What Is a Limited Partnership and How Does It Work?
Businesses are formed through a number of different methods and structures. Different business structures are selected for a number of reasons: decision-making structures, financial implications, tax adjustments, flexibility, etc…One common example of a business structure or investor structure is the Limited Partnership or an LP. Let’s explore what exactly a Limited Partnership is, and the Pros and Cons of working within this specific structure.
What Is a Limited Partnership?
A Limited Partnership is a business partnership of 2 or more partners. Limited Partnerships are made up of partners that contribute a significant financial investment to the business. There are a few specifications that make a Limited Partnership what it is. Within the partnership, there is always 1 General Partner while the remaining member or members of the LP are considered Limited Partners.
Beyond the breakdown of how the members of the LP are structured and held responsible, an LP operates in a few specific ways. For starters, they are pass-through entities. This means that the Limited Partnership itself is not subject to corporate income tax. Instead, the LPs profits flow through to the owners or members, or in this case Partners, and then those profits are taxed under individual income tax laws. Most states in the U.S. have specific laws governing the formation of LPs and most states require some form of registration of said LP with that state’s Secretary of State.
Typically, LPs are formed as an ideal structure to raise capital for a particular set of investments that ensures limited liability for most members of the LP to protect losing more than they invest and maximizing their opportunity for gains. In tech, LPs are a common structure for many Venture Capital Firms or Private Investment Firms.
In summary, remember these key takeaways about LPs:
- LPs have at least 2 members
- A Limited Partnership always has a General Partner while additional members are Limited Partners.
- LPs are pass-through entities.
- LPs protect most members’ assets with losses only ever being possible for the amount initially invested.
- Limited Partnerships are a great structure for raising capital for large, potentially risky investment opportunities – like software and technology companies.
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How Does a Limited Partnership Work?
Diving in more specifically to the structure of a Limited Partnership’s members, it’s critical to understand the difference between the General Partner and the Limited Partner(s).
- The General Partner oversees and runs the business including the day-to-day operations and management of the business, it’s activities, and it’s investments. Additionally, the General Partner takes on unlimited liability for the debt of the business as well as any obligations or activities as outlined in the partnership.
- The Limited Partner or Limited Partners do not make any decisions in the execution and operation of the business. However, they only have limited liability for the debt of the business, with liability only up to the amount they invested. Limited partners are sometimes known as passive or silent investors since they have no stake in the business and are more like general company shareholders with the type of influence they can have on the operations of the business.
How Do You Form a Limited Partnership?
The process of forming a Limited Partnership is fairly straightforward. As mentioned above, most states require Limited Partnerships to be registered with the state’s Secretary of State. So for most LPs in most states, the first step to forming an LP is to file as an official LP within the state your LP will be based in – the state your LP is registered in doesn’t mean that is where all your Limited Partners have to be residing, as they will pay individual income tax in their respective states, but it is where your LP will be registered to operate or where your LP will be headquartered. As part of registration with your Secretary of State, most states will require the LP to pay a filing fee.
When an LP is officially recognized by the state government, the Limited Partnership will be granted a Certificate of Limited Partnership. This certificate includes the names and addresses of the general partner or partners, the street address of the LLP’s principal office, and a brief, formal statement of the partnership’s business.
After the legal registration is complete, the next step to forming a Limited Partnership is to create a Limited Partnership Agreement. The LP Agreement will be a formal, legal document that governs how much ownership each Limited Partner has in the partnership, any partnership limitations or agreements that the General Partner must adhere to, and any other miscellaneous terms of the partnership. The Limited Partnership Agreement will serve as the foundational, fundamental outline of how your newly formed LP will operate.
What to Include in a Partnership Agreement
The Limited Partnership Agreement is a critical part of the formation of an LP. There are a number of pieces of information that should be included in a standard partnership agreement.
- Business Name: The formal name of the Limited Partnership should be clearly outlined at the heading of the partnership agreement.
- Business Purpose: The goal of the Limited Partnership should be outlined within the agreement. This should include the reason for establishing the LP as well as the purpose this LP will serve – what it’s investing in or why it’s formation will be a positive outcome for said business projects or initiates it will impact.
- Partner Structure: The Partnership Agreement should list out the roles and responsibilities of the General Partner and the Limited Partner(s). The agreement should also include the existing names of the GP and any current LPs – this can be amended at a later date if more LPs join or some exit the Limited Partnership. In addition to just outlining the specific roles of each partner, the partnership agreement should outline how specifically partners can leave the partnership.
- Ownership shares and capital contributions: This section of the Partnership Agreement should outline the specific capital contributions of the LPs within the Limited Partnership, as well as the equivalent ownership stake and shares that each LP is granted. This section should also cover how specifically any profits or losses will be divided among partners depending on their contributions and partnership status (Limited or General).
- Voting Rights and Decision Structure: Clearly outline how decisions within the partnership will be made. If there are voting rights for members beyond the General Partner(s) outline that. Additionally, outlining a plan for decision making should the GP have any trouble upholding their role or need to step down for any reason.
- Dissolution Guidelines: Like any business, not all LPs are going to have a successful outcome or last forever. As your forming your Limited Partnership, clearly outline what will happen should the lP ever dissolve – outline how assets will be divided, how knowledge will be dispersed, and any other structural outlines or decisions will be made.
