Business partnerships can be either general or limited, and as far as tax codes are concerned, exist as long as profits, losses and costs of a business are shared. While general partnerships are more common, limited partnerships are a popular method of raising capital from passive investors who prefer to not be involved in day-to-day business operations. Limited partnerships (LPs) have two sets of partners, namely one or more general partners who have personal liability and one or more limited partners who are not liable for debts. Business owners who do not want the liability for the debts incurred by the corporation prefer this option. Limited partners usually do not play any role in the day-to-day management of the company.
Pros of Limited Partnerships:
- Generally, pass-through taxation is applicable to limited partnerships, meaning that the tax burden is passed on to the partners instead of the partnership itself. Thus, profit earnings are passed on to the partners in the form of wages, income, and profit payments and each partner pays tax that is proportionate to his individual share of profits.
- A business can obtain much-needed investment capital by giving more passive investors the option of reducing their risks by becoming limited partners
- Since there is no direct involvement of limited partners in the management of the business, general partners enjoy full autonomy and have the right to make important business decisions.
- In the case of a general partnership, all partners are responsible for the debts and other liabilities. The liability of a limited partner does not exceed his capital investment in the company.
In the event of a lawsuit the names of the limited partners cannot be included in the list of defendants. Limited partnerships are quite common in businesses such as restaurants and other business ventures where there is high financial risk. The limited partners will only provide the necessary funds, and stay aloof from the business operations and management. Due to this lack of involvement in management of business, LPs are also called “passive investors”. In order to enter limited partnership, partners need to file the necessary formation documents with the concerned state agency along with the state filing fees applicable.
Cons of Limited Partnerships
Limited partnerships do have downsides:
- Certain tax rules restrict LPs from claiming partnership losses beyond $25,000 per year. If losses exceed this amount the partners can carry forward the amount of passive investment losses to be claimed in the tax returns for the following year. This limit is exercised each tax year and is applicable to all those who are only concerned with the capital aspect of business ventures and in no way interfere in the business affairs.
- It is fairly easy to compute tax if partners have invested only cash. However, if non-cash financing options, such as vehicles or real estate, are involved more complicated tax rules are applicable.
- Sometimes limited partners may be tempted to participate in the management of the business and may therefore want to step out of the passive investor role. This kind of involvement may make them general partners and forbid them from exercising their limited liability privilege.