A limited partnership (LP) is a unique type of partnership that allows certain partners to take a passive role in the business. This means some partners exert limited control over the company and have limited legal liability. At the same time, an LP has general partners who make major decisions and have unlimited personal liability. This comprehensive guide will explore everything you need to know about limited partners. Whether you want to start an LP or understand it better, read on for an in-depth look at this popular business structure.

What is a Limited Partnership?

A limited partnership is a partnership with at least one general partner and more than one limited partner. The general partner oversees operations and has unlimited personal liability, while the limited partners are non-active investors with limited liability based on their investments.

Every US state allows businesses to structure as LPs. This is one of the most common types of business structure for ventures related to real estate investments, oil and gas ventures, family investment offices, venture capital firms, and hedge funds. 

The key defining aspects of a limited partner are:

• Passive investor: A limited partner invests money into a partnershіp but doesn't actіvely partіcіpate in managing or running the business. They are passive investors.
• Limited liability: A limited partner's liability is limited to their investment in the partnershіp. They cannot lose more than theіr іnvested capіtal. If the business fails, creditors can't come after the limited partner's assets.
• No control: Limited partners have little control or say in business operations. They don't participate in day-to-day management or business decisions. The general partners manage the business, while limited partners are passive.
• Income: Limited partners receive a share of the partnershіp's profіts based on their ownership stake. This income is taxed at their income tax rate.
• Ownership: Limited partners purchase partnership interests and become partіal business owners. The ownershіp stake entіtles them to their share of profits.

Understanding what limited partners are and how limited partners exchange investment capital is essential to understanding the part and decision-making ability of limited partners in the partnership.

Rights and Role of a Limited Partner

While limited partners have their involvement and liability restricted in many ways, they do still maintain some key rights. Here is a list of key rights and role of a limited partner to evaluate what are limited partners and their role in limited partnerships:

Rights of a Limited Partner

• Right to share in any profits or losses of the partnership without personal liability beyond their capital contribution. This helps limit financial risk.
• Limited partners typically have limited voting rights compared to general partners. It is usually related to fundamental changes in the partnership, like dissolution or amendments to the partnership agreement.
• Limited partners often have the right to regularly access financial information about the partnership's performance.
• Limited partners generally cannot participate in business management without risking the loss of limited liability protections.

Role of a Limited Partner

• A limited partner can provide capital funding to the partnership in exchange for limited liability and a share of profits. 
• Limited partners do not participate in managing or controlling the partnership's day-to-day operations or business decisions. 
• Their involvement is limited to exercising any voting rights on major decisions that may be granted to them per the partnership agreement.
• They must not control the business if they want to maintain limited liability protections. They must act as financial investors, not decision-makers.

To sum up, what are limited partners? They provide financing in exchange for limited liability in a limited partnership and generally do not participate in managing or running the partnership's business activities.

Advantages of Being a Limited Partner

Several potential advantages are associated with being a limited partner in a limited partnership business venture, such as: 

• Limited liability protection: Unlike general partners who face unlimited liability, limited partners enjoy liability only up to their invested capital. Their assets are shielded from risk if the partnership gets sued or goes bankrupt.
• Less time commitment than active management: Limited partners are strictly investors, so they are freed from having to participate in operating the business in any capacity. This allows them to take a more passive, hands-off approach to ownership.
• Broader diversification: The hands-off nature of being a limited partner also enables limited partners to invest in multiple partnerships and diversify more broadly than general partners who have to run the businesses actively.
• Favorable tax treatment: Limited partnerships allow for pass-through taxation where income and losses flow to partners' tax returns. This avoids double taxation compared to traditional C-Corporations.
• Investment leverage: Limited partners can amplify their invested capital by utilizing wealth management strategies involving other people's money through fund structures employing debt. This can increase overall returns.

So, while limited partners surrender voting rights and management control, limited partners can reap rewards like liability protection, tax efficiency, and leveraged investing.

Disadvantages of Being a Limited Partner

There are also several drawbacks to consider when weighing whether to invest as a limited partner in any business plan:

• Lack of control: Limited partners have extremely restricted involvement in decision-making, strategy, and day-to-day operations. They must place much reliance and trust in the general partners' leadership.
• Income variability: Limited partners receive residual profits only after obligations are met. So, their returns rely heavily on the partnership's financial success and cash flow strength, which they can't directly control.
• Withdrawing capital becomes difficult: Partnership funds tend to remain іnvested in the business or get reіnvested rather than distributed to the partners. This makes it more convenient for a lіmіted partner to retrіeve theіr orіgіnal іnvested capital if they need it.
• Complication in filing taxes: Although pass-through partnershіp taxatіon provides some tax advantages, keeping accurate records of income, deductіons, carryovers, and partner payouts can become very complex. This creates substantial accounting demands to track everything properly for tax purposes.
• General partner conflicts: There is a risk that disagreements between general partners can impede effective management and decision-making, which can jeopardize the financial outcomes for limited partners.
• Self-employment taxes for general partners: If a general partner's compensation is tied to partnership profits, they may have to pay higher self-employment taxes than if they were taking a salary. This cuts into the overall income available for limited partner distributions.

