Business Entities: Limited Partnerships

A limited partnership is a type of business entity. It offers, among other things, the flexibility of a general partnership with the added feature of limited liability for certain partners. A limited partnership must consist of two or more owners, at least one of whom must be a general partner and the other a limited partner. There is no maximum limit, however, on the number of either type of partner. State law and the partnership agreement will govern the limited partnership. Your partnership agreement should contain, among other things, each partner’s distributive share of partnership profits and losses. Indeed, this agreement can contain anything that is deemed appropriate by the partners and, of course, not prohibited by law. In cases where the partnership agreement fails to address an issue, your state’s version of the Uniform Limited Partnership Act (ULPA) or the Revised Uniform Limited Partnership Act (RULPA) will fill in the gaps.

When It Can Be Used

A limited partnership must have two or more partners: at least one general and one limited partner, both of whom will carry on a business-for-profit as co-owners.

Strengths

Limited Partnership Does Not Terminate Upon the Death, Withdrawal or Incapacity of a Limited Partner
Generally, the withdrawal, death, bankruptcy, retirement, insanity, expulsion, or resignation of a limited partner does not dissolve the partnership.

Relatively Simple and Inexpensive to Create and Operate
Quite unlike a corporation, a limited partnership is inexpensive and simple to create and maintain. A limited partnership is a creature of state statutory law and generally requires more effort than a general partnership. You must file a certificate of limited partnership with the secretary of state and create a partnership agreement. These certificates generally contain the partnership’s name, address, and purpose. Contact the secretary of state where the partnership will be formed to learn the specific requirements of that state.

No Limit on the Number and Type of Partners
A partnership is unlimited in the number and type of partners it may have. Contrast this to an S corporation, which is severely restricted in the types of shareholders it can have. For example, while a partnership can have other business entities as partners (including S corporations), an S corporation can generally have only individuals or certain trusts as shareholders.

Profits Taxed Only Once
A limited partnership is not assessed an entity-level tax. Rather, the partners pay a tax on the partnership profits. Therefore, the partnership is not subject to the double tax often associated with a C corporation. The partnership must, however, file an “informational” return with the IRS. However, certain publicly traded partnerships (including limited partnerships) may be taxed at the entity level.

Note: For tax years beginning prior to January 1, 2003, dividends were taxed as ordinary income. In an attempt to mitigate some of the burden of double taxation, various pieces of legislation provide that dividends received by an individual shareholder from domestic corporations and qualified foreign corporations are taxed at the rates that apply to capital gains. Most recently, in general, the American Taxpayer Relief Act of 2012 permanently extended the preferential income tax treatment of qualified dividends and capital gains, and established new rates for higher-income taxpayers. Capital gains and qualified dividends are now generally taxed at 0% for taxpayers in the 10% and 15% tax brackets; at 15% for taxpayers in the 25% to 35% tax brackets; and at 20% for taxpayers in the 39.6% tax bracket. Also, as a result of the Affordable Care Act of 2010, an additional 3.8% Medicare tax applies to some or all of the investment income for married filers whose modified adjusted gross income exceeds $250,000 and single filers whose modified adjusted gross income is above $200,000.

Management is Centralized
A limited partnership usually offers centralized management. The general partners manage the partnership. Contrast this to a general partnership, in which all of the partners manage the partnership absent an agreement to the contrary.

Partners can Deduct Losses and have Them “Specially Allocated”
Partners can deduct the losses of the partnership on their personal tax returns. Most significant, a partner can have deductions “specially allocated” to him or her. A disproportionate number of deductions may be allocated to the partner who pays the most taxes. The result is potentially lower taxes. Your method of allocating losses should be recorded in your written partnership agreement. In addition, the method of allocation chosen must have a substantial economic effect for it to be valid. A partnership is a good idea if you anticipate large losses in the first several years of operation because it allows partners to reap immediate tax savings. This feature gives the partnership an advantage over an S corporation:

Example: Ken has a 25 percent interest in the partnership. The partnership agreement allocates 50 percent of all losses to him so as to save him some money in taxes. The partnership has had $50,000 in losses this year alone. Ken can deduct 50 percent of this $50,000 ($25,000) on his personal tax return (assuming that this allocation has substantial economic effect). If instead Ken were an S corporation shareholder, his deduction would be limited to his percentage of ownership in the corporation—25 percent.

