gains, and losses from its operations, but it does not pay income tax. Instead, it passes through any profits or losses to its partners.

The share of the profits or losses allocated to each general partner and limited partner is reported on Schedule K-1 (Internal Revenue Service Form 1065), which is provided to the Internal Revenue Service and to each general partner and limited partner. Each general partner and limited partner must report their allocated share of the income of the California Limited Partnership even if a distribution of profit is not received. The income is taxed at the individual tax rates of each general partner and limited partner.

Self-Employment Taxation of a California Limited Partnership

In the context of a California Limited Partnership, self-employment taxes are a critical aspect to consider. Self-employment taxes are essentially the equivalent of the payroll taxes withheld from the paychecks of salaried employees, and comprise of Social Security and Medicare taxes. Specifically, the self-employment tax rate at the time of this writing in 2024 is 15.3% on the first $168,600 of net income and then 2.9% on any net income in excess of the first $168,600.

For a California Limited Partnership, only the income that is considered guaranteed payments or “active income” (i.e., income received for services rendered to the California Limited Partnership) is subject to self-employment taxes. The general partners, who manage the operations of the California Limited Partnership, are subject to self-employment taxes since they actively participate in the business.

On the other hand, the profits that are merely a return on an investment are usually not subject to self-employment tax. This distinction is crucial for limited partners who typically do not participate in the day-to-day operations of the California Limited Partnership, and therefore their share of the net profit of the California Limited Partnership should not be subject to self-employment taxes.

It is important to note that tax laws can be complex and change frequently. In particular, the self-employment tax cap for the first 15.3% usually increases annually.

California Income Taxation of a California Limited Partnership

In terms of California income taxation, California Limited Partnerships are also subject to pass-through taxation. This means that the Limited Partnership itself does not pay California income tax. Instead, the income or loss of the California Limited Partnership is passed directly to the general partners and limited partners who report this income or loss on their own personal State of California income tax returns. A California Limited Partnership is required to file an annual information return (California Franchise Tax Board Form 565) to report income, deductions, gains, and losses from its operations, but it does not pay income tax itself.

The share of the income or loss allocated to each general partner and limited partner is reported on Schedule K-1 (California Franchise Tax Board Form 565), which is provided to the California Franchise Tax Board and to each general partner and limited partner. Each general partner and limited partner must report their allocated share of the net income of the California Limited Partnership on their individual tax returns regardless of whether a distribution of net profit is made to the general partners and limited partners.

California Annual Franchise Taxes of a California Limited Partnership

California Limited Partnerships are subject to an annual franchise tax imposed by the State of California. This tax is essentially a fee for the privilege of doing business in the state and is levied irrespective of whether the partnership has active business operations or generates any income during the tax year. As of the time of writing this in 2024, the minimum annual franchise tax for a California Limited Partnership is $800 per year.

Taxation of a California LLC

The taxation of a California LLC is flexible and may be elected by the members or managers of a California LLC.

A California LLC with only one member (a California Single-Member LLC) is disregarded for tax purposes by default, but a California Single-Member LLC may also elect to be taxed as a traditional corporation or an S Corporation.

A California LLC with more than one member (a California Multi-Member LLC) is taxed as a partnership (like a California Limited Partnership) by default, but a California Multi-Member LLC may also elect to be taxed as a traditional corporation or an S Corporation.

This section will examine federal and state tax implications, self-employment taxation, and annual franchise taxes related to California LLCs, providing a comprehensive understanding of how California LLCs are taxed.

Federal Income Taxation of a Single-Member California LLC Disregarded for Tax Purposes

A Single-Member California LLC that is disregarded for tax purposes is treated as a California Sole Proprietorship by the Internal Revenue Service, meaning that the Single-Member California LLC does not file a separate federal income tax return. Instead, the single member of the Single-Member California LLC reports the income, deductions, gains, and losses of the Single-Member California LLC on their individual federal income tax return. This reporting is typically done on Schedule C (Profit or Loss from Business) of the Internal Revenue Service Form 1040 tax return of an individual, but if the Single Member is another business entity, the reporting would be done on the federal tax return for that entity.

Federal Income Taxation of a Multi-Member California LLC Taxed as a Partnership

A Multi-Member California LLC that is taxed as a partnership enjoys pass-through taxation just like a California Limited Partnership. This means that the taxes are not directly paid by the Multi-Member California LLC, but instead, the profits or losses are passed on to the individual members who then report this on their personal tax returns.

The Multi-Member California LLC is required to file an annual information return (Internal Revenue Service Form 1065) with the Internal Revenue Service. This form is not used to pay taxes but to report the income, deductions, gains, and losses from the operations of the Multi-Member California LLC. The share of the income or loss allocated to each member is reported on Schedule K-1 (Internal Revenue Service Form 1065), which is furnished to the Internal Revenue Service and each member of the Multi-Member California LLC.