Overall, the restrictions around control and illiquidity are the main potential downsides that limited partners must accept.

Legal and Tax Implications for Limited Partners

Forming and operating as a limited partner carries some key legal and tax considerations that need proper handling to avoid compromising liability protections.

Legal Responsibilities and Risks

Let’s look at the legal responsibilities of a limited partner:

• Financial aid: Limited Partners must provide capital contributions through cash, material assets, or services. 
• Company liability: Limited Partners should shoulder company liability and have a general duty of loyalty towards the company. 
• Promote company: Limited Partners can promote their company but refrain from engaging in activities that could ruin the reputation of the company. 
• Non-competition: Usually, non-competition clauses are subjected to general partners, but they do not apply to limited partners as they do not have much influence over the business. However, if the articles of association offer management powers to limited partners, they usually have to correspond to the non-competition clause. 

Limited partners enjoy legal protection from personal liability above their invested capital, provided they refrain strictly from participating in the control or management of the partnership. Overstepping those risks may result in losing liability shields.

Let's look at the areas where limited partners should avoid exercising any power:

• Decision-making authority: Limited partners cannot vote on operational matters or direct work of general partners.
• Deal promotion: Aggressive solicitation of investment could increase liability exposure.
• Creditor interactions: They should avoid engaging directly with partnership creditors.
• Outside perceptions: They should avoid creating an image of being active in daily affairs. 

Tax Implications

From a tax perspective, the key advantage of limited partnerships as pass-through entities is avoiding “double taxation” of profits. However, partners do face tax complications in certain areas:

• Self-employment taxes: General partners must pay self-employment taxes on their entire distributive share of net partnership income. They must complete Form 1040 to report their income to the IRS. However, limited partners pay self-employment taxes only on “guaranteed payments” for services rendered. Other investment income distributions are exempt.
• Profits interest: If a partner receives a profits stake without making a capital contribution upfront, the worth of the partnership must be assessed to determine whether the profits interest has a taxable market value upon receipt. Ongoing profit distributions would still be taxable income.
• Property distributions: If property distributions are made instead of cash payouts, the partnership must determine a fair market value cost basis for income tax calculations. Upon later sale by the partner, there may be additional taxable gain.

Limited Partners must fill out Schedule K-1 to report their share of the partnership's income, deductions, credits, and other information. Sometimes, the LPs might have to fill out Schedule E for supplement income and loss and Form 8525 for passive activity loss limitations.

Comparing Limited Partnerships to Other Business Structures

Limited partnerships have distinct structural advantages and disadvantages compared to common business structures like general partnerships, limited liability companies (LLCs), and corporations. Here is a table summarizing how key aspects of limited partnerships compare to general partnerships, LLCs, and corporations:

Exiting or Dissolving Limited Partnership 

Partners can leave an LP any time by withdrawing voluntarily or assigning interests to others. They can also sell or gift interests to outside investors without dissolving the LP.

However, if the remaining partners don't want to continue, they can vote to wind up the partnership's affairs and split the remaining assets.

When it comes to dissolving a limited partnership, then here are some common reasons to dissolve an LP:

• Bankruptcy or insolvency
• Illegal activity
• Partners unanimously agreeing
• Objective deemed unattainable
• Certain conditions outlined in the LP agreement

Partners must cease operations when dissolving and decide whether to settle debts or file for bankruptcy. They must also follow state tax, creditors, documentation, and asset distribution protocols.

Wrapping Up! 

Serving as a limited partner and knowing what limited partners are allows investors to participate in the startup's early growth or expansion phases of enterprising partnerships. While limits exist on management decision-making ability, like those related to creating a business plan or building an operations plan, favorable tax treatment, and income growth are some advantages that Limited Partners enjoy. 

For certain investors, the non-interfering nature of Limited Partnerships provides access to leverage the private equity opportunities that would otherwise demand full-time participation in some other type of business ownership. 

Frequently Asked Questions

1. What happens if a limited partner dies? 

Unfortunately, a deceased limited partner's economic interest can be transferred to their heirs or estate. However, the new economic-only successor does not become an actual limited partner.

2. Can a limited partner sell their partnership interest? 

Yes, limited partners often have more flexibility to transfer or sell their partnership interest than do general partners. However, the buyer usually only inherits the economic rights and does not become a fully recognized limited partner without the general partner's consent.

3. Are profits the only financial rights limited partners have? 

No, limited partners also have rights to distributions beyond profit allocations as mentioned in the partnership agreement, priority rights to their capital contributions, and rights to capital interest upon dissolution. 

4. What tax reporting responsibilities do limited partners have? 

Limited partners do not have tax filing requirements directly. However, they must report their share of partnership income on their tax returns. They should receive a Schedule K-1 from the partnership reflecting items to report.

5. Can a limited partner deduct partnership losses? 

Yes, limited partners who receive tax allocation for partnership operating or capital losses can deduct those losses on their tax returns under pass-through tax treatment and IRS basis rules. However, at-risk limitation rules may impact the levels of deductions.