What Is a Limited Partnership and How Do You Form One?
A limited partnership is a business structure with general partners, who manage the business and take on liability, and limited partners, who invest but do not manage day-to-day operations.
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Key takeaways:
- Limited partnerships consist of both general and limited partners.
- General partners bring skills and labor, while limited partners bring financial resources.
- Limited partnerships work for a variety of businesses that want to pool resources among multiple owners.
What is a limited partnership?
A limited partnership is a business partnership in which there are two types of partners: general and limited. General partners manage the business and are jointly liable for the debts and obligations of the business. Limited partners have limited liability for business debts and obligations but don’t actively manage the business.
The limited partnership is a variation of a regular partnership and may work well if you plan on having multiple partners or investors.
How limited partnerships work
In a limited partnership, two or more individuals each contribute something of value to the company, such as money, property, skills or labor. Partners share in the profits and losses of the company. But there are two distinct types of partners: general and limited.
1. General partners
General partners participate in the day-to-day management of the business. Each general partner faces full personal liability for the debts, obligations and activities of the partnership. This means if someone has a legal claim against the partnership, they can sue any or all general partners. They can even lay claim to the general partners’ personal assets if the business assets of the partnership aren’t sufficient.
2. Limited partners
Limited partners are often called “passive investors” or “silent partners.” They typically contribute money to the business and share in the income stream of the business. However, they don’t participate in the day-to-day management of the company.
Limited partners are only liable for business debts and obligations up to the extent of their investment in the company. If a limited partner invests $1 million in the business, that’s the maximum they can be personally accountable for in a lawsuit against the company.
When are limited partnerships useful?
Pooling resources of general and limited partners can be critical to getting a business off the ground. General partners bring skills and labor, while limited partners bring financial resources.
Here are some situations where limited partnerships are common:
- Family businesses:
- Many family-owned businesses designate one or two members of the family as general partners with management responsibility. The other family members are limited partners, sharing only in the income of the business. Eventually, management responsibility passes on to younger family members who inherit the business. This is sometimes called a family limited partnership.
- Commercial real estate projects: A limited partner often fronts money for large commercial real estate projects, such as shopping malls and apartment complexes. The limited partner receives financial benefit from the income generated by the project, but they designate a general partner to oversee the completion of the project itself.
- Professional businesses: In professional industries, such as doctor’s offices and law firms, retiring members might wish to stay involved as limited partners. They’ll cede management control of the company to general partners.
- Estate planning: Another variation of a family limited partnership occurs with estate planning, where the general partner holds real estate on behalf of the heir. The asset produces an income stream for the heir, who will eventually hold the real estate in their own right.
Limited partnership taxes
A limited partnership is a pass-through entity, which means the partnership itself doesn’t pay taxes in the way a corporation would. Here’s how taxes work:
- The partnership fills out Form 1065 as an informational return and provides a Schedule K-1 to each partner with details of the partner’s share of the company’s income and losses.
- Using the Schedule K-1, each partner reports their share of the business income and losses on their personal tax return. The income is taxed at the owner’s personal income tax rate.
- If business losses are greater than profits, partners in a limited partnership can deduct losses up to their investment in the businesses. If their losses are greater than their investments, they can carry the losses to other years to offset the profitability of those years.
- Since limited partners don’t participate in the management of the business, their income is called passive income or loss. Passive income or losses can only offset other passive income.
Who pays self-employment taxes?
Only general partners pay self-employment taxes on their earnings. Self-employment taxes cover Social Security and Medicare taxes.
Limited partners don’t have to pay self-employment taxes, except on guaranteed payments received for services provided to the partnership, because they don’t participate in the day-to-day management of the business.
Limited partnership compliance
Since limited partnerships have investors, they are subject to many of the same securities laws as corporations. Issuing ownership shares in a limited partnership, called limited partnership units, is similar to issuing stock in an S corporation or C corporation.
Just like corporations, limited partnerships must hold investor meetings and allow all partners access to business books and financial records. Some states even require limited partnerships to publish an annual report.
Understand your state’s laws and requirements as well as possible. Every state, except Louisiana, has enacted some version of the Uniform Limited Partnership Act.
Other types of partnerships
Partnerships all consist of multiple people owning a business. But there are nuances to each partnership type.
| Partnership Type | Features |
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Pros and cons
It’s best to get help from a business attorney and tax professional when choosing a business structure like a limited partnership , but these are some pros and cons to consider.
Pros
Pool resources: This structure allows you to pool financial resources of limited partners, combined with the skills and labor of general partners.
Limited liability for limited partners: Limited partners can’t face liability beyond what they invest in the business.
General partners are independent: General partners can make management decisions, without having to consult limited partners.
Easy transitions: Limited partners can easily exit the business without causing management problems.
Simple tax filing: Limited partnerships have simple pass-through tax filing, where each partner reports their share of the business income and losses on their personal tax return.
Works for some business types: Certain types of businesses, like family-owned businesses and real estate companies, prefer limited partnerships.
Cons
General partners face more liability: General partners face maximum personal exposure for business debts and obligations.
No say for limited partners: Limited partners have no say in business decisions, which can cause tension among partners.
More paperwork: Limited partnerships require more paperwork and compliance than a general partnership.
When does it make sense to form a limited partnership?
In most cases, forming a limited partnership comes down to resource constraints and practicality. Someone might have a great business idea and the skills to make that idea a reality, but lack the cash to get started.
If that person can find a limited partner to front the cash in exchange for a portion of the business profits, then a limited partnership is born. The limited partner is shielded from liability, and the general partner agrees to take on more risk.
How to form a limited partnership
If you decide to form a limited partnership, you’ll have to file some paperwork to get started.
1. File a certificate of limited partnership. The certificate of limited partnership contains basic information about your company. You’ll file it with your state’s secretary of state office. Here’s what to include:
- Name of the business (typically must end in “Limited” or “Ltd.”).
- Registered agent of the business who will accept legal documents on the business’s behalf.
- Name and address of each general partner.
- Signature of general partner or person filling out the form.
2. Draft a partnership agreement. An agreement is not legally required, and it’s not filed with the state. Nonetheless, a partnership agreement is an important document because it provides a blueprint for operating your business. The agreement lays out the rights and responsibilities of each partner, stemming conflicts in the future.
3. Utilize online legal services if needed. If you want help filing your certificate of limited partnership, you can try an online legal service. Most online services make filing the form simple, and can also help you create a custom partnership agreement.
A version of this article was first published on Fundera, a subsidiary of NerdWallet.
On this page
- Key takeaways:
- What is a limited partnership?
- How limited partnerships work
- When are limited partnerships useful?
- Limited partnership taxes
- Limited partnership compliance
- Other types of partnerships
- Pros and cons
- When does it make sense to form a limited partnership?
- How to form a limited partnership
