A Limited Partnership (LP) can be defined as a business entity that is equally apportioned between one or more general partners who actively manage the business and take further risks about the business and one or more passive investors who do not participate in the management of the company.
They were originally formed around industries like real estate, private equity, venture capital, and other professional services. However, they appear to have room for operational latitude along with other liability shield options.
In the fact that many firms are looking for financing with a noticeable separation in capital management and its financial supply systems, the concept of LP structure is gaining interest, particularly in such models.
This guide explains what an LP is, where to use it, its pros and cons in addition to a step-by-step process of setting it up.
What Is a Limited Partnership (LP)?
An LP (Limited Partnership), is a legal business structure registered as a separate entity where there are two categories of partners, those that actively manage the business (general partners) and those that are passive.
Key Components of an LP:
General Partners (GPs):
- The role of a GP is more active as it’s GPs who notice and carry out the business affairs.
- In many words, GPs are faced with unlimited liability since their assets are liable to business obligations.
- They make decisions on business development and manage business processes.
Limited Partners:
- The role of limited partners is to put money into the business and expect returns; they are the quiet type of investors.
- They are called limited partners because their responsibility for debts is only equivalent to their investment
- Limited partners are prohibited from engaging in the business operations since this may lead to personal liability.
Advantages of a Limited Partnership
However, in terms of business operations, having certain limitations may be disadvantageous. Here are the relevant ones:
✅ Limited Liability of the Limited Partner
Indeed, limited partners are not personally responsible for the business’s debts and other shortest terms. Their risk in terms of finance is limited to the amount they invested.
✅ Tax pass-through
This means that LPs do not have to pay taxes at the entity level, as that is done at the partner level, thus not doubling taxation. This is essential because overhead costs are reduced.
✅ Partition of Duties and Functions
The vast range of activities carried out by the general and limited partners have been clearly defined and allocated. Business operations are run by general partners while limited partners do not operate in the business but invest. This clear division reduces disputes and accelerates the decision-making process.
✅ Mobility of Capital
The Capital LPs can collect large resources from those limited partners who wish to invest without being able to take up active roles in the business. This is an advantage to the LP, especially if they are involved in large projects like real estate construction or private equity funds.
✅ Tailored Partnership Agreements
LP agreements are remarkably assorted and can functionalize the requirements of the business in question. This entails elements such as sharing of profits, decision-making processes, and mechanisms of conflict resolution or termination of the partnership.
✅ Preferable existence
Sometimes, LPs can still be in business even when any one of the limited partners dies or withdraws from business. This dependency is based on the partnership agreement that sets the rules of the business.
✅ Trust from Investors
The Limited Partnership LP’s laying out structure is usually good value to the investors, lenders, and stakeholders, which enhances the chances of raising funds or forming business partnerships.
Disadvantages of a Limited Partnership
An LP, however, is not without some substantial disadvantages that must be weighed before adopting this business structure:
✅ General Partners Face Unlimited Risk
Among those aspects is the fact that general partners are entirely liable for the debts and legal obligations of the business. So that role puts their assets at substantial risk which can be the less attractive role for some individuals.
✅ Limited Control for Limited Partners
Limited partners cannot take part in the business’s activities. If they do, they may endanger their limited liability protection by making them responsible for the business’s debts personally.
✅ Complex Formation Process
There is a more complicated method available when it comes to setting up LP structures when compared to establishing a general partnership which accounts for state registration and a partnership agreement.
✅ Dissolution Risks
The death, withdrawal insolvency, or deterioration of any general partner can translate to the liquidation of the LP unless such contingency arrangements are clothed in the partnership agreement.
✅ Ongoing Compliance Requirements
Several procedures will have to be put in place including the filling, reporting annually or every two years as well as maintaining payment processes for such state compliance issues and many others. These processes can increase administrative burden.
How to Form a Limited Partnership (LP)
There are specific legal procedures required by the state or the country before you can set up a Limited partnership.
Here’s a checklist that will help you do it step by step.
1. Choose a Business Name
As it is LP, naming the entity is the first step towards its formation.
State Regulatory Provisions:
- A registered business name should also comply with all legal prerequisites established by your state. The name of the business must always have the word “Limited Partnership“, or the abbreviations “LP” or “L.P.” as a suffix.
- In some jurisdictions, the use of selected prohibited words in a business name without the necessary license is illegal (such as ‘bank’ or ‘insurance’ ).
Distinctiveness:
- For a name to be registered in your state, no other business entities should bear the same name. Before registering the business name, confirm its availability, by performing a name availability search on your Secretary of State’s database.
Trademark Considerations:
- Before heading to the registrar, check if the name you wanted to use already has a trademark on it. It is appropriate to always try and grab a unique name when you can, to avoid any legal issues in the future and also maintain a distinct identity for the brand.
