Limited Partnership

What is a Limited Partnership?

A limited partnership (LP) is a type of business structure recognized in many countries around the world. Fundamentally, it is simply a legal partnership between two or more partners.

There must be at least one limited partner and one general partner (GP) to form a limited partnership. The general partner oversees and manages the limited partnership, and the limited partners are not active in managing the business.

Limited partnerships are typically set up as investment vehicles for a certain purpose like investing in a real estate project or a venture capital fund. In such cases, the general partner manages the investment and the partnership itself may have a limited life (funds may need to liquidate, or exit, their investments at some point over the defined life of the fund).

While general partners have unlimited personal liability if something goes wrong under their management, limited partners are only liable up to the amount of their investment, hence the name limited partners.

For example, if there is a legal judgment against the limited partnership, the general partners have unlimited liability to “cure” the judgment, but the limited partners would only lose the amount of their investment. Simply put, general partners’ personal assets may be used to satisfy obligations if the LP can’t meet the limited partnership’s obligations.

Regardless of form, limited partners must contribute either money or assets to the partnership in order to share in the partnership’s profits (or losses), usually on a pro-rata basis.

Characteristics of a Limited Partnership

A limited partnership has distinctive characteristics relative to other business forms, mostly related to the roles and liabilities of its partners. The following are some key characteristics of a limited partnership:

1. Two types of partners

• Limited Partners (LP): LPs contribute either money or assets to the partnership in order to share in the partnership’s profits (or losses). Limited partners are not involved in the day-to-day management of the partnership. In other words, LPs are considered passive investors. In a worst-case scenario, limited partners would only lose the amount of their investment.
• General Partners (GP): GPs run the day-to-day operations and manage the business. GPs can also enter into binding legal agreements on behalf of the limited partnership. However, general partners are also subject to unlimited liability in a worst-case scenario.

If the partnership’s assets are insufficient to cover its liabilities, general partners’ personal assets may be used to satisfy obligations. General partners will usually charge management fees as compensation for managing the limited partnership.

2. Potentially limited duration

When a limited partnership is structured as an investment fund, it may have a finite lifespan, and the investments would need to be liquidated according to the partnership agreement. A limited partnership might also be dissolved in certain situations (this would be specified in the partnership agreement).

3. Pass-through taxation

Limited partnerships are typically structured as pass-through entities. This means that the partnership itself is not subject to income tax, but its partners are. The partnership’s profits and losses are passed through to the individual partners, and the partners report their proportion of the profits and losses of the partnership on their own personal tax returns.

4. Formation

Forming a limited partnership is usually easier than forming a corporation. Corporations typically require significantly more initial documentation, as well as ongoing documentation, depending on where the corporation is formed.

Limited partnerships, on the other hand, usually require less documentation upon formation. The main partnership document is the partnership agreement, which outlines the contributions, responsibilities, and profit allocation among the partners.

5. Transferring an interest

Selling an interest in a partnership is more difficult than other business forms and may require the consent of the other partners.

Disadvantages of a Limited Partnership

1. One of the biggest disadvantages of the limited partnership structure is the unlimited liability to general partners. As discussed earlier, general partners manage the daily operations of the partnership and may be held fully accountable in a worst-case scenario; whereas limited partners are only at risk up to the amount invested in the partnership. Because of this, general partners may charge the limited partnership management fees.
2. Despite being generally easier to form and maintain, limited partnerships are potentially subject to greater tax complexity. Limited partners are not subject to self-employment taxes; however, since the partnership itself is not subject to income taxes, it must have a system to allocate profits and losses to the various partners. This allocation may require limited partners to file their tax returns on an extended basis, as the appropriate documentation from the partnership may not be available until just before the typical income tax deadline. As an example, in the United States, partnerships send the form K-1 to limited partners but those forms may not arrive until a couple of weeks before income taxes are due (April 15 in the US). This may require partners to request an income tax filing extension. However, the taxpayer/partner must still make an estimated payment on April 15, even if the partner won’t file until later in the year.
3. Partnerships are an inherently less liquid investment as the ability to buy and sell partnership interests is difficult and may require the other partners to consent to the transaction. This makes partnerships impractical for larger companies, especially publicly traded companies.

