- How It's Taxed
A limited partnership (LP) is a partnership in which the duties and obligations of the partners are divided between one or more “general partners” and one or more “limited partners.”
A general partner is a partner with the same liability and power as in a general partnership, who is responsible for managing the partnership and its operations. Like the partners in a general partnership, general partners in an LP are personally liable for all of the partnership’s debts and other obligations.
A limited partner, in contrast, does not participate in the partnership’s management and day-to-day operations. In fact, the limited liability of the limited partner usually depends on adhering to specific prohibitions against being actively involved in the management or operation of the partnership business.
Unlike the general partner, the limited partner is usually not personally liable for the partnership’s debts and other obligations, except to the extent of the capital he has contributed to the partnership (or is obligated to contribute in the future under the partnership agreement).
Advantages and disadvantages for this form of partnership are analogous to those of a general partnership. The main advantage of a limited partnership is the limited liability that limited partners enjoy, protecting them against personal liability for the partnership’s debts and other obligations.
The limited liability protection afforded limited partners makes this a more attractive entity than a general partnership in that it is easier to attract investors than a general partnership where each general partner’s personal assets are at risk.
It is therefore far easier to market limited partner interests as an investment, particularly with respect to discrete projects such as real estate development. However, such limited partner interests are generally considered “securities” and will thus be subject to regulation under federal and/or state securities laws.
With the advantage of limited liability, however, comes the disadvantage of not being able to actively participate in the management of the LP.
An LP must have at least one general partner and one limited partner, but there is no legal maximum on the number of either type of partner. However, as a practical matter, the limited partners are the passive investors who fund the business venture and the general partners are typically an individual or small, manageable group that operates the business on a daily basis.
Both general and limited partners may be individuals, trusts, estates, or other entities. General partners are often limited liability entities because of the unlimited personal liability imposed on the status of a general partner.
The preservation of a limited partner’s limited liability protection is dependent upon very restricted rights to participate in the management of the business or have voting rights on decisions of the partnership.
A limited partner who violates the restriction on participating in management of the LP risks losing his limited liability for partnership debts and obligations. Limited partners are, nonetheless, typically given certain voting rights with respect to major partnership decisions such as:
- The sale of all (or substantially all) of the partnership’s assets
- The admission, removal, or retention of a general partner
Usually, the formation and operation of limited partnerships are regulated under state statutes, which define the obligations and duties of these classes of partners and impose other obligations. For example, limited partnership statutes usually require that a “Certificate of Limited Partnership” (or similar form) containing specified information be filed with the appropriate state authority and kept current.
The death or resignation of a limited partner does not cause the dissolution of an LP. However, statutes typically provide that if a general partner dies or resigns, the LP will be dissolved unless certain conditions are met.
How It’s Taxed
A limited partnership is a pass-through tax entity like a general partnership where profits and losses are reported and factored on the individual tax returns of all partners. An LP is also given the same flexibility as a general partnership to allocate profits, losses, and gains regardless of one’s percentage of equity interest in the partnership.
How is a limited partnership formed?
Unlike a general partnership, a limited partnership can only be formed through a written agreement establishing the status of one or more “general” partners and one or more “limited” partners.
Do I need to file any document with my state to form a limited partnership?
Yes. A limited partnership is created as a legal entity by filing a Certificate of Limited Partnership (or equivalent document) with the Secretary of State or other state agency handling entity formations.
Do I need to have a written partnership agreement?
Yes. A written LP agreement is required to identify the status of general and limited partners and to describe the profit and loss allocations among other provisions.
Do all partners have equal authority and power?
The general partners all have equal authority and power unless a written partnership agreement provides otherwise. An agreement may give one or more partners specific powers or authority to act on behalf of the partnership. This additional power and authority may be all-inclusive or limited to certain specific situations. Limited partners are prohibited from participating in management (with a few exceptions for major changes in the partnership) or they risk losing their limited liability protection.
Do all partners share equally in profits and losses?
The partnership agreement will specify each partner’s percentage share of profits and losses. A partner may have one percentage interest for profit distributions and yet another percentage interest for loss allocations.
Do all general partners have unlimited personal liability?
By definition, all general partners have unlimited personal liability for the debts and obligations of the partnership’s business. While the general partners can agree among themselves to alter their share of personal liability, this is not binding on a creditor who may seek full compensation for damages from any general partner.
What is the liability of a limited partner?
A limited partner who retains this status by not improperly participating in the management of the partnership business is only at risk for the capital contributed to the partnership. A limited partner has no personal liability for any claims against the partnership and the limited partner’s personal assets are not at risk.
Does a limited partnership pay federal or state income tax?
No. A limited partnership, just like a general partnership, is not a tax-paying entity. It is a “pass-through” tax entity where profits and losses are allocated to each partner on a pro rata basis. Each partner then reports his or her share of profits on a personal 1040 tax return and pays income tax at the individual level. The partnership files an “information” return at the federal and state level indicating the profit or loss allocations made to each partner.
Is a limited partnership subject to any other type of tax?
Possibly. Because a limited partnership is a limited liability entity like a corporation or LLC, many states impose a “franchise tax” in a minimum annual amount or as a percentage of revenues, assets or other factors.
Does a partner have to pay income tax on profits if they’re not distributed?
Yes. Since a limited partnership is not a tax-paying entity, the IRS will treat a partner’s share of profits as if it had been distributed in full for tax purposes whether or not the partner actually received any or all of the profit.