When two or more people form a business, they can choose to structure the company as a partnership, corporation, or limited liability company (LLC). A limited partnership is a special kind of partnership that is useful in certain situations.
Here's an overview of limited partnerships that will help you understand how a limited partnership is structured, its advantages and disadvantages, and how to create one.
Business Entities and Personal Liability
A big concern for business owners is the extent of their personal liability for the debts of the business. Any business can incur various types of debts, such as from borrowing money to finance operations, purchasing goods and services on credit, owing wages to employees, tax obligations, and lawsuit judgments. But what happens if the business is unable to pay its debts?
Business assets are the first source for debt payment. If the business does not have sufficient assets to pay its debts, creditors will seek payment from the owners' personal assets. This means that creditors may go after the owners' personal bank accounts, real estate, vehicles, investments, and other property. This is called personal liability.
Thus, business owners want to limit their personal liability for the debts of the company. Such a limitation of liability is one of the primary purposes of organizing a business as a limited partnership, corporation, or LLC.
Understanding limited partnerships requires an understanding of general partnerships. A general partnership exists if two or more people operate a business as joint owners and do not form a corporation or an LLC. With a general partnership structure, each partner is personally liable for the debts of the business, and each partner has the right to participate in managing the business operations.
A limited partnership structure also has two or more owners but has two categories, or classes, of owners:
- General partners, who operate the business and have the same unlimited personal liability as partners in a general partnership
- Limited partners, who are not permitted to participate in operating the business but have limited personal liability for partnership debts—the most a limited partner can lose is the amount they invested in the business
A limited partnership must have at least one general partner and one limited partner. General partners can limit their liability by forming a separate corporation or LLC, but this makes the business formation even more complex than a corporation or LLC alone.
Pros and Cons of a Limited Partnership
As with any type of business entity, limited partnerships have pros and cons. Some relate to the business as an entity, and some relate to whether you are a general or limited partner.
Advantages of a limited partnership include:
- The business can raise capital by enticing investors to become limited partners by offering them personal liability protection.
- Compared to an LLC or corporation, a limited partnership is easier and cheaper to form, with fewer record-keeping and reporting requirements.
- General partners can take on investors without giving up any control of the business.
- Limited partners can invest in the company without incurring personal liability.
Disadvantages of a limited partnership include:
- It may be more difficult to borrow money than with a corporation or LLC.
- It may be easier to transfer an interest in a corporation or LLC than an interest in a limited partnership.
- State and federal securities laws typically place limits on limited partners, such as to their total number, relationship to the general partners, and state of residence.
- General partners remain personally liable for business debts.
- Limited partners do not have any say in business operations.
All of these factors should be weighed to determine whether a limited partnership is right for your business.
Alternatives to a Limited Partnership
If you set up a limited partnership, you can attract investors without giving them any management authority. This same goal can be achieved by structuring the business as a corporation or an LLC. However, this involves more complex organizational documents, increased record-keeping requirements, and more complex tax filings.
Some states allow you to form a limited liability partnership (LLP), which is basically a general partnership that gives each partner some degree of personal liability protection. LLPs are typically only available to certain professionals, such as accountants, attorneys, and physicians. One partner in an LLP is not personally liable for the negligence or misconduct of another partner but remains personally liable for the debts of the partnership as a whole. LLPs are typically used if state law prohibits certain professionals from forming an LLC.
How to Form a Limited Partnership
Limited partnerships are governed by state law. Therefore, the law of the state where the limited partnership is formed dictates the exact formation requirements. Generally, limited partnerships are formed by creating two documents:
- Limited partnership agreement, which sets forth the details of the agreement between both the general and limited partners
- Certificate of limited partnership (sometimes called a registration statement), which is filed with the appropriate state agency to register the limited partnership
Determining whether a limited partnership is right for your company requires an evaluation of your personal liability concerns, formation and record-keeping requirements, and tax considerations. This may require the assistance of legal and accounting professionals to be sure you're forming the limited partnership properly.