Last month, I looked at the pros and cons of limited companies, as part of my answer to the question, asked by a great many business owners, "What business structure should I use?" This month, it's the turn of LLPs.

Limited-liability partnerships, or LLPs, are both misunderstood and neglected. But this may be because they are still very young. We all remember experiences from our youth when we were ignored or treated as somehow contemptible just because of our tender years, and LLPs have only recently celebrated their 10th birthday. But I'm convinced that there's a very bright future ahead of them as a business structure, and hopefully this piece will explain some of the reasons why I hold that view. Put briefly, I think LLPs are almost invariably the most tax-efficient structure for an owner-managed business, of certain fairly common size criteria, to use.

LLPs are a belated response, on the part of the Government in the late 1990s, to pressure from large firms of lawyers and accountants, who wanted a similar structure to the LLC, which has existed in the United States for a great many years. Eventually, Messrs Blair and Brown obliged, with the Limited Liability Partnerships Act 2000, and Ernst & Young, one of the big four accountancy firms, was the first LLP to be formed, on 6th April 2001. Very shortly afterwards, all the large and, indeed, many not-so-large firms of lawyers and accountants followed suit.

And this is one of the sources of misunderstanding of what LLPs are all about. There's a common view that they are only suitable for professional firms, and somehow don't work for other trades and businesses.

Nothing could be further from the truth. Just as an example, the legislation specifically envisages LLPs being set up for purely investment businesses. In fact, there's no reason at all inherent in the structure why it should not be used for all kinds of trades and business activities.

So, what is an LLP? It's a body corporate, like a limited company, and that means it is a separate person legally, which can contract in its own name, own assets, sue and be sued, and so on. Like a limited company, it is subject to strict accounting and company secretarial requirements. Possibly most importantly, like a company, it provides limited liability protection for its members, so that in the disaster scenario all they stand to lose (unless they've personally guaranteed any of the LLP's debts) is the amount they have invested in the business.

All of these features LLPs share with limited companies. But there are two important differences from companies.

First, LLPs come, at least initially, without any fixed rules or capital structure. You can make up the rules as you go along, depending on what you want to achieve, but there's no legal requirement for any constitutional document, such as an LLP agreement. This differs from the situation with limited companies, which come with a pre-set memorandum and articles of association (although these can be changed).

Unlike companies, LLPs have no share capital. Amounts can be introduced into the LLPs as capital, and taken out again, with no formality at all. Arguably, though, this just replicates, in the LLP context, the common practice of private companies being capitalised by way of directors' loans rather than fixed share capital.

To sum up, in most respects, LLPs could be described as limited companies without the formality.

But it's when you come to look at the tax treatment of LLPs that the situation becomes really interesting.

There are various ways of describing this, one being to refer to an LLP as 'transparent' for tax purposes. Another is to describe them as being taxed in the same way as partnerships.

The first important point to note about this tax treatment is that members of an LLP, as such, are treated as self-employed. There's no fiction of the business being the employer, and the people actually running that business being employees, as there is for limited companies. And if you read last month's article, where it talked about the disadvantages, from the tax point of view, of running your business through a limited company, you will recall that a number of these relate to the fiction of employment status for the main shareholders/directors in the company.

National Insurance, for example, is very much higher for an employee than it is for a self-employed individual, as the tables at the back of this book show. It can cost anything up to 17% or so more to take your earnings out of the company as director than it would do to take the same earnings in an LLP as a member.

Second, I pointed out precisely how disadvantageous the treatment of cars is in a limited-company structure. LLPs, being taxed as partnerships, with the car drivers being self-employed members, don't suffer from these disadvantages at all, because these disadvantages spring from the status of the company car drivers as employees.

Finally, those who recall the summary of the disadvantages of limited companies last month will also recall the major problems experienced, in limited companies, in introducing new blood into equity in the business. This simply doesn't apply, at least under current HM Revenue & Customs (HMRC) practice, where the business is a partnership or LLP. Instead, you can introduce a new member, with equity in the business, with no tax complications whatsoever.

I have also referred to the description of LLPs as being tax 'transparent'. What this means is that, as with a partnership, the LLP itself has no tax existence, with profits and losses being attributed directly to the members as if they were sole traders, and assets of the LLP being treated, for capital gains taxation purposes, as if they were owned directly by the members.

So this also ticks the 'losses' box in my series of tax problems arising from using limited companies. Losses arising in a limited company can only be used against the company's own profits, which very often in practice means carrying them forward against future profits - if any - from the same trade. In an LLP, the transparent nature of the entity means that the losses can be used in the same way as losses arising in a partnership or sole trade, that is directly against the other income, from whatever source, of the partners. In the early years of a trade carried on through an LLP, losses can be carried back up to three years, generating a very nice repayment if the member has paid a lot of tax in those earlier years.

