If you’re starting a new business with at least one other person, you’ve probably considered forming a limited partnership.
The limited partnership (or LP) is a formal American business structure that involves at least one general partner and at least one limited partner, but what exactly do those terms mean, and how would they apply to your business?
Although it is not an uncommon business entity, we often find that our readers have some misconceptions about the role of the limited partnership in our modern business landscape.
After all, while there are plenty of LPs in existence, they are not nearly as popular as some other business entities like the limited liability company or the corporation. In this article, we’ll discuss what the limited partnership is and what types of businesses it’s right for. Is the LP a good entity choice for your company?
What Is a Limited Partnership?
A limited partnership (LP) is an American business entity that has a formal formation process with your state government.
This type of company needs to have at least two owners, and those owners must operate the business using an unbalanced partnership model, in which one owner is known as the general partner and one owner operates as the limited partner.
The LP is a good choice for companies with ownership groups that don’t want to share equally in the responsibilities of operating the business. The general partner is a much more hands-on position, as this person is intimately involved with the daily operations of the company. The limited partner is far less involved with the day-to-day details, and is often referred to as a silent partner due to their less visible involvement with the business.
Another interesting aspect of this uneven partnership model is that the limited partner has no liability for the company’s debts or other obligations beyond the amount of investment they’ve made into the business. Because of this aspect, the limited partner is often a passive investor who only wants to invest money into the company in exchange for a small amount of control regarding the major decisions of the business.
The other attractive part of the limited partner role is that this individual receives personal asset protection. Much like owners of limited liability companies or corporations, the limited partnership shields the limited partner’s personal assets from a lawsuit against the business.
If there’s a settlement or judgment against your LP, the limited partner’s car, house, personal bank accounts, and more will be protected from your creditors.
How Does a Limited Partnership Compare to a Limited Liability Company?
The most popular alternative to a limited partnership is the limited liability company.
The LLC is a much more common business entity than the LP, and while they do share some important commonalities, there are also some ways that these business structures vary considerably. Let’s first discuss the common characteristics between the LLC and the LP.
When compared to corporations, both the limited partnership and the limited liability company are quite flexible structures. Corporations have highly specific rules and regulations regarding management and ownership, but LPs and LLCs have much more flexibility in these areas that allow owners to set up their own managerial frameworks.
Another close similarity is that of pass-through taxation. With pass-through entities like LPs and LLCs, the company’s profits and losses pass through the business structure itself, and are instead claimed by the individual owners on their personal tax returns.
There is no corporate-level tax paid with these business structures, which is a significant difference from corporations, which typically pay taxes on both the corporate level and the individual level.
The personal asset protection for a limited partner is also similar to the LLC’s limited liability protection, but there’s a crucial difference that makes this more of a difference than a commonality…
Advantages of the LLC
- Personal Asset Protection: In a limited liability company, every owner has their personal liability limited by the LLC business structure, but in a limited partnership, only the limited partner receives this protection. For the general partner, operating an LP has plenty of risk involved.
- Single-Member Ownership: A limited partnership needs at least two owners to function (a limited partner and a general partner), but a limited liability company can be operated by one person on their own. In general, there’s even more ownership flexibility for LLCs than there is for LPs.
- No Role Restrictions: Speaking of ownership flexibility, the LP can’t operate without a limited partner and a general partner. If the limited partner decides that they want to become a general partner, the LP’s business structure may not allow this transition to take place. With an LLC, you’re allowed to adjust ownership shares and responsibilities as much as you’d like to. It’s as easy as setting up an LLC on your own or through a good online LLC service.
Advantages of the LP
- Attracting Investors: Even though neither the LP or the LLC is attractive at all for venture capitalists because the pass-through taxation is usually seen as a serious negative for VC purposes, it is much easier to attract investors in general to a limited partnership than it is for a limited liability company. The role of the limited partner is a great way to encourage investments into your business without giving up much control over operations. On the other hand, a limited liability company is typically not an appealing structure for investors of any kind.
- Consistent Legalities: The LLC as a business entity wasn’t widely accepted in all 50 states until the 1990s. Because of this, there isn’t much legal precedent for how courts should treat LLCs, and each state can have its own rules and regulations as well. In contrast, the LP is an older business type with more consistency with regard to legalities.
- Tax Deductions: LLCs aren’t eligible for very many deductions, especially compared to the LP. With a limited partnership, you can deduct health insurance costs, 401(k) expenses, pension plan contributions, and more. You can’t deduct any of these costs if you’re operating a limited liability company.
- Self-Employment Taxes: While general partners in an LP do have to pay self-employment taxes, limited partners do not. This means that the limited partner is not required to pay the 15.3% tax rate that is the combined employer and employee portions of both Social Security and Medicare, but the general partner and all LLC owners do pay this tax.
Which Types of Businesses Use the Limited Partnership Structure?
The limited partnership isn’t exactly an uncommon business structure in any industry, because the limited partner/general partner relationship can be valuable for a variety of business types.
Still, there are some types of businesses where the LP is significantly more popular than others, including law firms, accounting firms, and financial investment companies.
Limited partnerships are especially popular for real estate companies, to the point where the term real estate limited partnership (RELP) is rather common. The reason for the RELP’s popularity is because this type of business allows experienced development firms or property managers to take the reins as the general partner, while attracting investments in the form of limited partners.
The LP is also quite popular for family businesses to be able to reduce their estate tax and gift tax responsibilities. By forming a limited partnership for your family, you can pass down your assets from one generation to the next by using the gift tax exemption for LPs.
In fact, this is such a popular route that this form of limited partnership is often referred to as the family limited partnership (FLP).
How to Form a Limited Partnership
If you are interested in forming your own limited partnership, you have a few different options for doing so. If you’re confident in your own knowledge and abilities, you could choose the DIY route for LP formation. In this scenario, you would need to visit your Secretary of State’s website to get the instructions for your state.
In general, this usually includes some general provisions (like choosing and reserving your business name), along with the preparation and filing of a document typically known as the certificate of limited partnership.
Because there are some aspects of limited partnership formation that can be rather complex, we don’t advise this route if you don’t have any experience forming LPs.
Another option is to hire a business attorney to form your limited partnership. While this route can often be quite expensive, it can be worth it because the lawyer’s expertise can give you the peace of mind that your LP was formed correctly.
However, our preferred option is to hire a business formation service to form your limited partnership, as this route is far more affordable than hiring a lawyer, but is still much more reliable than handling the formation process yourself.
While there are many such companies offering LLC and corporation formations, there aren’t as many that provide LP formations.
Conclusion
While the limited partnership isn’t nearly as popular as some other business entities like limited liability companies or corporations, the LP is still a fairly common American business structure that has some appealing attributes for the right kind of company.
If the benefits of the limited partner/general partner relationship appeal to you, the limited partnership might just be the right entity for you ― especially if you’re operating a real estate business, or a family-owned company.
Regardless of what type of industry your business operates in, we don’t typically recommend the DIY route for LP formations, because this is not as simple of an entity to form as an LLC is. However, if you hire a reputable company like LegalZoom or BizFilings to form your LP, you can still save lots of money compared to hiring an attorney for this task.