Each member must then include their allocated share of the income or loss of the Multi-Member California LLC on their own individual tax return, regardless of whether a distribution of net profit has been made to them. Consequently, members of a Multi-Member California LLC could potentially have a tax liability even if they did not receive any actual cash distribution from the Multi-Member California LLC during the tax year.

Federal Income Taxation of a California LLC Taxed as a Traditional Corporation

A California LLC that elects to be treated as a traditional corporation for tax purposes (often referred to as C Corporation taxation) is subject to what is commonly known as double taxation. The California LLC taxed as a C Corporation itself is taxed on its net income at the corporate tax rate. After paying corporate income tax, any distribution of remaining profits to members in the form of dividends is taxed again at the individual level.

A California LLC taxed as a C Corporation must file a corporate tax return with the Internal Revenue Service using Form 1120. On this form, the California LLC taxed as a C Corporation reports its income, deductions, gains, and losses. The California LLC taxed as a C Corporation then pays federal income tax at the corporate tax rate on its net income (revenue minus expenses, deductions, and credits). As of the time of writing in 2024, the federal corporate tax rate is 21%, but this reduced tax rate is set to expire after the 2025 tax year without legislative action.

The second layer of taxation occurs when the after-tax profits of the California LLC taxed as a C Corporation are distributed to its members. These distributions, known as dividends, are reported on the individual tax return of each member and are subject to tax at either the individual personal tax rate or dividend tax rate for the individual member.

However, not all income paid to members is subject to this double taxation. If a member is an employee of the California LLC taxed as a C Corporation and receives a salary or bonus as an employee, these are considered deductible expenses for the California LLC taxed as a C Corporation, thus reducing its taxable income. The employee-member pays personal income tax on this salary or bonus.

While double taxation may seem disadvantageous, some businesses may find benefits in this tax structure, such as a wider range of deductible business expenses, ease of raising capital, and potential for lower personal tax liability.

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

A California LLC that elects to be taxed as an S Corporation is subject to pass-through taxation similar to that of a California Limited Partnership or Multi-Member California LLC taxed as a partnership. This means that federal income taxes are not directly paid by the California LLC taxed as an S Corporation itself, and are instead passed through to the individual members who then report this on their personal income tax returns.

A California LLC taxed as an S Corporation is required to file an annual information return (Internal Revenue Service Form 1120S) with the Internal Revenue Service. This form is not used to pay taxes but to report the income, deductions, gains, and losses from the operations of the California LLC taxed as an S Corporation. The allocated share of the income or loss allocated to each member is reported on Schedule K-1 (Internal Revenue Service Form 1120S), which is furnished to the Internal Revenue Service and each member of the California LLC taxed as an S Corporation.

Each member must then include their allocated share of the income or loss of the California LLC taxed as an S Corporation on their own individual tax return, even if no distribution of net profit has been made. As a result, members of a California LLC taxed as an S Corporation may potentially have a tax liability even if they did not receive any actual cash distribution from the California LLC taxed as an S Corporation during the tax year.

Self-Employment Taxation of a Single-Member California LLC Disregarded for Tax Purposes or a Multi-Member California LLC Taxed as a Partnership

A Single-Member California LLC Disregarded for tax purposes or a Multi-Member California LLC Taxed as a partnership are subject to self-employment taxation. This means that the net earnings from these entities are subject to self-employment taxes, which include Social Security and Medicare taxes. The tax is levied on the individual members rather than the Single-Member California LLC Disregarded for tax purposes or a Multi-Member California LLC Taxed as a partnership itself.

The members of a Single-Member California LLC Disregarded for tax purposes or a Multi-Member California LLC Taxed as a partnership are considered to be self-employed and are not employees of the California LLC. Therefore, no contributions to the Social Security and Medicare systems are made by the LLC on behalf of the members. The responsibility for these contributions falls solely on the members themselves, in the form of self-employment tax which, at the time of this writing in 2024, is 15.3% on the first $168,600 of net income and then 2.9% on any net income in excess of the first $168,600.

Self-Employment Taxation of a California LLC Taxed as a C Corporation or S Corporation

Members of a California LLC that elects to be taxed as either a C Corporation or an S Corporation are generally not subject to self-employment tax on their share of the profits of the California LLC. This is because, in these tax structures, members are considered shareholders of a C Corporation or S Corporation, respectively, rather than self-employed individuals.

For a California LLC taxed as a C Corporation or S Corporation, only the salary paid to an owner-employee is subject to employment tax. The remaining income that is passed through to the owner as dividends or distributions, respectively are not subject to self-employment tax. This can potentially result in significant savings.

