Limited Partnership (LP)

What Is a Limited Partnership (LP)?

A limited partnership (LP)—not to be confused with a limited liability partnership (LLP)—is a partnership made up of two or more partners. The general partner oversees and runs the business while limited partners do not partake in managing the business. However, the general partner of a limited partnership has unlimited liability for the debt, and any limited partners have limited liability up to the amount of their investment. 

Understanding Limited Partnerships (LPs) 

A limited partnership is required to have both general partners and limited partners. General partners have unlimited liability and have full management control of the business. Limited partners have little to no involvement in management, but also have liability that’s limited to their investment amount in the LP.

Types of Partnerships

Generally, a partnership is a business where two or more individuals have ownership. There are three forms of partnerships: limited partnership, general partnership, and limited liability partnership. The three forms differ in various aspects, but also share similar features.

In all forms of partnerships, each partner must contribute resources such as property, money, skills, or labor to share in the business’ profits and losses. At least one partner takes part in making decisions regarding the business’ day-to-day affairs.

Limited Partnership (LP)

A limited partnership is usually a type of investment partnership, often used as investment vehicles for investing in such assets as real estate. LPs differ from other partnerships in that partners can have limited liability, meaning they are not liable for business debts that exceed their initial investment.

General partners are responsible for the daily management of the limited partnership and are liable for the company’s financial obligations, including debts and litigation. Other contributors, known as limited (or silent) partners, provide capital but cannot make managerial decisions and are not responsible for any debts beyond their initial investment. 

General Partnership (GP)

A general partnership is a partnership when all partners share in the profits, managerial responsibilities, and liability for debts equally. If the partners plan to share profits or losses unequally, they should document this in a legal partnership agreement to avoid future disputes.

A joint venture is often a type of general partnership that remains valid until the completion of a project or a certain period passes. All partners have an equal right to control the business and share in any profits or losses. They also have a fiduciary responsibility to act in the best interests of other members as well as the venture.

Limited Liability Partnership (LLP) 

A limited liability partnership (LLP) is a type of partnership where all partners have limited liability. All partners can also partake in management activities. This is unlike a limited partnership, where at least one general partner must have unlimited liability and limited partners cannot be part of management. 

LLPs are often used for structuring professional services companies, such as law and accounting firms. However, LLP partners are not responsible for the misconduct or negligence of other partners. 

How To Form a Limited Partnership

Almost all U.S. states govern the formation of limited partnerships under the Uniform Limited Partnership Act, which was originally introduced in 1916 and has since been amended multiple times. The majority of the United States—49 states and the District of Columbia—have adopted these provisions with Louisiana as the sole exception.

To form a limited partnership, partners must register the venture in the applicable state, typically through the office of the local Secretary of State. It is important to obtain all relevant business permits and licenses, which vary based on locality, state, or industry. The U.S. Small Business Administration (SBA) lists all local, state, and federal permits and licenses necessary to start a business.

Partnership Agreement

In addition to external filings, the partners of the limited partnership must draft a partnership agreement. This document is an internal document that defines how the business will be operated. This agreement outlines the rights, responsibilities, and expectations of each partner. This document is not filed with an state or government entity, and the document may be referred to as the operating agreement.

The partnership agreement should identify two key financial aspects of the company. First, the agreement should identify how profits and losses will be shared. This includes how profits will be distributed to partners. Second, the agreement should identify the process and expectations for when a partner wants to sell their stake in the partnership. This may include a notice period or expectations around the first right of purchase from other partners.

Advantages and Disadvantages of a Limited Partnership (LP)

The key advantage to an LP, at least for limited partners, is that their personal liability is limited. They are only responsible for the amount invested in the LP. These entities can be used by GPs when looking to raise capital for investment. Many hedge funds and real estate investment partnerships are set up as LPs. 

Limited partners also don’t have to pay self-employment taxes as they are not active members of the business. LPs are pass-through entities, meaning the entity files a Form 1065, and then partners receive Schedule K-1s that they use to include their portion of the income or loss on their own personal tax returns.

On the downside, LPs require that the general partner have unlimited liability. They are responsible for 100% of management control but also are on the hook for any debts or mishandling of business dealings. As well, limited partners are only allowed limited involvement in operations. If their role is deemed non-passive, they lose personal liability protection. 

LP vs. LLC

Limited liability companies (LLC) and limited partnerships share several similarities. Both entities have a certain degree of freedom in how they define the role of the entity’s members and the entity’s structure. This includes having control over voting, financial terms, or fiduciary responsibilities of each member.

Both types of entities also incur pass-through tax treatment. This means each investor is subject to reporting their share of the entity’s profit on their personal tax return. Both LPs and LLCs are not subject to federal income tax.

There are some differences in each legal entity starting with the corporate structure. Limited partnerships contain general partners and limited partners, while a limited liability company may have as many members as it wants. In general, all members of an LLC usually have the right to manage the business, while limited partners of an LP can not be active participants.

Another key difference is the aspect of liability. General partners of an LP have unlimited personal liability, meaning they may be held liable for any debts and obligations of the company. Limited partners are often not liable for partnership obligations. Alternatively, LLCs often provide corporation-like protection for members in which members are often not held directly liable for the company’s debts.

Last, LLCs have a bit more flexibility regarding how they are taxed. LLCs can elect to be taxed as a C Corporation, an S Corporation, or a disregarded entity. Both an LLC and LP’s default tax status is to be taxed as a partnership.

Limited Partnership and Taxes

Limited partnerships are treated fairly similarly as general partnerships in regards to taxes. Limited partners are treated as a pass-through entity and files Form 1065 as an information return. The limited partnership also provides a Schedule K-1 to each partner to report each partner’s share of business income and losses on the partner’s individual tax return.

If the limited partnership were to incur a loss, each partner could deduct this loss on their personal returns up to their investment in the company. Partners can also carry losses to future years if their loss is greater than their investment-to-date amount.

Income or losses from a limited partnership are called passive gains or losses. This is because each partner is not actively participating in the business. This is especially important for tax reasons as passive activity can only be offset by other passive income; passive losses can only be used to offset passive gains. This also plays a key part in self-employment taxes. Limited partners do not pay self employment tax on most payments as they are not active participants in the business; meanwhile, general partners usually have to pay self-employment taxes.

The Bottom Line

Limited partnerships are generally used by hedge funds and investment partnerships as they offer the ability to raise capital without giving up control. Limited partners invest in an LP and have little to no control over the management of the entity, but their liability is limited to their personal investment. Meanwhile, general partners manage and run the LP, but their liability is unlimited.