Caution: There are several significant restrictions on a partner’s ability to deduct losses. These restrictions include the passive loss and at-risk rules.

A General Partner’s “Basis” is Typically Increased by Partnership Liabilities
General partners are typically liable for all of the partnership’s obligations. For this reason, general partners are usually permitted a dollar-for-dollar increase in their basis in the partnership (what they paid for their partnership interest) for their share of partnership liabilities. General partners are allowed to deduct their allocable share of losses to the extent of their tax basis in the partnership. Limited partners, however, are usually not permitted a basis increase for the liabilities of the partnership because their liability is limited to their personal investments. In other words, unlike general partners, limited partners generally do not share in the risk of economic loss with regard to the liabilities of the partnership. This feature can result in tax savings to the general partner and gives general partners an advantage over S corporation shareholders:

Note: For purposes of determining whether a partnership liability is included in a partner’s basis, partnership liabilities are first allocated to those partners who bear an economic risk of loss with respect to a liability (called a recourse liability). In general, a partner bears an economic risk of loss with respect to a liability if the partner guarantees the liability, pledges property as security for the liability, or is required to make additional contributions to the partnership with respect to the liability. If no partner bears an economic risk of loss with respect to a liability (called a nonrecourse liability), the liability is generally allocated to all partners in the same proportion as they share profits. With respect to partnership liabilities, limited partners can generally increase their basis only for nonrecourse liabilities allocated in this manner.

Example: General partner Ken paid $1,000 for his 50 percent partnership interest. Thus, Ken’s basis in the partnership is $1,000. Subsequently, the partnership borrows $20,000 from a third party. Ken, who assumes partnership liabilities in proportion to his ownership interest, now has a basis of $11,000 ($1,000 + [$20,000/2]). Ken can now deduct his share of partnership losses (which can be specially allocated) up to $11,000. (On the other hand, if Ken bears 100 percent of the economic risk of loss with respect to the $20,000 loan—perhaps Ken is required to pay the creditor if the partnership defaults—Ken could increase his basis to $21,000 ($1,000 + $20,000). However, if the other partners bear 100 percent of the economic risk of loss, Ken’s basis would remain at $1,000.)

While partnership basis may increase with increased liabilities allowing more losses to be deducted, basis will be subsequently reduced as liabilities are paid down or when the business is sold and the liabilities are paid off.

Example: Assume the same facts as in the preceding example except that Ken is instead a 50 percent shareholder in an S corporation. Because S corporation shareholders cannot increase their basis by loans from third parties, Ken’s basis will remain at $1,000 despite the $20,000 loan to the S corporation. Therefore, Ken can deduct his pro rata share of losses up to $1,000.

	Old Basis	Liabilities Added to Basis	New Basis
General Partner	$1,000 +	($20,000/2)	= $11,000 (Basis reduces as liability is paid down)
S Corporation Shareholder	$1,000 +	$0	= $1,000

Ownership Interests in a Limited Partnership can Generally be Freely Assigned
Absent a contrary provision in the partnership agreement, both general and limited partners can generally assign their partnership interests to another (called an assignee) without restriction. An assignment, in contrast to an outright sale, is only the transfer of economic rights. The assignee generally gains only the right to receive profits or deduct losses. You can restrict a partner’s right to assign or sell his or her partnership interest by including a restrictive provision in the written partnership agreement.

Limited Partnership is Flexible in Sharing Profits and Control
A limited partnership can create ownership interests that provide preferential treatment to partners when profits are distributed or that disallow participation in management by certain general partners (limited partners can never participate in management). A limited partnership can thereby regulate the sharing of profits and control, unlike an S corporation, which is relatively inflexible in this regard.

