Limited Partnership: Overview, Taxation, and Examples

A limited partnership is a company in which two groups of partners own it: general partners and limited partners.
Learn the specifics of what a limited partnership is and how it differs from other forms of corporate partnerships. In this article, we’ll also see the importance of a limited partnership agreement, how the taxation works, and some real-life examples of the partnership.

What is a Limited Partnership?

General partners own and run a corporation, while limited partners invest in it but do not make operational decisions or bear personal responsibility for company debt. A limited liability partnership may be formed by bringing together one or more of each type of partner.

Limited partnerships are often used by businesses in which the professionals involved wish to delegate ownership of the company to the general partner. A limited partnership, for example, could be used by real estate investors.

Another common use of a limited partnership is in a family business, which is known as a family limited partnership. Family members can pool their funds, appoint a general partner, and watch their investments grow.

LP is an acronym for Limited Partnership.

How Limited Partnerships Work

An LP must have at least one general partner who is in charge of the day-to-day operations of the firm. The general partner may be a person or a legal entity such as a company. These forms of partners make business-related decisions and are also entirely responsible for the company’s debts and litigation.

One or more limited partners are also part of an LP. They often refer to these people as “silent partners” because they don’t have to do anything other than invest in the company to receive a cut of the profits. They are passive owners who do not engage in business management.

Limited partnerships are pass-through corporate vehicles for taxation purposes. So, this means that the business’s income tax goes through to the individual partners. Individual partners pay income taxes based on their share of the company, much as in other forms of partnerships. This share, also known as a distributive share, is reported on the owner’s personal tax return, and income taxes are charged at the individual’s personal tax rate.

When the LP suffers a loss, they handle the general partner and limited partners differently for tax purposes. Even if the client has no other income to cover the loss, the general partner will accept it.

A limited partner earns a passive income because they do not engage in the day-to-day operations of the partnership. This means they can’t take a loss to lower their taxes if they don’t have any other revenue to cover the loss.

Read Also: Silent Partner: Overview, Agreement, Rights & How to get one

How to Establish a Limited Partnership

One can form an LP, like any other company, by registering with your state and paying a filing fee.

In addition to registration, you will need to draft a limited partnership agreement outlining all of the partners’ obligations. The limited partnership agreement also specifies how the partnership’s profits will be distributed among the partners. It should also contain clauses that answer the issue, “What if the general partner dies?”

Advantages and Disadvantages of Limited Partnerships

An LP has the same benefits as other forms of partnerships, but with the option of limited partners: these partners may reduce their liability while still benefiting monetarily from the business’s growth.

The main drawback of an LP is that the general partner is legally responsible for all management decisions. So to offset these risks, this individual will normally need adequate compensation.

Alternatives to Limited Liability Partnerships

An LP varies from a general partnership in that it only has partners who engage in company management. All general partners are liable and share in all gains and losses.

A limited liability partnership is a hybrid between a partnership and a business. Both partners in this form of partnership are called limited partners with limited liability. However, all of them are qualified to engage in business management.

Instead of making individuals take personal responsibility, a corporation may form a limited liability company (LLC) that acts as the general partner and assumes all liability.

Limited Partnerships Taxation

For taxation, the Internal Revenue Service handles limited partnerships similarly to general partnerships, with a few exceptions.

#1. Limited Partnership Taxation by Pass-Through

The pass-through taxation system is used to tax limited partnerships. They distribute profits and expenses to spouses and list them on their personal tax returns. Also, they distribute profits and losses to partners in proportion to their ownership stakes. For example, if a partner owns 51% of his LP, he receives 51% of the gains and losses.

LP participants, on the other hand, may consent to share income disproportionate to their own interests by special allocations. The operating agreement for the LP specifies these special allocations.

#2. Deductions

On the partners’ individual tax returns, business costs are deductible. Hence, allowable business costs, including gains and losses pass on to partners concerning their own interests for deductions on their tax returns. Equipment acquisitions, start-up, and maintenance costs are examples of company expenditures that can be deducted. LPs submit Schedule K-1 Forms to their partners, which report the number of gains, losses, and deductions distributed to them.

#3. Taxes on Self-Employment

One of the taxation benefits for limited partners in Limited Partnerships is that the IRS does not treat workers in the same way that general partners do. Since LPs’ earnings are not taxable wages, they don’t pay self-employment taxes, which are a combination of Social Security and Medicare taxes. This is a tax exemption for limited partners since, as of 2013, the self-employment tax rate is 15.3 percent of the taxable income of general partners.

#4. Information Return

An LP is required by the IRS to file an annual information return. An information return specifies the distribution of gains, losses, and deductions to each participant. So, the IRS uses information returns to ensure that member allocations are accurate. Type 1065 is used by LPs to file information returns, not by individual members.

Considerations

Partners will exclude losses on their personal tax returns only up to the value of their ownership interests. If their losses outweigh their interests, they will carry the difference forward to future years. Furthermore, LPs may prevent any or all profits allocation to partners if they need to retain money inside the organization for business improvements. Partners, on the other hand, would pay income taxes on their share of earnings, even though they did not earn the entire amount.

Limited Partnerships Real-Life Examples

#1. Limited Partnership Example

LPs are common in time-sensitive ventures such as filmmaking and real estate. The general partners of a film are the director, writer, and editor. The limited partners are the companies that spend money on filmmaking. In a real estate business, the general partners are professional property managers, while the limited partners are outside investors.

#2. Limited Liability Partnership Example

Limited Liability Partnerships are popular in medical practices, law firms, and accounting firms. Ernest & Young LLP is a professional services company based in London, England. Ernst & Whinney and Arthur Young & Co. (two companies) combined to form the firm in 1989. All of these firms are limited partners.

What is a Limited Partnership Agreement (LPA)?

Considering starting a company with one or more partners? A Limited Partnership Agreement specifies the terms of your partnership and assists in ensuring the viability of your future business venture. So, with an agreement between you and your partners on your ownership rights and responsibilities, you will return to working together to achieve your business objectives.

A Limited Partnership Agreement establishes all of the terms of the limited business partnership, from ownership rights to buy-out options and everything in between. You may also assign unique management positions to your partners. Limited partners (those whose responsibility for the firm’s debts is proportional to their investment) usually do not have management authority.

Your Limited Partnership Agreement should include details such as the name, address, and purpose of forming the partnership; whether limited partners have any voting rights over day-to-day business decisions; how decisions will be made (by unanimous vote, majority vote, or majority vote based on percent ownership); the names, percent ownership, and also the capital contributions of the partners.

This document is also known as the LP Agreement.

Bottom Line

Hedge funds and investment partnerships commonly use limited partnerships to raise money without giving up control. Limited partners invest in an LP and have little or no influence over the entity’s management. Their responsibility is limited to their personal investment. Meanwhile, the management and operation of LP are by general partners, but their liability is unlimited.

Limited Partnership FAQs

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