As discussed in our articles on Basic Characteristics of Various Types of Business Entities, and The American System of Business-Limited Liability Entities, any person considering engaging in business should seriously consider the advantages of creating an entity which would have limited liability attaching to the owners. Please review the above articles before reading further.
In the United States, where litigation is a business fact of life, such limited liability can mean the difference between bankruptcy if things go wrong, and maintaining a nest egg that allows a second chance. Since starting a business is always a risky task, a limited liability entity is almost always a good approach.
In other articles we have discussed the corporate structure and limited liability companies. The third type of limited liability entity often utilized is the LIMITED PARTNERSHIP. This article shall deal only with the third type of limited liability business entity, the limited partnership.
The Basics of Limited Partnerships:
A limited partnership is a partnership that has at least two classes of partners, a general or managing partner who operates the company and limited partners who invest but do not partake in day to day decisions. Assuming they maintain their “limited status,” the limited partners do not have personal liability for the limited partnership debts. The general partner does have unlimited liability…but can be a limited liability entity itself, e.g. a corporation or an limited liability company.
Once created, the entity engages in business as a separate entity, signing all documents and signing all contracts as a limited liability partnership. The general partner acts as the person managing it and can hire a non owner manager to do various operations, such as managing a particular property, etc.
The limited partnership has one or more “limited partners” and one or more “general partners.” Limited partners are individuals who do not participate in the control of the limited partnership and who are not generally personally liable for the debts of the limited partnership. General partners are individuals who do actively participate in the control of the limited partnership and who are fully liable for the debts of the limited partnership.
Limited partnerships are generally required to utilize a written limited partnership agreement. Although in some jurisdictions such an agreement can be oral, that is a very dangerous approach and would face attack from third party creditors if things went wrong.
Like a general partnership, the limited partnership is generally not subject to federal or California income tax. Most limited partnerships choose to be taxed as general partnerships, where each individual generally pays taxes on his or her share of the allocated income from the limited partnership. A limited partnership is also subject to an annual franchise tax fee imposed by the State of California.
Basic Features:
- Minimal reporting requirements
- Business profits subject to taxation only once
- Partnership is a "pass through" tax entity
- No requirement for annual meetings or minutes.
- General partner has a fiduciary duty to the limited partners. Limited partners have no fiduciary duty to the entity.
- Easily created and often used in real estate investments where the general partner runs the property while the limited partners, as owners, are only involved in major decisions concerning the property.
- Ownership harder to transfer than a corporation or a limited liability company. Often has “first right of refusal” of ownership interest to the other limited partners or the general partner.
- Always has one person or entity personally liable for debts (the general partner.)
- Less flexible than a corporation or limited liability company in changing management roles and thus harder to use if the asset or business alters over time. Much more properly used to hold one asset or a few assets which will maintain the same business model over a long period of time.
- Less formal structure with clearly defined roles, unlike a corporation with shareholders, bylaws, corporate officers and directors as well as a hundred years of case law defining rules and responsibilities. Generally, the limited partnership agreement defines rights and duties.
- Less attractive as an investment to outside persons who may be interested in purchasing an interest.
- Limited partners are restricted in how active they can become which can become a real problem if the general partner is not doing an adequate job. Limited partners who become too active risk being accused of becoming defacto general partners thus personally liable for debts.
Partnership Formation
Many of the problems business partners encounter are a direct result of a failure to properly plan the partnership operations and relationship amongst the partners. All too often the positive energy and excitement present at the beginning of the business relationship eclipses the perceived need to spend even a modicum amount of time and money methodically setting up the properly created partnership. The prevalence of sample partnership agreements on the Internet leads people to believe that merely downloading and signing these agreements protects their rights. This is often not true. See our article Preprinted Forms Don’t Go To Trial. Like buying insurance, you only know you needed to spend the money when it is too late to do it.
Too often, friends forego written agreements because of an unstated belief that suggesting a written agreement conveys distrust to the other partner and this might sour the relationship. It is worth acknowledging that every partnership starts with a certain degree of trust between partners. The sheer number of partnership disputes is evidence that proper planning is undervalued.
A variety of issues should absolutely be considered at the onset of the business relationship, such as:
- Addition of new partners in the future