What Is An Example of a Limited Partnership Business?
Now that we’re clear on what a Limited Partnership Business is and have the basics for the formation of one, it’s important to understand the types of businesses that may benefit from being established as Limited Partnerships.
- Commercial Real Estate Projects – Real estate, especially commercial real estate, typically requires a lot of capital up front in order to get a project off the ground and finished. This makes large commercial real estate projects a great candidate for a Limited Partnership Business. An experienced real estate investor or contractor may choose to form an LP for a large commercial project and serve as the general partner if the know space and market and are confident they can get a return. The LP structures secures that project capital up front from the limited partners and allows the general partner operators, maybe a lead investor or contractor or even construction company, to front the risk and manage the project.
- Estate Planning Businesses – If someone has a large estate that will need to be divided up and passed on, an LP is a good option to ensure this is done fairly and efficiently. An LP for an estate can ensure one primary partner is responsible for managing said estate and any ongoing businesses tied to that estate, while the Limited partners of said estate can benefit financially from a few very specific entities or allowances from said estate but will have no governing control of the assets. This LP is a great way for someone to ensure their estate is properly taken care of after they pass.
- Family Businesses – A business looking to operate without any external partners or investors, but rather, keep all financial stake within the business to family funds or money is a great candidate for a Limited Partnership. Within a family owned business, a specific family member can be designated as the General partner of the business and ensure all operations of the business run smoothly, while family money from other members serving as limited partners can finance the business. This keeps debt tied to the family vs. taking on any additional, outside debt.
Limited Partnership Pros and Cons
Like all business structures, there are pros and cons to forming a Limited Partnership.
- Easy to Create – With essentially a 3-step process (Register with the state, pay a feel, write up an agreement), LPs are one of the easiest business types to create. This makes forming an LP as a way to fund and launch a business a great option. Additionally, LPs don’t come with formal reporting requirements like annual board meetings or shareholder meetings. The General Partner of the LP will handle decisions as clearly outlined in the partnership agreement.
- Personal Liability Protection – For the majority of stakeholders in an LP, the limited partners, there’s a limit to what they are liable for in the business. As stated, limited partners are only liable for the amount up to their investment so the risk is a lot more black and white and much less risky than other investment opportunities or business structures for the majority of stakeholders in an LP.
- Pass Through Entity – There is no self-employment taxes for limited partners and there are no corporate taxes for LPs, all partners are taxed with standard income tax so the financial structure of an LP is extremely straightforward and attractive for the participants.
- Less Formal – Outside of outlining the guidelines between the General Partner(s) role and the Limited Partner(s) role, there aren’t a lot of required formal structure or guidelines for running an LP. This allows LPs to be one of the most informal options for running your business which for many types of businesses is a great benefit, especially if the business is straightforward and extra structure or obligations would be unnecessary or frivolous.
- Unlimited Personal Liability for the General Partner – While the Limited Partners benefit greatly from an LP structure, an General Partner in an LP is taking on unlimited personal liability with the business. This can be a huge risk and be extremely detrimental to a personal finance situation if said business does go under or doesn’t pan out as intended with its specific investments. For a lead investor to take on a GP role, the risks of unlimited personal liability are certainly something to consider.
- Limited Partner Participation – If having a stake in decisions about yoru investments is important to you, then investing as a limited partner in an LP could be a major con. Limited partners don’t have any say or influence on what happens within the LP which can be a con if you end up not liking the outcome of certain GP decisions or existing investments or outcomes within your LP.
- Ownership Changes – LPs come with a number of challenges with ownership and leadership. On the leadership side, it’s not a flexible structure for bringing in new management. Based on the way LPs and GPs are determined, from financial and liability stake, it’s not a straightforward process to bring in new operators – it requires a certain amount of financial contribution and changes ot the limited partnership agreement. On the ownership side, this also makes it hard to transfer to other investment entities like LLCs due to the way the capital and liabilities are divided out. An LP may not be the right structure if selling the business is part of the end game plan.
After diving into the details of Limited Partnerships, how they are structured, and the pros and cons of selecting a Limited Partnership to establish your business, you may still have a few questions on the mind.
Limited Partnership: Frequently Asked Questions (FAQ)
How Are Limited Partnerships Taxed?
LPs will not pay income tax. They are pass-through organizations so the individual partners of the LP will pay income taxes on their investments, earnings, and losses.
How Do Limited Partners Earn Returns?
Limited Partners will earn returns via dividends when their investments via the LP produce returns. Limited Partners will receive dividends in proportion to how much they invested in the Limited Partnership business.
What Securities Laws Are Limited Partnerships Subject To?
In general, LPs are subject to all state and federal security laws and must be registered unless a clear exemption is stated and available in their state or at the federal level for their specific business.
What Is the Difference Between a Limited Partnership and a Sole Proprietorship?
A sole proprietor is someone who owns an unincorporated business by themselves. A Limited Partnership requires at least 2 partners – a general partner and a limited partner – but may have more than 2 partners as well.
What Is the Difference Between a Limited Partnerships and an LLC?
An LLC, or a Limited Liability Company, is a company where there is limited liability to all owners. This differs from an LP because there is not one sole partner that has unlimited liability, so all members of an LLC have more protection for their investments. Both types of businesses are pass-through businesses from a taxation perspective.
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