Partner can Contribute Appreciated Property Tax Free
You can contribute property to the partnership in exchange for your partnership interest. Such a contribution is generally tax free even if the property has appreciated in value since you purchased it. Such a transfer occurs when a partner exchanges real property (an office building to be used by the partnership, for example) for an ownership interest in the partnership. However, there may be later consequences for a partner who contributes appreciated property, including possible recognition of gain. When a partner contributes property to a partnership, allocations of income, deductions, and gain and loss must be made to the partner to reflect any difference between the property’s fair market value and its basis to the partnership. If the partnership distributes the property to another partner within seven years of its contribution, the contributing partner recognizes gain or loss on the distribution unless the contributing partner receives certain like-kind property. If contributed property has a built-in loss, the loss can only be allocated to the contributing partner and the basis in the property for other partners is limited to the fair market value of the property at the time of contribution.

Liquidation of a Partnership is Generally Tax Free to Partners
Generally, when a partnership is liquidated (all of its assets distributed to the partners) the partnership is not taxed. However, a partner may recognize gain or loss to the extent money is distributed to the partner in liquidation of the partnership. Contrast this to an S corporation, which is treated as if it sold the assets to the shareholders at fair market value (FMV). A cash liquidation of a partnership is treated like a sale. A partner who is relieved of liability for a partnership debt is treated as receiving money. Items that generally generate ordinary income are taxed at ordinary income tax rates. For example, unrealized receivables and potential depreciation recapture are fully taxed as ordinary income, and gain or loss from inventory is ordinary income or loss. Otherwise, gain or loss is generally treated as capital gain or loss.

Tradeoffs

Limited Partners Cannot Participate in Management
The limited partners are not permitted to manage the partnership. If a limited partner does participate in management, that partner will lose his or her liability protection. In such a case, the limited partner will be personally liable. Such liability will extend, however, solely to those persons transacting business with the partnership who reasonably believe, based upon the conduct of the limited partner, that the limited partner is a general partner. If a C corporation is made the sole general partner in a limited partnership, the limited partners can indirectly, yet safely, participate in the management of the limited partnership by controlling the C corporation as officers or directors. The corporate officers must, however, clearly document the fact that the corporation is the general partner. Moreover, the corporation must be operated in a manner that would not forfeit its limited liability feature (e.g., corporate formalities must be observed). Otherwise, the limited partners would render themselves vulnerable to creditors.

All General Partners and Those Limited Partners who Participate in Management are Personally Liable for Partnership Acts
General partners are personally liable for partnership obligations and, generally, for the acts of other partners. Limited partners, however, are typically protected from such liability. For those limited partners who participate in management (which is a prohibited act), such protection is withdrawn as to those third parties who were led to reasonably believe (by the acts of the limited partner) that the limited partner was a general partner. For the limits on a partner’s liability for the acts of other partners, see Questions and Answers. Liability of a partner may be minimized if (1) the partnership has substantial assets, which would allow the partnership to borrow in a nonrecourse manner (partners do not personally guarantee partnership loans), (2) the partnership has plenty of liability insurance, and/or (3) the general partner is a C corporation.

Example: Ken and Sue started a “spring water” business and formed a limited partnership, with both of them being limited partners. They designated a corporation, which they had also formed, as the sole general partner. Subsequently, the partnership was sued when it was discovered that Ken and Sue were actually using tap water instead of natural spring water. Because corporations offer limited liability, only the assets of the corporation were vulnerable to the suit. The personal assets of Ken and Sue, however, were safe because both were limited partners (assuming of course, the corporate veil could not be pierced).

General Partners can Typically “Bind” the Partnership
Absent agreement to the contrary, each general partner has the authority to make the partnership responsible for his or her acts. Limited partners cannot typically bind the partnership. However, a limited partner or a general partner prohibited from binding the partnership by the partnership agreement can still bind the partnership by acts involving a third party who is reasonably unaware of the restriction on the partner’s authority. Have a written partnership agreement and provide for the rights and obligations of each partner as to one another as well as to third parties.