Domain name availability:
- When it comes to LP’s online presence, having a corresponding domain name is important in the present-day world. It would be prudent to have the domain assigned at an earlier stage to save on future aggression.
2. Draft a Partnership Agreement
This agreement should contain all of the fundamental terms of the partnership, namely:
- Roles and responsibilities of each partner.
- The distribution of profits and losses;
- The process of expansion or contraction of the partnership;
- The process of business operation;
- Business resolution modalities.
While not all jurisdictions require a written partnership agreement to form a partnership, none present were likely to see its worth in avoiding conflicts.
3. File a Certificate of Limited Partnership
- Send necessary documents to the Secretary of State [or equivalent] of your state.
- This document often contains:
- Partnership name and business address.
- Names and business addresses of the general and limited partners.
- The name and the address of the registered agent.
- The costs of filing differ from one state to another, approximately $50 to $500.
4. Obtain an Employer Identification Number (EIN)
The Internal Revenue Service (IRS) allocates a unique number known as an Employer Identification Number (EIN) to Limited Partnerships (LPs) for taxation purposes.
What is the relevance of an EIN?
- In opening a business account
- While recruiting and employing employees.
- For state and federal taxes.
Where to apply:
- On the IRS website, you can fill out an application for an EIN online.
- The application is free, and you will get your EIN as soon as you finish the whole process.
5. Secure Licenses and Permits
Depending on the nature of your business and where you intend to operate, some different licenses and permits may be required.
Federal Licences:
- For businesses engaged in certain regulated activities like liquor, firearms, or transport, federal permits may be necessary.
State Licenses:
- These depend on the locality and the nature of the business. Other frequent examples are professional licenses for accountants, contractors, or healthcare practitioners.
Local Permits:
- Additionally, other permits may be required such as zoning permits or approvals from the health department which can be obtained from the city or county.
6. Open a Business Bank Account
One of the most important aspects is to get a specific business bank account to handle the LP’s finances and maintain liability protection.
Why It Matters:
- Helps separate personal and business finances.
- Makes accounting and tax reporting easier.
- Serves to limit the liability of limited partners.
Necessary Documents:
- Certificate of Limited Partnership.
- EIN from IRS.
- Partnership agreement (in certain cases).
LP vs. Other Business Structures
LP vs. General Partnership
A General Partnership (GP) is among the easiest structures to manage as all the partners are fully involved in managing the company. However, this is not the case with LP since this breaks down the management positions and the liability allocation to the partners.
Management Responsibilities:
- General Partnership:
- In a GP, each one of the partners participates in the management of the business. The partners make decisions equally unless it is stated otherwise in a partnership agreement.
- Involvement on such a level may create disagreements as to the opinions and priorities concerning the strategic directions.
- Limited Partnership:
- In an LP, day-to-day management of the business as such is only retained by the general partners.
- Those who have bought the limited partners are sometimes called passive investors. These people lack management functions but they are protected from a high degree of liability.
Liability Exposure:
- General Partnership:
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- In GPs, each of the partners has virtually unlimited personal liability for that business’ debts and obligations. This protects the owners from actions being taken against their assets in case of being sued or going bankrupt.
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- Limited Partnership:
- General partners in an LP do not escape unlimited liability but limited partners are only liable to the extent of what they put into the business.
- This structure attracts such investors who wish to limit their financial investment.
Use Cases:
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- General partnerships are best suited for small business operations where risks are low and all the partners actively run the business since they are equally invested in its operations.
- For businesses requiring a considerable amount of investment and some partners who would rather play a passive role, LPs are better suited.
LP vs. Limited Liability Company (LLC)
An LLC brings the limited liability of a corporation along with the benefits of the partnership’s structure and tax. The differences become more apparent when LPs and LLCs are compared concerning liability and management.
Liability Protection:
- LP:
- Under limited partnerships, limited partners have limited liability, while only general partners are personally responsible for the obligations of these activities.
- This leaves an element of risk for general partners who need to be moderate in their activities so that risk is managed properly.
- LLC:
- Every person holding membership within the LLC, regardless of whether they are participants in the management or non-participants, enjoys limited liability.
- This quality makes LLCs become the preferred option for many businesses that seek a wide range of cover where all the owners need protection.
Management Flexibility:
- LP:
- There is no management of the LP and thus decision-making can be fast due to the participation of only general partners but this creates an imbalance where limited partners have less decision-making power.
- LLC:
- The management of LLCs does not have a rigid structure. The members may decide to collectively manage the business (member-managed) or can also decide to hire managers (manager-managed).
- This flexibility enables LLCs to suit and strike the right balance between small-scale and large businesses quite efficiently.
Taxation:
- Both LPs and LLCs do not bear double taxation unlike corporations as they enjoy pass-through taxation.
- On the other hand, several different options may be available to LLCs, for example being taxed as an S corporation, depending on the vision of the company.