However, the IRS requires that if a member of a California LLC taxed as a C Corporation or S Corporation provides services to the California, that member must pay themselves a reasonable salary which is subject to federal employment tax. The definition of a reasonable salary varies, but it generally means a salary that is similar to what other businesses would pay for the same or similar services.

California Annual Franchise Taxes of a Single-Member California LLC Disregarded for Tax Purposes or a Multi-Member California LLC Taxed as a Partnership

Every Single-Member California LLC disregarded for tax purposes and every Multi-Member California LLC taxed as a partnership is required to pay an annual minimum franchise tax of $800 to the State of California.

In addition to the annual franchise tax, these Single-Member California LLCs Disregarded for tax purposes and Multi-Member California LLCs taxed as a partnership may also be subjected to the California LLC Fee if their annual gross revenue exceeds $250,000.

The California LLC Fee is a sliding scale fee based on annual gross revenue. For example, if the gross revenue ranges from $250,000 to $499,999, the fee is $900; if it ranges from $500,000 to $999,999, the fee is $2,500; for gross revenue ranging from $1,000,000 to $4,999,999, the fee is $6,000; and for gross revenue of $5,000,000 or more, the fee is $11,790.

It is important to note that gross revenue for the purposes of the California LLC Fee includes items such as gross receipts, less returns and allowances, plus all cost of goods sold, and all amounts received or accrued as a result of the sale or exchange of property or the performance of services. A Single-Member California LLC disregarded for tax purposes and every Multi-Member California LLC taxed as a partnership may be subject to the California LLC Fee even if operating at an annual net loss.

California Annual Franchise Taxes of a California LLC Taxed as a C Corporation

A California LLC that elects to be taxed as a C Corporation is subjected to the California annual franchise tax. This tax requires every California LLC taxed as a C Corporation to pay either the minimum tax of $800 or 8.84% on its net income, whichever is greater.

California Annual Franchise Taxes of a California LLC Taxed as an S Corporation

A California LLC that elects to be taxed as an S Corporation is subjected to the California annual franchise tax. This tax requires every California LLC taxed as an S Corporation to pay either the minimum tax of $800 or 1.5% on its net income, whichever is greater.

Personal Liability Protection of a California LLC vs a California Limited Partnership

One of the significant differences between a California LLC and a California Limited Partnership is the level of personal liability protection each entity offers to its members or partners.

Personal Liability Protection for Members of a California LLC

A California LLC provides personal liability protection to all its members. This implies that members are not personally responsible for the business debts and liabilities. Their personal assets such as homes, vehicles, and personal bank accounts are shielded from creditors seeking to recoup the business debts. The financial responsibility of members is typically limited to their investment in the LLC.

Personal Liability Protection for General Partners and Limited Partners of a California Limited Partnership

A California Limited Partnership consists of at least one general partner and one or more limited partners. While limited partners enjoy personal liability protection similar to LLC members, this personal liability protection does not apply to general partners. General partners are personally liable on a joint and several basis for all the business debts, liabilities, obligations, and legal judgments against a California Limited Partnership, meaning their personal assets are at risk in case the business cannot meet its financial obligations.

A California LLC offers more comprehensive personal liability protection compared to a California Limited Partnership, particularly for those individuals who actively participate in managing the business, however limited partners are likely to receive better personal liability protection compared to members of a California LLC.

The Operating Agreement of a California Limited Liability Company vs Limited Partnership Agreement of a California Limited Partnership

The Operating Agreement of a California Limited Liability Company (LLC) and the Limited Partnership Agreement of a California Limited Partnership differ profoundly in their structure and functionality.

Operating Agreements of California Limited Liability Companies

The Operating Agreement of a California LLC is a binding contract among the members of the California LLC that outlines the ownership, member duties, managerial structure, and operating procedures of the California LLC. The California LLC Operating Agreement provides flexibility in terms of management structure because the California LLC can be managed by its members or by appointed managers. It also allows for the distribution of profits and losses in any manner agreed upon by the members, not necessarily in proportion to their ownership interests.

Limited Partnership Agreements of California Limited Partnerships

The Limited Partnership Agreement of a California Limited Partnership typically outlines the roles of general and limited partners, profit and loss distribution, and the decision-making process. Unlike a California LLC, a California Limited Partnership must have at least one general partner who has unlimited personal liability. Limited partners, who have limited liability, typically do not participate in the daily management of the business. Profits and losses are usually distributed according to the California Limited Partnership Agreement, which typically allocates them based on the proportion to the investment of each partner.

While both Operating Agreements and Limited Partnership Agreements set the framework for business operations, the Operating Agreement of a California LLC offers more flexibility and personal liability protection, while the Limited Partnership Agreement of a California Limited Partnership provides a more traditional structure and roles, which might be beneficial for businesses seeking outside investors.