Partners Typically Cannot Sell Their Partnership Interest
Generally, a partner cannot sell (as opposed to assign) his or her partnership interest unless every partner consents to the transfer, or the partnership agreement provides for such sale. Otherwise, the sale of a partner’s interest typically dissolves the partnership for “nontax purposes.” In other words, the partnership would no longer exist as far as state law is concerned, though the IRS may still tax it as a partnership. A partnership will, however, dissolve for “tax purposes” when one of two things occurs. The first is a cessation of business. This means that no portion of the business is conducted by any of the partners. The second scenario is when there are exchanges or sales (within 12 months of the creation of the partnership) that total 50 percent or more of the total interest in the partnership profits or capital. If the partnership continues to operate after either of these events, it will be treated as if the partnership contributed its assets to a newly created partnership and then liquidated and distributed its interests in the new partnership to the partners of the terminating partnership in proportion to their respective interests in the terminated partnership. (Sale of 50 percent or more of the total interest in an electing large partnership—for more on this, see Questions and Answers—will not cause the partnership to dissolve for tax purposes.) The remaining partners can nonetheless continue the business upon the withdrawal of a partner by placing a provision in the partnership agreement to that effect. Interests in certain publicly traded partnerships (for more on this, see Questions and Answers) may be freely transferrable.

Partners Typically Have the Right to Withdraw from Partnership
Unless a partner is restricted from doing so, through a provision in the partnership agreement, a partner can typically withdraw from the partnership. If the withdrawing partner is a general (not a limited) partner, the withdrawal generally causes the partnership to dissolve for nontax purposes.The partnership will not dissolve upon a general partner’s withdrawal if there is at least one remaining general partner and the partnership agreement permits the continuation of the business. A partner can be prohibited from withdrawing through the partnership agreement. If so, the remaining partners can sue a withdrawing partner for violating the partnership agreement. If this seems harsh, think about this: A partner with no such incentive to remain could unilaterally dissolve the whole partnership against the wishes of all other partners merely by withdrawing.

Life of the Partnership is Generally Limited to the Life of the General Partners
A partnership does not “live” forever. Typically, the lifetime of the limited partnership is limited by the lifetime of each general partner. The withdrawal, death, bankruptcy, retirement, insanity, expulsion, or resignation of a general partner dissolves the partnership for nontax purposes. The remaining partners can nonetheless continue the business upon the death of a partner by placing a provision in the partnership agreement to that effect.

Fringe Benefits are Taxable to Partner-Employee
Fringe benefits (e.g., bonuses, leased automobile) are taxable to partner-employees. Contrast this with a C corporation, whose shareholders typically receive fringe benefits tax free.

How To Do It*

Consult an Attorney
You should consult an attorney experienced in business planning. Your attorney should be familiar with your state’s law, which will prescribe the requirements you will need to fulfill.

Carry on a Business-for-Profit with Two or More Co-owners
Since any partnership is essentially two or more co-owners carrying on a business-for-profit, you must be sure that your business fits this description. The business ownership and profits must be shared with at least one general and one limited partner.

File the Certificate of Limited Partnership and Create a Written Partnership Agreement
Because the limited partnership is a creature of state law, you will be required to deliver a certificate of limited partnership to the secretary of state. Your state law will dictate what this document should contain. (Your attorney can help you here.) You must also create a written partnership agreement, in which you will set forth, among other things, how the partnership is to operate and in what manner profits and losses are to be shared among the partners.

Your Two-Member Unincorporated Entity is a Partnership by Default
Your unincorporated organization is automatically classified as a partnership if it has at least two members, unless it files with the IRS to be classified as an association taxable as a corporation.

*Checklist is not exhaustive.

Tax Considerations

Partners Can Deduct Losses and have Them “Specially Allocable”
A partner can deduct partnership losses on his or her personal tax return. Indeed, a partner in a high tax bracket can have deductions specially allocated to him or her through the partnership agreement. The method of allocation chosen must have a substantial economic effect for it to be valid. This feature gives the partnership an advantage over an S corporation:

Example: Ken is a 25 percent general partner. The partnership agreement allocates 50 percent of all losses to him so as to save him some money in taxes. The partnership has had $50,000 in losses this year alone. Ken can deduct 50 percent of this $50,000 ($25,000) on his personal tax return, assuming the allocation has substantial economic effect. If instead Ken were an S corporation shareholder, his deduction would be limited to his percentage of ownership in the corporation—25 percent.

