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Understanding Limited Partnerships

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What Is a Limited Partnership in Business?

A limited partnership, or LP, forms when two or more people own a business. Unlike some other forms of partnerships, however, there are two classes of partners in a limited partnership company:

  • General partners: General partners own and operate the business. They retain full management of the business, and they bear unlimited liability for the business's obligations and debt.
  • Limited partners: Sometimes called silent partners, limited partners invest money or property in the business. These partners don't have the right to decide the way the company operates, and they don't have voting power. However, they also don't have any personal liability when it comes to business debts. Liability is limited to the amount of investment a limited partner has in a company. LPs can have any number of limited partners.

Limited partnerships were designed to allow people to invest in a business without taking on personal liability to do so. However, general partners do retain personal liability in a limited partnership.

Alternatives to Limited Partnership Companies

Depending on a business's goals, alternate structures may be better suited. Other business partnership structures include:

  • General partnerships: This type of partnership only has partners that participate in a company's management. All general partners have liability, and all can share in profits as well as losses.
  • Limited liability partnerships: This type of partnership brings together elements of a corporation and a partnership. In limited liability partnerships, all partners are considered limited partners and have limited liability. All partners are also permitted to participate in the company's management.
  • Limited liability companies: A limited liability company, or LLC, serves as the general partner itself. Instead of having individuals take on personal responsibility, the LLC takes on all of the liability.

How Do Limited Partnerships Work?

Limited partnerships require at least one general partner who remains responsible for the business's day-to-day management. The general partner can be either a person or an entity such as a corporation. General partners make decisions that affect the company, so they are fully liable for any lawsuits or debts that the business takes on.

Limited partnerships must also have at least one limited partner. Limited partners invest in a business to get a share of profits, but they are otherwise passive owners. Liability is limited to the investment they make in the partnership.

Limited partnerships are pass-through business entities for tax purposes. In other words, the business's income tax passes to the individual partners. As with other kinds of partnerships, individuals pay income taxes according to their share of the business, known as a distributive share. The distributive share passes through to the business owner's tax return, and they must pay taxes at their own personal tax rate.

General partners and limited partners are not treated the same way in terms of taxes when the LP has a loss. The general partner may take the loss, even if they do not have other income to offset the loss. On the other hand, because limited partners do not materially participate in running a partnership, their income is considered passive. Therefore, limited partners cannot take a loss to reduce their income taxes if they do not have other income to offset the loss.

Advantages and Disadvantages of Limited Partnerships

Businesses and individuals may have various reasons for forming a limited partnership. The decision comes with both advantages and disadvantages.

Advantages of limited partnerships include:

  • Investment potential: By adding more limited partners, these partnerships have a way to generate capital investments. For example, general partners can raise investments from friends or family for a business venture without ceding any control of their business.
  • Pass-through taxation: Income is not taxed at the business level in a limited partnership. Business profit and loss are instead passed through to partners so that they can report these profits and losses on personal tax returns.
  • Full oversight for the general partner: General partners keep complete management control over their company.
  • Personal asset protection for limited partners: The structure of a limited partnership protects limited partners up to the amount of their investment.

Disadvantages of limited partnerships include:

  • Complete liability for general partners: One big disadvantage of a limited partnership is that the general partner bears all legal liability for management decisions. General partners assume complete responsibility for both lawsuits and debts. For example, if a business is sued, the general partner's personal assets, such as their car and home, are at stake.
  • Difficulties involved in running an active business: Limited partnerships provide a good structure for raising investments, especially in terms of real estate. However, limited partners can't help manage or run the business, which can make running an active business challenging for the general partner.
  • Interests are considered securities: Because limited partners are passive investors in the LP, their shares are considered securities. Thus, these shares must follow federal and state government securities regulations.

Common Uses for Limited Partnerships

People generally choose to form limited partnerships for two main reasons:

  • Commercial real estate projects: LPs are useful in the development of commercial real estate projects. Typically, the general partner organizes and manages project construction and maintenance. The limited partner is an investor and puts up the money for a project, getting a return on the income stream once the project is complete.
  • Family limited partnership: LPs can also be used in a family business. Family members can pool their resources and then designate a general partner. Family limited partnerships can also be created when the general partner holds real estate and the limited partners are heirs. If the LP has an income stream and the parties do not want the real estate to be sold if the general partner dies, they may form this kind of LP.

How to Form a Limited Partnership

It's always a good idea to speak with an accountant and an attorney when setting up a limited partnership to ensure that you're creating the best business structure for your goals. Details of registering an LP vary by state, but most processes include these typical steps:

  1. Decide the state you will register in: Some states offer greater advantages than others. The requirements to form an LP also vary depending on the state you're in. You can find information about state filing requirements on the U.S. Small Business Administration website. Consult with a lawyer to learn more about state business law and tax codes.
  2. Register in your state: You must file with the proper state agency and pay a filing fee to form an LP. You will need to apply with the name for the business. Many states require that your business name includes the term "LP" or "limited partnership" in the name.
  3. Create a limited partnership agreement: This legal document will outline the roles of the general partner and limited partners. The agreement should also describe:
    • How losses and profits will be divided between the partners
    • How partners may leave the partnership
    • How the partnership may be dissolved
    • Provisions for what will occur should something happen to the general partner
  4. Obtain the proper permits and licenses: Limited partnerships require certain permits and licenses to operate legally. The requirements will vary based on the business's locality, industry, and state.

When creating a limited partnership agreement, it is important to work with an experienced lawyer to ensure the contract contains all necessary components.

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