How Limited Partnerships Work

When it comes to business there are a number of purposes to form a limited partnership agreement. Here’s how limited partnerships work.

Limited Partnership

A limited partnership (LP) is a type of partnership where one owner, the general partner, has unlimited liability in the company. The other partner, the limited partner, only has a limited amount of liability in the company as defined by the investment that partner has made in the company.

Understanding a General Partnership

By contrast, a general partnership is a partnership between two or more people where all the partners have a stake in the business. When most people refer to a “partnership,” they’re referring to a general partnership. The general partners aren’t truly separate corp entities from the business and business profits are taxed at each partner’s tax rate. Each partner is liable for the business. If someone brings a lawsuit against the business, they are actually suing the business partners who are then jointly liable for the judgment.

There doesn’t have to be a formal limited partnership agreement to form a general partnership, although having a formal agreement does help solve disputes. If two people start doing business together, they’re in a general partnership. To establish a limited partnership, legal documents must be filed with the state’s secretary of state to establish the limited partnership. Without filing these documents, the partners are all general partners and equally share in normal business management and the profits and losses.

How Limited Partnerships Work

The limited partnership is its own entity separate and distinct from the rest of the business. The business must have at least one general partner for any other person to be a limited partner. The general partner can be an individual, multiple individuals, or a corporation.

Limited partners aren’t involved in the everyday management and operations of the business. They also do not have the right to elect a board of directors. They can typically participate in a decision liquidate the business. The limited partner only funds money to the
partnership and the general partner(s) make all the decisions about how that money is spent.

Limited partners aren’t personally liable for the business’ debts or lawsuits. However, since the limited partner does have money invested in the business, that limited partner does stand to lose if the business goes under. However, the limited partner has to be careful that they don’t become involved in the business. Otherwise, they can be construed as more than a limited partner and held personally liable for debts and other claims. State laws differ on how active the limited partner can be and still be considered a limited partner.

When it comes to taxes, the limited partner claims business income on their personal taxes. But, this income isn’t subject to self-employment tax, which is comprised of Social Security and Medicare taxes, since that income was not earned income.

Family Limited Partnership

Families may form family limited partnerships where are the partners are family members. The FLP can be used to minimize estate taxes since shares can be passed from one generation to another at a lower tax rate. In recent years, the IRS has become more suspicious of people using FLPs to avoid taxation and the agency has threatened to disregard this type of partnership. Forming a FLP has other advantages. It allows the business to plan family successors and keeps some family members from being personally liable for the business debts.

The only thing that really makes a FLP different from a regular limited partnership is that the members in an FLP are family members. It’s the estate tax laws that make a FLP an attractive option for family businesses.

Limited Liability Partnership

Another type of partnership is a limited liability partnership (LLP), where all the owners have limited personal liability in the group. This limited liability protects partners from being liable for another partner’s actions. For example, a group of doctors might form a limited liability partnership so they each are not held liable for a single doctor’s malpractice lawsuit. Some states have laws that restrict limited liability partnerships to certain professional groups.