Restrictions are Placed on the Deductibility of Losses
A partner’s ability to deduct his or her distributive share of losses is limited to the partner’s basis in the partnership: generally, what the partner paid for his or her partnership interest plus (among other things) his or her pro rata share of the partnership’s liabilities. Losses that exceed a partner’s basis may be carried over and deducted in a subsequent year to the extent that the partner then has a basis greater than zero.

Example: Assume the same facts as given: Ken is a 25 percent general partner. The partnership agreement allocates 50 percent of all losses to him so as to save him some money in taxes. The partnership has had $50,000 in losses this year alone. Ken can deduct 50 percent of this $50,000 ($25,000). However, because his basis in his partnership interest is only $20,000, Ken can deduct that amount only and will have to carry the remaining $5,000 loss to subsequent years and deduct it when he has basis available to offset the loss.

Caution: There are several significant restrictions on a partner’s ability to deduct losses. These restrictions include the passive loss and at-risk rules. For more on this, see Questions and Answers.

Partners are Taxed on Their Distributive Share of Income
Both general and limited partners are taxed on their distributive share of partnership income or gain regardless of whether it is actually distributed. Note, though, if a partner’s share of income is retained by the partnership, his or her basis is increased dollar for dollar. This ensures that a partner is not taxed twice (once when the partnership retains earned income and again when the partner sells his or her partnership interest or when the income is subsequently distributed). Alternatively, as you may have guessed, when partnership income is distributed to a partner, there is a corresponding decrease in his or her basis. A partnership (or any other pass-through entity for that matter) that anticipates retaining earnings for business purposes should consider distributing enough income to allow each partner to pay his or her tax liability.

Partners are Subject to Self-Employment Tax
General and limited partners may render services to the partnership. Payments for such services are called guaranteed payments. Such payments are subject to self-employment tax. A self-employment tax is also imposed upon the general partners’ distributive shares of partnership income. Limited partners, however, are not assessed a self-employment tax on their share of partnership income.

Wages to Partner-Employees are Generally Considered Business Expenses by the Partnership
Wages paid to partners who render services to the partnership are called guaranteed payments. Such payments are considered business expenses of the partnership and are subtracted, like all other business expenses, from partnership earnings. The remainder is considered profit (or loss). This profit (or loss), reported by the partnership on Form K-1 (informational tax form), is either distributed to the partners or retained by the partnership. The partners then report their share of profit (or loss), regardless of whether anything has actually been distributed, on their personal tax returns.

Example: Ken and his sister Liz are 50 percent partners in a donut shop. Ken is paid $10,000 a year for donut making (guaranteed payment). Liz provides no services. Last year, the shop had $70,000 in income. Assuming no other business expenses, the total income to be allocated to all partners including Ken is $60,000 ($70,000 – Ken’s $10,000). Of this amount, Ken and Liz each get 50 percent, or $30,000. Ken pays income tax on $40,000 ($30,000 + $10,000 salary) and Liz pays taxes on $30,000.

If, however, a guaranteed payment is conditioned upon partnership profits, the payment is considered a portion of the partner’s distributive share and is therefore not treated as a business expense. Such payment would not be combined with other business expenses and would not get subtracted from partnership earnings.

Example: For his services, Ken has instead been promised his 50 percent partnership interest or $30,000, whichever is greater. The donut shop has $50,000 in income. Because 50 percent of $50,000 is $25,000, Ken gets $30,000. The amount that is considered a guaranteed payment is $5,000 ($30,000 – $25,000). Thus, Ken’s $30,000 represents his distributive share of partnership income ($25,000) as well as his salary (guaranteed payment of $5,000). The amount to be distributed to the other partners is $20,000 ($50,000 – Ken’s $30,000).

Fringe Benefits are Deductible by Partnership, Taxable to Partner-Employee
Fringe benefits are generally deductible by the partnership. However, like 2 percent S corporation shareholders, partners are taxed on the fringe benefits received. Contrast this with a C corporation, whose shareholders typically receive certain fringe benefits tax free.