Arguably of most importance of all, the deemed direct ownership of the assets of the LLP by the members brings into play the generally more favourable rules of capital gains tax (CGT), where those members are individuals. In one particular scenario, the same asset, sold at a gain, would be subjected to about 33% tax if owned by a company, but only 10% if owned by an individual. An LLP enables you to tap into the more favourable individual CGT regime.

I've concentrated, in all of the above, on the differences between LLPs and companies, because companies are likely to be the most favoured alternative structure for businesses to choose. But one ought to bear in mind that all of the tax benefits of LLPs that I've mentioned in this article are equally applicable to partnerships and sole traders. The difference is that LLPs as bodies corporate enable floating charge lending to take place (although some banks are slow to catch on to what LLPs precisely are) and, particularly importantly, LLPs bring with them the advantage of limited liability for debts, which ordinary partnerships don't.

Here are five misconceptions about LLPs:

In an ordinary partnership, insolvency means all of the assets of the partners being vulnerable to the liquidator. So, in practice, a general partnership structure isn't going to be chosen by anyone running a business that entails any kind of risk. Since this comprises a good proportion of businesses, the introduction of LLPs in 2001 has opened up the benefits of partnership taxation to a much wider range of businesses than would have been able to tap into it before.

One by-product of this limited liability, which businesses generally have been slow to catch on to, is the ability to widen significantly the participation of your people in membership. Here, I probably need to clear away another possible misunderstanding.

A partner in an LLP is technically called a 'member'. In limited company terms, an LLP member is something like a shareholder and something like a director, but his status need not be identical with either: remember, with an LLP, you make up the rules yourself.

From the practical point of view, membership of an LLP, like a shareholding in a company, can give you three specific powers and advantages: a share in the income profits, a share in the capital profits and a right to vote.

With a limited company, it's usually expressed in percentage terms, and these apply to all three of the above. So, if you have 10% of the share capital of the company, you receive 10% of the dividends paid, 10% of the capital value on sale or winding up and a 10% vote in general meetings of members. And, just as shareholders in companies don't need to be granted all three of these benefits, or all three in the same proportions, nor do LLP members.

So the real possibility exists of introducing members into your LLP who have no rights over the running of the business, or ultimate equity rights in its capital, but merely a right to income.

This right to income can also be a right to a fixed amount each year, rather than a percentage of the total profits. So the result, if you have a fixed share, non-voting, non-equity partner, is actually pretty close to that of an employee in a company, but with the status of 'member' accorded by way of recognition on the letterhead and the name of the member being on record at Companies House.

It appears to be HMRC's practice to treat such members as self-employed, even though their relationship to the business, in substance, may be closer to that of an employee. From the business's point of view, the benefits of having a person working for you as an LLP member rather than as an employee are huge: principally, you have no obligation to pay the 13.8% employers' National Insurance levy. For businesses whose staff costs are high, this can be a wonderful addition to the bottom line profits.

I've gone into some detail on this particular benefit of the LLP structure because, for practical reasons, it marks LLPs out from all other business entities. Individuals who may be suitable candidates for fixed-profit membership of an LLP would be very badly advised if they accepted an equivalent role in a partnership. For a start, treatment as self-employed is by no means so well assured in a partnership as it is in an LLP. But more importantly, from the individual's point of view, unlimited liability comes along with this partnership status, which is not matched by any control given to the individual over how the business is run. So those who do control the business could be running up liabilities for which the fixed profit partner is then responsible, and there's nothing he can do about it. A well-advised individual, then, would say that it's got to be an LLP or nothing, in most situations.

It could be argued that, in extolling the virtues of LLPs, I've forgotten one very important disadvantage: the fact that the headline rate of tax on profits is much higher for individuals than for limited companies. If you're not looking to distribute all of your income, there's no doubt that limited companies have the advantage of keeping your tax rate down to the 20s per cent where it might have been 40% or even 50% in a partnership. True, these advantages are illusory if you're going to pay the income out to the shareholders/directors, where it will be subject to income tax and possibly also National Insurance. But, for businesses which retain their profits, and make profits over the 40% tax threshold, surely the limited company structure has an unbeatable lead over the partnership/LLP structure?

I think not, but the reasons why an LLP seems to be the better structure, generally speaking, even in circumstances like that, are complex enough to warrant another article.

This article is adapted from Alan's forthcoming book, The Entrepreneur's Tax Guide, which will be published in early 2012.