What is a Limited Partnership?
A Limited Partnership (LP) is a legal business structure, formed with more than one business owner. An LP consists of at least one “general” partner and at least one “limited” partner. There may be more than one of each. General partners are those who make business decisions and manage day-to-day operations. They also assume unlimited personal liability for the legal and financial debts of the company. Limited partners are silent partners who invest money or property in the LP, but they do not control running the business, nor are they personally liable for the company’s debts.
The LP structure has been around since the 1970s, before the Limited Liability Company entity type came to be, and it still has advantages for some businesses today.
Types of business that may benefit from forming a Limited Partnership include:
- Professional services firms that wish to delegate the management of the company to a general partner
- Real estate investors
- Family businesses
- Film production companies that want to invest in short-term projects
Before business owners decide to use the LP structure, it’s critical to understand how it will affect them from legal, financial, and operational standpoints. States have their own rules and requirements for starting and running a Limited Partnership; doing some research and asking for the advice of a qualified attorney, accountant, and tax advisor can help shed light on whether the LP or a different structure will offer the most advantages.
Limited Liability in an LP
A Limited Partnership’s general partners accept full personal liability for the financial debts and legal liabilities of the company. So, if the business cannot pay its bills or gets sued, the general partners’ personal assets (house, savings accounts, car, etc.) may be at risk.
As passive owners in the LP, limited partners’ liability is limited to their investment in the partnership (similar to the liability assumed by members of an LLC). Limited partners must maintain a passive role, otherwise, they risk losing their personal liability protection.
Income Tax Treatment With an LP
In a Limited Partnership, the business’s profits and losses “pass through” to the partners, who report them on their personal tax returns and get taxed on their share of the profits; income does not get taxed at the business level.
If the business experiences a loss, typically, the general partners may report the loss, but limited partners may not (because they don’t participate in the daily running of the business).
General partners, because they work in the business, must pay self-employment taxes (Medicare and Social Security). Limited partners, usually, do not pay self-employment taxes because their profits from the partnership aren’t viewed as “earned income.”
A Limited Partnership must prepare a special tax form (Schedule K-1) for its partners each year and an information return (IRS Form 1065).
Management of an LP
General partners are those that make everyday business decisions and manage the LP’s operations. An individual or corporation can serve as a general partner in a limited partnership.
Limited partners in the business act as silent partners, and, generally do not have a say in how business is conducted. Note that in some states, exceptions exist that give limited partners the right to vote on issues that affect certain aspects of the business, such as the structure of the LP, addition or removal of general partners, dissolution of the partnership, or changes to the partnership agreement.
How to Form a Limited Partnership
Most states recognize the Limited Partnership business entity type. Forming an LP involves filing a “Certificate of Limited Partnership,” a document that is similar to the articles of organization that an LLC files. Filing fees for registering a Limited Partnership usually land close to what it costs to form an LLC or incorporate.
An LP will also need a partnership agreement to formalize the responsibilities of the partners and designate what percentage of profits each partner is entitled to.
As with any type of formal business entity, an LP must designate a registered agent and obtain all the required business licenses and permits (local, county, state, and federal) to operate the business legally.
Advantages of a Limited Partnership
- Limited Partners’ Personal Assets Have Protection – While general partners in an LP are personally liable for legal and financial debts of the company, the LP’s limited partners can only lose their financial investment in the business; their personal assets are not at risk in the event of the business running into financial debt or a lawsuit.
- Clarity in Management – An LP’s general partners have complete management control. Limited partners do not have a say in how the company’s operations are handled. This may simplify day-to-day decision-making. The LP’s partnership agreement will specify how the business should be run and how the distribution of profits and losses should be handled.
- Simple to Form – Compared to a corporation, a limited partnership may be cheaper and easier to set up. Limited partnerships do not require establishing a board of directors, writing bylaws, or issuing stock.
- Capital Investment Potential – To acquire more capital for the business, a limited partnership can add additional limited partners. Because investors know they will have limited liability when investing as limited partners, an LP may be able to more easily get the funding it needs than forms of business that do not offer personal liability protection to owners.
- Minimal Ongoing Business Compliance Requirements – The LP structure has fewer compliance formalities than a corporation. Generally, an LP must submit an annual report to the state, maintain a registered agent, pay taxes, hold an annual meeting with its partners, and keep all business licenses and permits up to date.
- Pass-through Taxation – The business itself does not pay income taxes. Instead, the individual partners report and pay taxes on their share of company profits. This can lower the overall tax burden by eliminating the double taxation that happens with corporations (whereby some profits get taxed at the business level and then again at the individual level when profits are distributed to shareholders).
- Easy to Transfer Ownership – Limited partners may leave the company or be replaced. The Limited Partnership does not need to be dissolved when partners retire, pass away, or opt out of the business.
Disadvantages of a Limited Partnership
- Not All Owners Have Personal Liability Protection – Only limited partners enjoy protection of their personal assets. General partners remain personally liable.
- Limited Partners Must Watch Their Step – Limited partners must not overstep their bounds. If a limited partner gets involved in running the business, that partner may lose their limited liability status and become personally liable for debts of the business.
- Self-Employment Tax Burden May Be Prohibitive for General Partners – With pass-through taxation, an LP’s general partners must pay self-employment tax, in addition to income tax, on their profits from the business. This may become excessive for some individuals.
Is the Limited Partnership Structure a Good Fit for Your Business?
Before you register your business as a Limited Partnership or other business entity type, it’s important to understand which will be most advantageous in your situation now and in the future. Research the laws and requirements of your state and local governments. Also, request the advice of an attorney and accountant to ensure you understand the legal and financial effects. CorpNet’s Business Structure Wizard can also help you identify which business structure might best serve your needs.
Fortunately, after you’ve made an informed decision about your business entity and are ready to register your company, CorpNet is here to make the process fast and easy! No matter where you are in the United States, we can prepare and file your business formation documents for you—affordably and accurately. Contact us today to get started living your business dream!