What is a Limited Partnership (LP)?

A limited partnership is like owning a house and having roommates move in…

Suppose you recently bought a house and invite a few friends to move in. You all split the bills and get the perks of living together. But ultimately, it’s your house, and you call the shots. You’re also stuck with any emergencies that come up, such as a leaky roof. A limited partnership is like that house — One person has primary decision-making power and liability in the business (the homeowner), while the others are silent financial partners (the roommates).

A limited partnership is a business with two or more owners in which one partner is responsible for all of the liability, while the others have limited liability.

Often business partners split everything down the middle — That includes profits, debts, and power. In the case of a limited partnership, the general partner has all of the decision-making power, but is also personally responsible for all of the business’s debts and financial obligations. Other owners are silent partners — They put in money and get profits, but don’t get the control. At the same time, they are not personally liable for the company’s debts.

In some partnerships, two owners are fully involved in the day-to-day operation of the business. It makes sense for them to have equal liability and equal control. But when one partner will run the company while the others will act as silent partners, a limited partnership might make more sense.

An operating agreement is a contract that members of a partnership draft and sign to outline each owner’s rights and responsibilities within the business. Regardless of what type of partnership you’re starting, an operating agreement may be a good idea. It helps ensure that everyone is on the same page and can help avoid conflict later.

In this document, partners can figure out how much voting power each member will have. In the case of a general partnership or a limited liability partnership, members often divide all decision-making power equally, though they don’t have to. But in the case of a limited partnership, the general partner has control while others are silent partners.

In an operating agreement, you may also want to spell out ownership shares, how you’ll divide profits and losses, what will happen if one partner dies or wants out of the business, and how you’ll handle disputes.

Taxation for limited partnerships is relatively simple. Unlike most corporations, which have to pay corporate taxes before distributing profits to owners (who then also have to pay income taxes on the distributed profits), partnerships avoid double taxation.

Limited partnerships have pass-through taxation, meaning the profits and losses pass through to the owners. Each owner reports his or her share of profits and losses as income and deductions on their individual tax returns.

Suppose you and a partner go into business together and decide to split everything down the middle. If the company has $50,000 in revenue and $5,000 in expenses, then you’ll each report $25,000 in income and $2,500 in deductions on your taxes.

In addition to income taxes, limited partnership owners also have to pay self-employment taxes, which are the portion of payroll taxes that an employer normally covers on employees’ behalf. When you’re self-employed, you pay both the employer and employee portion.

Finally, partnership owners, like with most self-employed people, have to pay quarterly estimated taxes. The Internal Revenue Service (IRS) operates on a pay-as-you-earn basis, meaning you generally have to pay taxes on your income as you receive it, not in a lump sum later on. That’s why in a typical job, your employer withholds money for taxes from each paycheck. When you’re self-employed, you have to make those tax payments yourself each quarter.

Limited partnerships aren’t the only type of business partnership. Two other common structures are general partnerships and limited liability partnerships.

The most straightforward kind of partnership is a general partnership. You don’t need to file any paperwork to form this type of business. If you and a partner start operating a business together, you’re automatically a general partnership. Parties entering into a general partnership may still want to take the time to write up an operating agreement.

General partnerships have pass-through taxation, just like limited partnerships.

General partnerships can involve more risk for the owners than other types of partnerships. There’s no separation of liability between the business and the owners, so you and your partner are fully responsible for the debts and obligations of the company.

The other type of partnership is a limited liability partnership. This is similar to a general partnership, with one critical difference: The owners of a limited liability partnership aren’t responsible for the company’s liabilities, beyond the amount they put into the business. In this type of structure, both partners have equally limited liability, and each has decision-making power in the business.

It’s important to note that limited liability might look different from one state to another. Some states remove all personal liability, while others only limit personal liability for the negligence of a partner. Other business structures, such as corporations, generally offer more protections for business owners.

Limited liability partnerships pay taxes in the same way that both limited partnerships and general partnerships do — Profits and losses pass through to the owners.

To create a limited liability partnership, owners need to file the appropriate paperwork with their state’s government (usually the secretary of state’s office). They may also want to create an operating agreement.

Limited partnerships can have upsides and drawbacks for all participants. For the limited partners, meaning those with limited liability, this type of business ownership comes with lower risk. If someone sues the business, limited partners aren’t responsible for paying any costs that ensue, beyond the money they invested in the company.

This insulation from risk comes at a cost. In a limited partnership, owners who give up their liability also generally give up their decision-making power. In some cases, they might prefer it this way. But if the general partner is making decisions that the limited partners disagree with or that they feel are limiting profits, then the structure can be problematic.

There are also pros and cons for the general partner. If you want to start a business where you call all the shots but don’t have the funds to make that happen, a limited partnership can be a great deal. You can launch with the help of a partner without ceding control. It might be easier to make decisions quickly without too many cooks in the kitchen. The general partner gets some benefits of a sole proprietorship (meaning they call all the shots), with the extra bonus of someone else’s money.

But being the general partner in a limited partnership also comes with downsides. First, being the only partner handling day-to-day operations can be a daunting and perhaps lonely process. Unlike in a limited liability partnership, where all owners are separate from the liabilities of the company, the general partner still takes on liability in a limited partnership.

Suppose someone sues the business, and the court orders the company to pay damages. The other partners aren’t responsible for paying those damages — Only the general partner has to shell out. Corporations and limited liability companies (LLCs) protect all owners, not just some, from personal liability. Another potential disadvantage for both parties is that limited partnerships make it more difficult than corporations to transfer an ownership interest from one party to another.

But there are advantages for all partners, too. Limited partnerships are relatively simple to set up and involve less paperwork than corporations. Additionally, the business doesn’t have to pay corporate taxes. Instead, each partner claims his or her share of the profits and losses on their tax return, avoiding the double taxation that corporations are subject to.

Starting a limited partnership can be a fairly quick process. Before you file any paperwork, sit down with your partner or partners, and make sure everyone is on the same page as far as control and liability within the company. You’ll probably want to hire an attorney to help with the details to ensure you do everything correctly.

When starting a limited partnership, you may want to create an operating agreement. Since you’re entering into a business relationship, it may be a good idea to agree on the details ahead of time. This part is especially important when one partner is taking on all of the authority and risk.

Next, you need to file the appropriate paperwork with your state government, usually with the secretary of state. You’ll submit a form called a certificate of limited partnership, along with a filing fee. On this form you’ll share the following information:

• Name of the partnership
• Business address
• Latest date on which the limited partnership will dissolve
• Point of contact for the business
• Name and address of the general partner
• Name of the person drafting the certificate

This article contains general information regarding ownership concepts and not legal advice. Please consult with your attorney before entering into any legal agreements.