Limited Partnership: What It Is, Pros and Cons, How to Form One

What Is a Limited Partnership (LP)?

A limited partnership (LP)—not to be confused with a limited liability partnership (LLP)—is a business owned by two or more parties. These must include at least one general partner who runs the business and has unlimited liability for any debts. The limited partners have liability only up to the amount of their investment.

The limited partnership business structure is often used as a vehicle for individuals who pool their money to invest in real estate or other assets.

Key Takeaways

A limited partnership (LP) is a business entity that requires at least one general partner and one or more limited partners.
The general partner has unlimited financial liability.
LPs are pass-through entities that have little or no reporting requirements.
Most U.S. states govern the formation of limited partnerships and require registration of the entity.

Limited Partnership (LP) — Investopedia / Madelyn Goodnight

Understanding Limited Partnerships (LPs)

A limited partnership is required to have at least one general partner and one or more limited partners.

General partners have full management control of the business and also have unlimited financial liability for their financial obligations. Limited partners have little or no involvement in management, but their liability is limited to the amount of their investment in the LP.

Hedge funds and real estate investment funds are often set up as LPs in order to protect their investors from the financial fallout of a failed venture.

Partnership agreements should be created to outline the specific responsibilities and rights of both general and limited partners.

Types of Partnerships

Generally, any partnership is a business owned by two or more individuals. There are three forms of partnerships: limited partnership, general partnership, and limited liability partnership.

In all forms of partnerships, each partner contributes resources such as property, money, skills, or labor, and in return shares in the business' profits and losses. At least one partner makes decisions regarding the business' day-to-day affairs.

Limited Partnership (LP)

Most limited partnerships are formed by investors who are pooling their money to invest in assets such as real estate. LPs differ from other partnerships in that the partners, except for general partners, have limited liability, meaning they are not on the hook 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. All other contributors are known as limited (or silent) partners. They provide capital but cannot make managerial decisions and are not responsible for any debts beyond their initial investment.

Limited partners can become personally liable if they take a more active role in the LP.

General Partnership (GP)

A general partnership is a company structure that requires all of its partners to share in the profits, managerial responsibilities, and liability for debts of the business. The partners share the profits and responsibilities equally unless the legal partnership agreement states otherwise.

A joint venture is a type of general partnership that is formed to complete a specific project and will be dissolved with its completion. 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 and the venture.

Limited Liability Partnership (LLP)

A limited liability partnership (LLP) is a type of company that gives all partners limited financial liability. All partners can also participate in management decisions.

This is unlike a limited partnership, in which at least one general partner must have unlimited liability and limited partners cannot be part of management. LLP partners are not responsible for the misconduct or negligence of other partners.

LLPs are most often used as business structures for groups of professionals such as lawyers or accountants.

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 introduced in 1916 and has since been amended many 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, the partners must register the venture in the applicable state, typically through the office of the local secretary of state. The business permits and licenses that are required vary according to locality, state, or industry.

The U.S. Small Business Administration (SBA) lists all local, state, and federal permits and licenses that are necessary to start a business.

Partnership Agreement

In addition to external filings, the partners of a limited partnership must draft a partnership agreement. This is an internal document that defines how the business will be operated. The agreement outlines the rights, responsibilities, and expectations of each partner.

The document is not filed with a government entity.

The partnership agreement should identify two key financial aspects of the company. First, it should specify how profits and losses will be shared and how profits will be distributed to the partners. Second, it should identify the process to be followed by a partner who wants to sell their stake in the partnership. This may include a notice period and specify the expectations of the other partners regarding the first right of purchase.

Advantages and Disadvantages of a Limited Partnership

The key advantage to an LP for its limited partners is the protection from personal financial liability beyond the amount of their investment. The general partners are willing to take the biggest risks in order to raise capital for their investments.

This is why many hedge funds and real estate investment partnerships are set up as LPs.

Tax Considerations

Limited partners 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. The partners receive Schedule K-1 forms to report 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 all management decisions and are liable for any debts or mishandling of the business.

On the other hand, limited partners must stay out of business operations. If their role is deemed non-passive, they lose personal liability protection.

Pros

Personal liability protection for limited partners
Pass-through entity for taxation (i.e. only taxed once unlike C-corp)
Ease of creation and reporting (e.g. no required annual meetings)
Less formal structure
No self-employment taxes for limited partners

Cons

GPs have unlimited personal liability (although they also have management control of the LP)
Limited partners barred from management decisions
Ownership can be harder to transfer than other entities, such as an LLC
Not as flexible for changing management roles

LP vs. LLC

Limited liability companies (LLCs) 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 returns. Neither type of company is 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 cannot be active participants.

A key difference is in 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 not held directly liable for the company's debts.

Finally, 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.

Composed of general partners and limited partners
Limited partners cannot be active in the daily management of the company
General partners often have personal liability for the company
LPs are taxed as partnerships

LLC

Composed of owners often referred to as members
Unless otherwise stated, all members have the right to participate in management
Members often have no liability for the company
An LLC may be taxed as a partnership, C-Corp, S-Corp, or disregarded entity.

Limited Partnership and Taxes

Limited partnerships are treated similarly to general partnerships in regard to taxes. Limited partnerships are treated as pass-through entities and file Form 1065 as an information return. The limited partnership also provides a Schedule K-1 to each partner so that their share of business income and losses can be reported 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 the amount of their investment in the company. Partners can also carry losses to future years if the 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. General partners usually have to pay self-employment taxes.

What Type of Business Is a Limited Partnership?

Businesses that form a limited partnership generally own or operate specific assets, such as the property owned by a real estate investment partnership.

One party (the general partner) has control over the assets, manages the business, and can be held personally liable for its debts. The other participants (limited partners) are investors who have no role in management and are not responsible for its debts beyond the amount of their investment.

What Is the Difference Between an LLC and a Limited Partnership?

Both LLCs and LPs offer flexibility in how they structure responsibilities, share profits, and pay taxes.

An LP allows certain investors (limited partners) to invest without having a management role or any personal liability, while the general partners carry all the liability.

With an LLC, the owners can shield themselves from personal liability, but all generally have management roles. An LP must have at least one limited partner.

LLCs have greater flexibility for tax reporting. Often, the general partner of an LP will be structured as an LLC to help provide personal liability protection, as LLC managers are typically not held personally responsible for the businesses’ liabilities.

What Is the Difference Between an LP and LLP?

An LP and LLP have a similar structure. However, LPs have general partners and limited partners, while LLPs have no general partners. All partners in an LLP have limited liability.

What Is Limited Partnership Taxation?

Limited partnerships are taxed as pass-through entities, meaning each partner receives a Schedule K-1 to include on their personal tax returns.

What Are the Benefits of a Limited Partnership?

Limited partnerships are ideal entities for raising capital for a particular investment or set of assets. They allow limited partners to invest while keeping their liability limited.

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 or 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.