LLC Operating Agreement vs Partnership Agreement: Which Do You Need?

Choosing the right business structure is one of the most consequential decisions an entrepreneur can make. Two of the most common structures for multi-owner businesses are the Limited Liability Company (LLC) and the partnership. Each is governed by its own foundational document: the LLC Operating Agreement and the Partnership Agreement. Understanding the differences between these documents, and the entities they govern, is essential for making an informed decision.

Entity Type Differences

An LLC is a hybrid entity that combines the operational flexibility of a partnership with the liability protection of a corporation. It is created by filing Articles of Organization (or a Certificate of Formation, depending on the state) with the state. The LLC Operating Agreement is the internal governance document that defines how the LLC is managed, how profits and losses are distributed, and how decisions are made.

A partnership is a business relationship between two or more persons who agree to carry on a business for profit. A general partnership can be formed without any filing; it exists by default when two or more people go into business together. A limited partnership requires filing a Certificate of Limited Partnership with the state. The Partnership Agreement is the document that governs the relationship between the partners and the operation of the business.

Liability Protection

This is the most significant practical difference between the two structures. LLC members enjoy limited liability, meaning their personal assets (homes, savings, personal vehicles) are generally protected from the debts and liabilities of the business. If the LLC is sued or incurs debt, creditors can typically only reach the assets of the LLC itself, not the personal assets of its members.

General partners in a partnership have unlimited personal liability. Each general partner is personally responsible for all debts and obligations of the partnership. If the partnership cannot pay its debts, creditors can go after the personal assets of any general partner. This is joint and several liability, meaning each partner can be held responsible for the full amount, not just their proportionate share.

Limited partnerships offer a middle ground. General partners still have unlimited liability, but limited partners have liability limited to their investment in the partnership. However, limited partners cannot participate in the day-to-day management of the business without risking the loss of their limited liability protection.

Management Structure

LLC Operating Agreements define one of two management structures. A member-managed LLC is run by all of its members, similar to a general partnership. Each member has a say in the day-to-day operations. A manager-managed LLC appoints one or more managers (who may or may not be members) to handle operations, while the other members are passive investors. The Operating Agreement specifies which structure applies and details the authority and responsibilities of managers.

Partnership Agreements typically give all general partners equal management rights unless the agreement provides otherwise. In a limited partnership, the general partners manage the business while limited partners are passive. The Partnership Agreement should clearly define each partner's management authority, including what decisions require unanimous consent versus majority vote.

Taxation

Both LLCs and partnerships are pass-through entities by default. This means the entity itself does not pay income tax. Instead, profits and losses pass through to the individual members or partners, who report them on their personal tax returns.

For multi-member LLCs, the IRS treats the LLC as a partnership for tax purposes. The LLC files Form 1065 (U.S. Return of Partnership Income) and issues Schedule K-1s to each member. Members pay income tax on their share of the profits and must also pay self-employment tax on their distributive share if they are active in the business.

Partnerships follow the same tax treatment, filing Form 1065 and issuing Schedule K-1s. General partners pay self-employment tax on their entire distributive share. Limited partners typically pay self-employment tax only on guaranteed payments for services rendered, not on their share of partnership income.

One important advantage of the LLC is tax flexibility. An LLC can elect to be taxed as an S-Corporation by filing Form 2553. This can reduce self-employment tax for members who work in the business by allowing them to take a reasonable salary (subject to employment taxes) and receive additional profits as distributions (not subject to self-employment tax). Partnerships do not have this option.

Formation Requirements

Forming an LLC requires filing Articles of Organization with the state and paying a filing fee. Most states also require an annual report and fee to maintain the LLC in good standing. While an Operating Agreement is not always legally required, it is strongly recommended and is required in some states like New York, California, Maine, Delaware, and Missouri.

A general partnership requires no filing at all. It exists by operation of law when two or more people engage in a business for profit. However, a written Partnership Agreement is critical because without one, the partnership will be governed by the default rules of the state's version of the Uniform Partnership Act (UPA) or Revised Uniform Partnership Act (RUPA), which may not align with the partners' intentions. A limited partnership requires filing a Certificate of Limited Partnership.

Fiduciary Duties

Partners in a partnership owe each other strong fiduciary duties, including the duty of loyalty (not to compete with the partnership, not to deal with the partnership on behalf of an adverse party, and not to usurp partnership opportunities) and the duty of care (not to engage in grossly negligent or reckless conduct). These duties are largely defined by statute and case law, and the Partnership Agreement can modify them only to a limited extent.

LLC members and managers also owe fiduciary duties, but the extent and nature of these duties vary significantly by state. Some states, like Delaware, allow LLC Operating Agreements to eliminate or modify fiduciary duties entirely (subject to an implied covenant of good faith and fair dealing). Other states impose mandatory minimum fiduciary duties that cannot be waived.

Dissolution

Partnership dissolution can occur when a partner withdraws, dies, or becomes bankrupt, unless the Partnership Agreement provides otherwise. Under the UPA, any change in the composition of partners technically dissolves the partnership. The RUPA has a more flexible approach, distinguishing between dissociation (a partner leaving) and dissolution (winding up the business).

LLC dissolution is typically governed by the Operating Agreement. Common dissolution triggers include a vote of the members, the occurrence of a specified event, the death or withdrawal of a member (though most Operating Agreements allow the LLC to continue), or a court order. LLCs generally offer more continuity and stability than partnerships.

When to Choose Each

Choose an LLC with an Operating Agreement when liability protection is a priority. If the business involves significant risk, debt, or potential lawsuits, the liability shield of an LLC is invaluable. An LLC is also preferable when you want tax flexibility, including the option to elect S-Corporation taxation. LLCs work well for businesses with both active and passive members, and for businesses that want to customize fiduciary duties and governance rules.

Choose a partnership with a Partnership Agreement when simplicity and low cost are priorities. General partnerships require no filing fees and minimal formality. Partnerships may be appropriate for professional firms (law firms, accounting firms, medical practices) in states where professionals cannot form LLCs. Limited partnerships are useful for investment vehicles where passive investors provide capital and general partners manage the business.

Key Takeaways

• LLC members have limited liability protection; general partners have unlimited personal liability.\n- Both are pass-through entities for tax purposes, but LLCs can elect S-Corporation taxation.\n- LLC Operating Agreements offer more flexibility in defining management structure and fiduciary duties.\n- General partnerships require no state filing, while LLCs require Articles of Organization.\n- LLCs generally provide better continuity and stability than partnerships.\n- The best choice depends on your priorities: liability protection and flexibility favor an LLC; simplicity and low cost favor a partnership.