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Limited Partnership Explained

17. What are the major characteristics of a “limited partnership”?

The limited partnership is a specialized form of partnership. The purpose of the limited partnership is to allow individuals to organize into an entity form that allows the flexibility of a general partnership, while allowing for special rights, duties, and protections for “limited partners”. The major characteristics of the limited partnership are as follows:

•    Creation and Maintenance – A limited partnership, unlike a general partnership, must be filed with a state government to come into existence. The application must state the purpose of the business and list the name and general contact information for all limited and general partners. Indicating who is a limited partner is important so as not to deceive third parties with regard to ownership and control of the business entity. Forming a general partnership also requires a written agreement between the partners that identifies and indicates the limited partner status of any limited partners. Only one general partner and one limited partner are required; however, there can be numerous limited and general partners.

⁃    Note: The partners must undertake the initial filing process and follow any required updates or filings by state government. This includes updating the records in the event of any change in ownership of the limited partnership, such as the entrance or exit of partners. Further, if a limited partner becomes a general partner, or vice versa, the records must be updated.

⁃    Example: Martin and I decide to form a partnership. Martin wants to be a limited partner and allow me to run the business as general partner. We enter into a limited partnership agreement. We then register the entity with the Georgia Secretary of State’s office. In the registration, we identify Martin as the limited partner and me as the general partner.

•    Continuity – As for continuity, the same rules apply as those of the general partnership. Because the limited partnership will always has a partnership agreement, it generally includes provisions governing the continuity of the business in the event of dissociation by a partner. It will also outline the events that constitute an automatic dissociation event, such as personal bankruptcy of a member.

•    Ownership – The limited and general partners own the limited partnership in whatever percentage is allocated in the limited partnership agreement. This is the same as in a general partnership. Generally, the default partnership rules regarding ownership do not apply, as the limited partnership cannot exist without a limited partnership agreement that allocates ownership interest. The main difference in ownership interest is how it arises. Generally, the limited partners receive an ownership interest in exchange for providing capital (either funds or physical resources) to the limited partnership; while the general partner generally receives an ownership interest for either capital or labor provided to the limited partnership.

⁃    Example: Clark and I decide to form a limited partnership. Clark will contribute funds to the business and will act as limited partner. I will contribute effort to the business and will be a general partner. Clark and I will have equal ownership of the partnership.

•    Control – Control is the most defining aspect of a limited partnership. As in a general partnership, general partners in the limited partnership control and have authority to act on behalf of the partnership. Limited partners, on the other hand, cannot take part in management or decision-making of the business. This prohibition includes limitations on taking part in any of the actual operations of the business. More specifically, they cannot exercise control over any activity or anyone carrying out a business activity. A limited partner that exceeds this limited authority may lose her limited partner status and be deemed a general partner. This is a scary proposition for the limited partner, as a general partner is subject to personal liability for the obligations and torts of the partnership, where the limited partner is not. As such, the limited partner is relegated to being a passive investor in the business activity.

⁃    Note: Statutes in some jurisdictions allow a limited partner to take limited part in the following activity without being converted into a general partner, such as: serving as consultant or advisor to the partnership; voting on major partnership decisions; serving as guarantor or surety of partnership liabilities; inspecting records; receiving a partnership draw based upon her ownership interest; or receiving a return of capital invested.

⁃    Example: Tammy and I form a limited partnership. Tammy is the limited partner and I am the general partner. As general partner, I am charged with controlling all operations of the business. Tammy, as limited partner, cannot take part in any of the operational decision-making. She can, however, take part in any major business decisions that affect the ownership or structure of the business entity. In essence, Tammy is a silent owner and has no authority to act on behalf of the business entity.

•    Limited Personal Liability – The key advantage of a limited partnership is that the limited partner has limited personal liability for obligations and torts of the partnership. Specifically, the limited partner is only personally liable to the extent of her investment in the business. She cannot lose personal assets, only the assets that she has contributed to the partnership. General partners, on the other hand, face unlimited personal liability for obligations and torts of the partnership.

⁃    Note: Remember, actively participating in management will cause the limited partner to be treated as a general partner. This means losing the limited liability protection and risking one’s personal assets for debts of the business.

⁃    Example: Cary and I form a limited partnership. I am the general partner and Cary is the limited partner. Mark sues the limited partnership for failure to pay a debt. He receives a judgment against the business. If the business does not have the assets to pay or otherwise satisfy the debt, Mark can seek to satisfy the judgment against my personal assets. Cary can lose the assets she contributed to the business, but Mark cannot go after her personal assets.

•    Compensation – Compensation in a limited partnership is the same as in a general partnership. Limited and general partners are compensated through distributions of profits (partnership draw). It is common for either general or limited partners in a limited partnership to receive a special allocation of partnership profits that does not coincide with the percentage of business ownership.

•    Taxation – Limited partnerships are taxed similarly to a general partnership. The profits and losses of the limited partnership pass through to the owners and are reported on the owners’ personal income tax statements. The notable difference between the taxation of general and limited partners is that limited partners receive their distribution of profits as passive income. That is, they have not earned the income pursuant to work effort; rather, it is pursuant to a passive investment. As such, the limited partner’s income is not subject to self-employment tax (15.3% in 2016).

⁃    Note: The general partners must still pay self-employment tax on their share of partnership profits.

⁃    Example: David and I form a limited partnership. As general partner, I am active in the business. David, as limited partner, does not actively participate in business operations. At the end of the year, the limited partnership has profits of $10,000. David’s share of the profits ($5,000) is considered passive income. As such, David does not have to pay self-employment taxes on the income. My profits, in contrast, are active. As such, I will have to pay payroll taxes up on the $5,000 of compensation allocable to me.

•    Discussion: Can you think of a prominent limited partnership? Why does the limited partnership entity fit well with this business model?

•    Practice Question: In a short paragraph, can you describe the primary attributes of a limited partnership?

 

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