Management of California Limited Partnerships vs Management of California LLCs

In drawing distinctions between business entity types, understanding the management structure is crucial. Both California Limited Partnerships and California LLCs have unique management structures that can significantly impact the operations and decision-making processes within these organizations. This section provides a comparative analysis of the management structures of California Limited Partnerships and California LLCs.

Management of California Limited Partnerships

Management by General Partners

The management of a California Limited Partnership is generally vested in the general partner or general partners. The general partners have full control over the day-to-day operations of the business of the California Limited Partnership, and general partners have the power to make binding decisions on behalf of the California Limited Partnership.

No Management by Limited Partners

Limited partners, on the other hand, generally have a passive role in the business. They contribute capital and share in the profits of the California Limited Partnership, but they do not participate in the management of the business. This is a critical point because if a limited partner participates in the control of the business, they may risk losing their limited liability status, which protects their personal assets from the business debts, liabilities, obligations, and legal judgments against the California Limited Partnership.

Management of California LLCs

A California LLC offers more flexibility when it comes to management.

All Members Manage California LLC

In an all members manage structure of a California LLC, each member of the California LLC has an equal right to participate in the decision-making process of the business. This is referred to as a member-managed California LLC. All members are actively involved in the day-to-day operations of the California LLC, and each has the authority to make binding decisions on behalf of the California LLC. This structure is akin to a California General Partnership where each partner has a say in the management of the business.

Unlike in a manager-managed California LLC, where members might be passive owners, an all members manage structure ensures that each member is an active participant in business decisions and operations of the California LLC. However, the risk is that disagreements among members can stall decision-making and disrupt the smooth flow of business operations of the California LLC. An Operating Agreement, outlining the decision-making process and dispute resolution mechanism, can offer solutions to such potential issues in a member-managed California LLC.

California LLC Managed by One Manager

In a one manager-managed structure of a California LLC, the members appoint a single manager to oversee and conduct the daily operations and make decisions on behalf of the California LLC. This manager, who may or may not be a member of the California LLC, holds the authoritative power to make binding decisions for the California LLC without requiring the consensus of all members. This structure mirrors closely to the management structure of a California Limited Partnership with one general partner who manages the business.

The manager-managed structure of a California LLC is often chosen when the members prefer to be passive investors or when there is a need for a single decision-maker due to the size or complexity of the business of the California LLC. In this structure, the manager holds a fiduciary duty to the LLC and its members, meaning they must act in the best interest of the California LLC and its members and cannot engage in activities that would harm the business or provide them with an undue advantage at the expense of the California LLC or its members.

The specifics of the role, responsibilities, powers, and appointment or removal of the manager are typically outlined in the Operating Agreement of the California LLC. The Operating Agreement can also stipulate how the manager is to handle specific situations, such as the entry of new members, distribution of profits, or resolving disputes among members. This allows for a clear delineation of roles and responsibilities and provides a roadmap for managing the California LLC, making the one manager-managed structure an efficient and effective choice for many California LLCs.

California LLC Managed by More than One Manager

In a multiple manager-managed structure of a California LLC, the members appoint several managers to manage the operations and make decisions on behalf of the California LLC. These managers may or may not be members of the LLC themselves. They form a sort of managerial committee, each with the power to make binding decisions on behalf of the California LLC. This structure mirrors closely to the management structure of a California Limited Partnership with two or more general partners who manages the business.

In this structure, the appointed managers share the responsibility for running the day-to-day operations, making business decisions, and setting the strategic direction for the California LLC. This collaborative approach can provide a more balanced management structure, drawing on the diverse skills, experience, and perspectives of the appointed managers. However, it could also lead to potential conflicts and delays in decision-making if the managers disagree on certain issues.

Each of these appointed managers holds a fiduciary duty to the California LLC and its members, similar to the one manager-managed structure. The managers of the California LLC are required to act in the best interest of the California LLC and its members, and they cannot engage in activities that would harm the business or give them an undue advantage at the expense of the California LLC or its members.

The specifics of the roles, responsibilities, powers, and the process of appointing or removing managers are typically outlined in the Operating Agreement of the California LLC. The Operating Agreement can also stipulate how the managers are to handle specific situations, such as the admission of new members, distribution of profits, or resolving disputes among members. This comprehensive document provides a clear framework for how the LLC is to be managed, making the multiple manager-managed structure a viable choice for larger or more complex California LLCs.

Ready to Form a California LLC or California Limited Partnership, or Have More Questions? Contact Us Today!

Do not wait to take the next step in your business journey! Whether you are ready to form a California LLC or California Limited Partnership, or just have more questions, we are here to guide you. Contact the experienced attorneys at San Diego Corporate Law today. With our expertise and personalized assistance, we will ensure that your business needs are met with precision and professionalism. Reach out today and let’s get started on building your successful future together.