Examples of Limited Partnerships

Despite the disadvantages, limited partnerships are used in a variety of industries, including the following:

1. Private Equity (PE), Venture Capital (VC), and Hedge Funds: PE and VC firms, along with hedge funds, often structure their investment funds as limited partnerships. The PE, VC, or hedge fund will typically act as the general partner, making investment decisions and overseeing and managing portfolio companies. The investors are limited partners, only contributing capital and do not participate in daily operations. This is also common in the real estate industry. Often, these types of limited partnerships will have a finite life, especially private equity and venture capital funds.
2. Master Limited Partnerships (MLPs): Some oil and gas companies are structured as master limited partnerships. MLPs are unique in that they are publicly traded but limited to doing business in specific industries. An example of an MLP is Enterprise Products Partners.
3. Family Limited Partnerships (FLPs): Families with significant assets may create limited partnerships for estate-planning purposes. FLPs can be an efficient way to transfer wealth to younger generations while allowing the older generation to maintain control over assets. There may also be inheritance tax benefits when utilizing an FLP.

How is a Limited Partnership Different from a Corporation?

A limited partnership is similar in some respects to a corporation. In a limited partnership, the LPs own the partnership while the general partner manages it. In a corporation, shareholders are the owners and shareholders elect a Board of Directors, which in turn hires and oversees the managers of the corporation (like a CEO or CFO).

Additionally, both a limited partnership and a corporation result in limited liability for limited partners as well as for corporate shareholders.

However, there are many differences between limited partnerships and corporations. First, partnerships are known as pass-through entities and are not usually subject to tax at the partnership level. Therefore, limited partners will recognize their share of the partnership’s taxable income on their personal tax returns. Bottom line: there is only one level of taxation in a partnership (the individual partner level).

This is in contrast to a corporation, which pays income taxes on its taxable income. The corporation’s shareholders will pay tax if the corporation distributes dividends or if the shareholder sells shares at a gain. In other words, shareholders of corporations are effectively taxed twice: once at the corporate level, and then again at the shareholder level if shares are sold at a gain or dividends are received.

Additionally, most publicly traded companies are organized as corporations since corporations can have an unlimited number of shareholders, and calculating taxes is relatively easier when compared to a partnership. Also, it’s easier to transfer ownership of a corporation relative to partnership interests in a limited partnership. A corporate shareholder can easily sell shares but selling a partnership interest might require the consent of the other partners.

It is typically more difficult to create a corporation, which will require articles of incorporation and corporate bylaws. Additionally, there will be additional costs related to board meetings, shareholder meetings, and record maintenance. In contrast, a limited partnership just needs to obtain a certificate of limited partnership in the appropriate jurisdiction and have a partnership agreement. In other words, corporations are highly regulated and require a more formal creation process relative to limited partnerships.

Finally, corporations usually have an indefinite life. However, partnerships may have a finite life, as discussed previously. Nevertheless, this can be addressed in the partnership agreement.

How is a Limited Partnership Different from a Limited Liability Company (LLC)?

A limited partnership and a limited liability company are similar in many ways but differ in some key areas. Below are some key differences between the two structures.

1. While limited partnerships are managed by general partners, LLCs may be managed by their members (known as member-managed) or by certain designated managers (known as manager-managed, who can be either LLC members or outsiders).
2. While general partners have unlimited personal liability, all LLC members generally have limited liability, protecting their personal assets from the LLC’s debts and liabilities.
3. A limited partnership is a pass-through entity, while an LLC can be structured as a pass-through or a taxable entity, typically giving the LLC more flexibility in tax planning.

How is a Limited Partnership Different from a Limited Liability Partnership (LLP)?

Limited partnerships and limited liability partnerships are quite similar but differ in how liabilities are treated as well as how they are typically used.

1. Limited partnerships are managed by general partners and limited partners are passive members. This differs from limited liability partnerships, which are managed by all of the partners.
2. As the name implies, LLPs provide limited liability to all partners, whereas a limited partnership only provides limited liability to limited partners and not general partners.
3. LLPs are typically used in certain professional services like smaller law and accounting firms, as well as doctor’s offices so that all partners can work together to manage the LLP. In other words, limited partners manage the limited liability partnership, whereas GPs manage a limited partnership. However, each limited liability partner remains liable for their own professional malpractice or negligence. The limited liability partners are protected from the malpractice or negligence of the other limited liability partners.

Additional Resources

Corporation

Corporate Structure

Estate Planning

Family Limited Partnership (FLP)

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