Limited Partnership: What is it & How do they Work?
Partnerships are a common type of business entity which allows for multiple owners. Ordinary partnerships operate in a similar way to sole proprietorship, except with more than one owner. There is, however, the option to form a limited partnership. This is a special type of partnership with features that are akin to a limited liability company.
In this article we will explain what exactly a limited partnership is and how it differs from a general partnership. We will also discuss some of its advantages and uses.
Table of Contents:
- What Is A General Partnership?
- What Is A Limited Partnership?
- How Does A Limited Partnership Work?
- Advantages And Disadvantages Of A Limited Partnership
- Advantages Of A Limited Partnership
- Disadvantages Of A Limited Partnership
- Limited Partnership Uses
- Special Considerations For A US Limited Partnership
What is a General Partnership?
Before we get into defining a limited partnership, it is important to understand how a basic general partnership works. A general partnership is a common business entity, and the default type of partnership.
In a general partnership, all the partners are jointly responsible for the management of the partnership, and share in the profit and loss of the business. They are also personally liable for the debts and obligations of the business. In this way, a general partnership can be thought of as being similar to a sole proprietorship, except with more than one owner.
What is a Limited Partnership?
A limited partnership can be seen as a special type of extension of a general partnership. It is a type of partnership where there are two types of partners: general and limited.
General partners act as ordinary partners that manage the business and are liable for the debts and obligations of the partnership (in the same way as the partners of a general partnership do). In addition, there can be “limited partners”. These are partners who enjoy limited liability (i.e., are only liable to the extent of capital they have invested in the partnership). We will explore these different roles in more detail below.
How Does a Limited Partnership Work?
All partnerships must have two or more owners, and in a limited partnership, at least one owner must be a general partner. The partners all share in the profits and losses of the business, as well as being liable for the company debts and obligations to varying degrees.
This is true for both limited partnerships and general partnerships; however, limited partnerships have two distinct types of partners: general and limited.
General partners are more actively involved in the partnership. They participate in the day-to-day operations and management of the business. In addition, they are also jointly and personally liable for the debts and obligations of the partnership.
This means that claims can be made against their personal assets if the assets belonging to the partnership are insufficient to cover its obligations or legal claims. General partners have the benefit of being more directly involved in the partnership with a greater share in the business, but are at a greater personal risk due to the lack of limited liability protection.
In contrast, limited partners have reduced exposure to the debts and obligations of the partnership. The name “limited partner” is derived from the fact that these partners both play a limited role in the business, but also have the benefit of limited liability protection.
In this way, they are similar to shareholders of a corporation or members of a limited liability company. Limited partners invest money in the partnership, but they do not usually play a direct role in the day-to-day management.
They are also only liable to the extent of their investment in the company, and thus cannot be personally sued for the debts and obligations of the partnership. They are often referred to as “silent partners” and act more like passive investors than anything else.
It is important to understand that a partnership cannot consist entirely of limited partners, and there must always be at least one general partner, who is held liable for the partnership’s obligations.
Limited partnerships are therefore extensions of general partnerships, as they allow the addition of the limited partner role, or passive investor.
Advantages and Disadvantages of a Limited Partnership
Advantages of a Limited Partnership
- Additional Resources: In many cases, people are willing to act as passive investors in a company but do not wish to take on undue personal risk. The existence of limited partners allows the partnership to pool more financial contributions from investors who are willing to join as “silent partners”, along with the expertise and work contribution of general partners.
- Limited liability protection for limited partners: A limited partnership is a useful type of entity which provides limited liability protection to those who prefer to take the role of limited partners.
- Pass-through entity for tax purposes: a limited partnership is only taxed once at the personal level, unlike a C-corporation.
- Informal and flexible structure: a limited partnership has a less formal structure than a corporation or even LLC, and allows for greater flexibility in the roles and responsibilities of various partners.
- Greater control for general partners: General partners enjoy greater control over the management of the partnership, and do not have to consult with the limited partners before making day-to-day management decisions.
Disadvantages of a Limited Partnership
- Unlimited personal liability for general partners: general partners are exposed to unlimited personal liability for the debts and obligations of the partnership. This poses the risk of having their personal assets claimed in extreme cases where the partnership is unable to meet its financial obligations.
- Lack of power for limited partners: While limited partners have the advantage of limited liability protection, they do not have any direct power or control over day-to-day management or business decisions.
- Difficult to transfer ownership: due to the tiered ownership and direct participation of general partners, it can be more complicated to transfer ownership compared to other entities such as LLCs.
Limited Partnership Uses
Limited partnerships are indeed a less common type of business entity compared to corporations and LLCs, but they do have some special use cases for which they are well-suited:
- Family businesses: Limited partnerships are useful entities for family-owned businesses. This is because they make it possible to name one or two family members as general partners, who typically take on the management responsibility, while the other family members can be involved as limited partners. The limited partner family members only share in the income of the business, but can also transition to the more active general partner role in the future. An example of this is passing on management of the business to younger generations when they inherit the business.
- Estate planning: Limited partnerships can be effectively used as estate planning tools, whereby the general partner holds property for their heir (who is named a limited partner). The property provides income for the heir due to their position as limited partner, and eventually they are promoted to general partner upon the death of the property holder, and thus gain full control over the property.
- Ownership transitioning: Limited partners are useful in cases where active partners want to reduce their direct involvement in the partnership and transition to the role of limited partner. An example is a professional business such as a law firm, whereby general partners transition to the role of limited partners once they retire. They therefore retain some involvement and exposure to the success of the partnership.
Special Considerations for a US Limited Partnership
In the majority of US States (with the exception of Louisiana), the formation of limited partnerships is governed by the Uniform Limited Partnership Act. It was originally formed in 1916, with the latest amendment being made in 2013.
Under this act, in order to form a limited partnership, it must be registered through the office of the local Secretary of State of the state in which the partnership is formed.
The business permits and licenses required vary according to the state in question, and it is important to obtain the relevant permissions and licenses. If a partnership does not explicitly register as a limited partnership, it is deemed a general partnership by default.
Limited Partnerships are dynamic and useful types of business entities which have a number of special use cases and advantages. They are certainly not the most well-known or popular type of business structure to use, but may indeed be the best choice in certain situations. Their level of flexibility and multi-tiered ownership is unique, and have been used with great success by family businesses, hedge funds, and small investment groups.
If you think that a limited partnership is the ideal type of business entity for your needs, it is a good idea to consult with an expert who can help you decide where and how to set it up, and discuss the other options which might be available.