Use Cases:
- LPs are great for joint ventures where a distinction between those who manage the project and those who invest in it is required for instance real-estate, or a film production project.
- LLCs are also geared for a broad range of activities starting from funded projects to fully functioning businesses, because of their liability coverage and ease of management.
LP vs. Corporation
Corporations being separate legal entities are more complex entities that provide the greatest liability coverage but come with increased compliance obligations and potential tax liability. Comparison of LPs and Corporations will help to understand their differences in terms of structure, income tax, and management components.
Legal Entity Status:
- LP:
- An LP of this state is not a sole entity in the sense of a corporation as an LP cannot exist without partners nor are there any other determinants. The business is owned by the partners engaged in it.
- Corporation:
- A corporation is a completely distinct legal entity, even if the shareholders, as its owners, do not have complete control over its assets.
- This separation, ensures the best form of liability protection, as the shareholders have no personal responsibility for the debts of the corporation.
Taxation:
- LP:
- The advantages of an LP include pass-through taxation, meaning profits and losses are reported only once and are therefore recorded only on the partner’s tax returns.
- Corporation:
- However, corporations face double taxation. The first tax is the corporate income tax on the business profits, then it is the tax on the dividends paid to shareholders.
- Nonetheless, S corporations still have the option of S corporations except they have very narrow criteria to qualify.
Management Structure:
- LP:
- In this case, general partners are the managers of the company with limited partners being the other investors.
- This separation encourages more role and responsibility flexibility.
Corporation:
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- Corporate organizations have to maintain a formal hierarchy that includes the board of directors, the officers, and the shareholders.
- Such structures tend to be somewhat more difficult to administer for smaller businesses since they are more rigid.
Flexibility:
- LP:
- Corporations are more difficult to set up and run than LPs because they have to meet more compliance issues regularly.
- Given the nature of profit sharing in LPs, most terms can be negotiated in the partnership agreement.
- Corporation:
- Corporation structures are rather strict as they have various formalities including reporting requirements, shareholder meetings, and the need to keep accurate books.
- As a result, this structure fits companies intending to raise capital by selling shares today or companies that intend to go public in the future.
Use Case Applications
- LPs are frequently applied in sectors such as real estate, private equity, oil and gas among others where passive investors provide some capital and do not take part in the managing.
- While corporates can be said to be suitable for bigger organizations especially those that are looking for investors or plans to be listed publicly.
Industries Where LPs Are Commonly Used
LPs are widely accepted in the areas stated below.
1. Real Estate Development
The development and financing of residential communities, commercial properties, or mixed-use developments.
LPs are popular in this kind of business. Project owners called general partners, are in charge of operations while the investors called limited partners are in charge of funds.
- Examples: LPs allow developers to raise enormous amounts of money with the help of limited partners.
- Benefits: There are many ways in which limited partners can earn passive income while minimizing the amount of exposure they have to liability. Also, they can collect returns without the involvement of being an active participant in the project.
2. Private Equity and Venture Capital
LPs strategically structure investment funds for high-growth start-ups and/or business turnarounds using capital contributed by limited partners.
- Examples: Investment funds that are targeting emerging technology companies or those that buy companies that are underperforming and turn them around.
- Benefits: In this case, many LPs avoid or are limited in LPs managing the operations themselves due to the nature of requirements. For instance: financing petroleum reserves or pipelines.
3. Professional Services
LPs facilitate non-managing members’ practice of soliciting liability-free structures whilst partners retain management regulating powers in industries such as law, accounting, or consulting.
- Examples: Growth of law or accounting companies.
- Benefits: It brings investors’ resources and, at the same time, protects the limited partners from liability for professional acts.
4. Film and Entertainment
A high amount of capital is needed to build up creative projects, in this context, films, TV shows, performances, etc., and LPs help in such cases.
- Examples: Independent films or Broadway.
- Benefits: Limited partners receive a share of the profits proportionate to the success of the project, time, and financial resources engaged without any creative input.
5. Renewable Energy
LPs promote investments in clean energy projects which involve a huge amount of initial capital investment.
- Examples: Solar farms, and wind turbine sites.
- Benefits: Attracts investors with interest in clean energies without too much liability.
EasyFiling can help in forming a Limited Partnership (LP)
Mostly, we would agree that Limited Partnership (LP) formation is a tedious process, quite intricate to execute without due regard to several factors like statutory obligations and intricate details. But this is where our professionals come to your assistance.
We take care of preparing and submitting the necessary documents as well as advise on any requirements particular to the state in question so that establishing the LP is hassle-free.
By using EasyFiling, you will experience professional assistance, needed tools, and information as well as a smoother process than you would with EasyFiling.
Book a free consultation today with Easyfiling to form a Limited Partnership.
Nabin Adhikari
