September 19, 2022 | Last Updated on: June 5, 2024
A partnership is a formal or informal business structure that allows two or more entrepreneurs to work together to achieve a common business goal. One of the most popular types of legal partnerships is the limited partnership (LP).
This article covers the basics of what this type of partnership is, how it works, and how it’s different from other partnership structures. It will also explain where and how to form a limited partnership.
A limited partnership (LP), unlike informal partnerships, is a formal legal entity. You register your partnership with your state’s Secretary of State. By registering with your state, the partnership gains liability protection for its owners, similar to business incorporation.
Individuals (sole proprietors), for-profit corporations, most types of businesses, and nonprofits can all form limited partnerships, taking either a limited or a general partner’s role. Startups, new businesses, and existing businesses can all form LPs.
A limited partnership is unique because it has two classes of partners: limited partners and general partners.
Limited partners are often referred to as passive investors. They contribute capital to the business but don’t make decisions about the day-to-day operations of the business.
General partners manage the everyday business activities of the LP. They may also invest capital in the organization, but their primary purpose is to drive business success. General partners set direction, develop strategies, manage operations, enter contracts, hire and fire employees, and more. They are the hands-on leaders of the organization.
The other key difference between the two types of partners is their personal liability related to the business.
Limited partners won’t be personally harmed by business decisions unless they overstep and start actively making decisions for the company. General partners have more responsibilities, which means they face more significant risks than limited partners.
A limited partnership has a formal startup process. It includes preparing and filing a Certificate of Limited Partnership. This document contains the roles of your partners and the identity of your registered agent. The registered agent can be an individual or professional service.
As part of the partnership formation process, the partners enter into a partnership agreement. This document is comparable to a Limited Liability Company’s (LLC) operating agreement. It documents the details of the relationship among the company’s partners.
A solid partnership agreement should clearly explain how the profits from the business will be split among the partners. If the limited partners get a cut of business income to compensate them for their investments, the partnership agreement explains how that happens.
The partnership agreement should also document how decisions are made in the organization. The general partner or partners make day-to-day decisions, similar to other small business owners. However, limited partners may need to be involved in significant decisions that impact the structure or functioning of the business. The partnership agreement must establish if, when, and how limited partners become involved in these decisions.
The partnership agreement must be clear, comprehensive, and complete. It’s wise to work with a business legal expert to ensure yours is crafted correctly.
There are many advantages to LPs. There are also a few things to look out for.
Limited partners have minimal liability in the business. If the business is sued or defaults on a debt, the only thing at risk for a limited partner is their financial investment in the LP. Their personal assets, including their house, car, personal bank account, artwork, and investments, are protected by the LP business structure. LPs reduce risk for passive business owners.
One of the critical reasons LPs are popular is because they’re attractive to outside investors. The personal assets of limited partners are protected, and they don’t have to be involved in the day-to-day operation of the business. LPs make it relatively safe and easy to own a business and earn revenue.
An LP has the same pass-through taxation structure as a general partnership. Instead of paying business taxes, the profits and losses of an LP pass through the business entity, and the partners pay taxes on this money based on their personal income tax situation. This avoids the double taxation issues that many corporations face.
Compared with corporations, limited partnerships are relatively easy to form. Plus, the ongoing maintenance process for an LP is quite simple. The paperwork requirements are more straightforward. Record keeping needs are much simpler than corporations, including C-corporations. In most states, LPs aren’t required to file annual reports. Articles of incorporation and articles of organization aren’t required for LPs. You also don’t need to create a board of directors. LP laws are simpler to navigate than corporate laws.
If a limited partner wants to leave the business, it’s a simple process. The same is true if you wish to add limited partners. Other business entity types can make doing these changes challenging.
While limited partners enjoy personal asset protection under an LP, general partners have a heavy risk burden in an LP. If an LP is sued or defaults on a debt, a general partner’s personal assets and business assets can be seized. The general partner is in total control of business operations. They also take on a great deal of risk.
While a limited partner doesn’t take on much risk in a limited partnership, they also don’t have much control over the operation. Limited partners are usually only consulted on big decisions that affect the LP’s overall operations. This can be frustrating if they feel the business is heading in the wrong direction.
The costs and requirements of registering a limited partnership differ by state. In most cases, the best state for small businesses to register in is their home state, especially if it’s a small operation working in a single region.
However, you may want to move to and register your limited partnership in a state with no income taxes or low income tax rates so you can limit the impact of taxes on the profits you earn from the LP. Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming are states with no state income taxes. Delaware is also considered a business-friendly state that could be worth looking into.
Unlike incorporating a business, annual fees and other types of regular expenses are low for LPs and typically don’t impact the decision of where to form an LP.
If you decide to form a limited partnership in another state, by law you may be required to file for foreign qualification to operate in the state legally. This is a highly complex area. If it’s something you’re thinking of doing, work with a lawyer, tax expert, and financial professional to find out if it’s possible and whether it makes sense for you.
Here are the steps you need to take when you decide that forming a limited partnership is the right option for your business. They’re identical for most states and will help ensure your business is compliant.
Come up with a business name for your new LP. Your LP’s name is crucial because it needs to make a great impression on the people or other businesses it’s targeting.
Another critical aspect of naming an LP is ensuring the name you want is available in your state and hasn’t been claimed by another entrepreneur. Search your state’s business database to ensure you can use the name you want.
All LPs in the United States must have a registered agent. Your registered agent is responsible for receiving document deliveries from your state, including paperwork you must complete and annual report reminders. They must alert you of their receipt and forward the documents to your business.
You can designate an individual or a professional service as your designated agent. The only limitation is that the LP cannot be the registered agent.
Completing this certificate and paying a filing fee registers your partnership with your state. The information required varies by state but usually includes:
Not all states require that partnership agreements be submitted with the Certificate of Limited Partnership. However, every LP should have one to govern its operation. It can help prevent ownership and other types of disputes which can cripple an organization.
Typically, a partnership agreement includes:
Work with a business legal expert to ensure your partnership agreement is structured correctly.
Acquire a federal tax ID number (often referred to as an EIN or employer identification number) from the Internal Revenue Service (IRS). An EIN is like a social security number for a business. It’s a nine-digit number used to identify your business for tax purposes. An EIN can help with other things like opening business bank accounts, hiring employees, and more.
Set up a business bank account and your accounting system. Use your business bank account exclusively for business purposes. Commingling business and personal expenses could put your LP at serious risk. When it comes to an accounting system, you probably want to work with an experienced business accountant to ensure things are set up correctly.
State laws and municipal regulations typically require LPs to obtain a business license and permits before opening. Specific industries require federal licenses and permits to operate, as well. A lawyer familiar with your business sector and state can help ensure you get all the legal documents you need to conduct business compliantly.
Work with a business insurer to ensure you get all the coverage you need to protect your LP. This could include workers’ compensation coverage, general liability protection, business property insurance, professional liability insurance, and commercial vehicle coverage.
If forming an LP on your own sounds too daunting, there are other options. You could hire a lawyer to help create your business, although this option is typically quite expensive, and the costs can be too high for startups on tight budgets.
If you can’t afford a lawyer, check into online business formation services. They provide an automated way to form an LP that can make the process relatively easy.
A limited partnership is not the only type of partnership ― there are also general partnerships, limited liability partnerships, limited liability limited partnerships, and joint ventures. Here’s a quick overview of each to help you feel confident that a limited partnership is right for you.
If you have any doubts about setting up an LP in your state or any other, get professional support to ensure it’s the right move for you and you set things up correctly.