A General Partner’s “Basis” is Typically Increased by the Partnership’s Liabilities
General partners are typically liable for all of the partnership’s obligations. For this reason, general partners are usually permitted a dollar-for-dollar increase in their basis in the partnership (what they paid for their partnership interest) for their share of partnership liabilities. General partners are allowed to deduct their allocable share of losses to the extent of their tax basis in the partnership. Limited partners, however, are usually not permitted a basis increase for the liabilities of the partnership because their liability is limited to their personal investments. In other words, unlike general partners, limited partners generally do not share in the risk of economic loss with regard to the liabilities of the partnership.

This feature can result in tax savings to the general partner and gives general partners an advantage over S corporation shareholders:

Technical Note: For purposes of determining whether a partnership liability is included in a partner’s basis, partnership liabilities are first allocated to those partners who bear an economic risk of loss with respect to a liability (called a recourse liability). In general, a partner bears an economic risk of loss with respect to a liability if the partner guarantees the liability, pledges property as security for the liability, or is required to make additional contributions to the partnership with respect to the liability. If no partner bears an economic risk of loss with respect to a liability (called a nonrecourse liability), the liability is generally allocated to all partners in the same proportion as they share profits. With respect to partnership liabilities, limited partners can generally increase their basis only for nonrecourse liabilities allocated in this manner.

Example: General partner Ken paid $1,000 for his 50 percent partnership interest. Thus, Ken’s basis in the partnership is $1,000. Subsequently, the partnership borrows $20,000 from a third party. Ken, who assumes partnership liabilities in proportion to his ownership interest, now has a basis of $11,000 ($1,000 + [$20,000/2]). Ken can now deduct his share of partnership losses (which can be specially allocated) up to $11,000. (On the other hand, if Ken bears 100 percent of the economic risk of loss with respect to the $20,000 loan—perhaps Ken is required to pay the creditor if the partnership defaults—Ken could increase his basis to $21,000 [$1,000 + $20,000]. However, if the other partners bear 100 percent of the economic risk of loss, Ken’s basis would remain at $1,000.)

Caution: While partnership basis may increase with increased liabilities allowing more losses to be deducted, basis will be subsequently reduced as liabilities are paid down or when the business is sold and the liabilities are paid off.

	Old Basis	Liabilities Added to Basis	New Basis
General Partner	$1,000 +	($20,000/2)	= $11,000 (Basis reduces as liability is paid down)
S Corporation Shareholder	$1,000 +	$0	= $1,000

Restrictions are Placed on Deductibility of Losses
A limited partner can take deductions to the extent of his or her basis in the partnership. Limited partners are also restricted by the passive loss limitation rules. Generally, these rules limit the deductions for losses from activities in whose management the taxpayer does not materially participate.

Partner can Contribute Appreciated Property Tax Free
You can contribute property to the partnership in exchange for your partnership interest. Such a contribution is generally tax free even if the property has appreciated in value since you purchased it. An example of such a transfer is when a partner exchanges real property (an office building to be used by the partnership, for example) for an ownership interest in the partnership. However, there may be later consequences for a partner who contributes appreciated property, including possible recognition of gain. When a partner contributes property to a partnership, allocations of income, deductions, and gain and loss must be made to the partner to reflect any difference between the property’s fair market value and its basis to the partnership. If the partnership distributes the property to another partner within seven years of its contribution, the contributing partner recognizes gain or loss on the distribution unless the contributing partner receives certain like-kind property. If contributed property has a built-in loss, the loss can only be allocated to the contributing partner and the basis in the property for other partners is limited to the fair market value of the property at the time of contribution.

Liquidation of a Partnership is Generally Tax Free to Members
Generally, when a partnership is liquidated, the partnership is not taxed. However, a partner may recognize gain or loss to the extent money is distributed to the partner in liquidation of the partnership. Contrast this to an S corporation, which is treated as if it sold the assets to the shareholders at fair market value (FMV). A cash liquidation of a partnership is treated like a sale. A partner who is relieved of liability for a partnership debt is treated as receiving money. Items that generally generate ordinary income are taxed at ordinary income tax rates. For example, unrealized receivables and potential depreciation recapture are fully taxed as ordinary income, and gain or loss from inventory is ordinary income or loss. Otherwise, gain or loss is generally treated as capital gain or loss.

If you have questions, contact the experts at Henssler Financial: