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A Limited Partnership (“LP”) is a special type of partnership created by state statute, consisting of two classes of partners: one or more Limited Partners and one or more General Partners.
Usually, the General Partner(s) will be a corporation or limited liability company. If the General Partner is not a corporation, more than one General Partner is typically involved in the partnership. The LP is usually for a fixed term of years. The General Partners share characteristics similar to those of partners in a GP, including personal liability for the debts and obligations of the partnership or of any partner engaged in carrying out partnership business. Their liability remains “joint and several,” but they alone have management authority and responsibility of the partnership.
Limited Partners assume no liability for partnership debts or obligations beyond the amount of their capital contribution, but they lose the right to participate in its management. Their role mimics that of a shareholder in a corporation; hence, they have no rights to the day-to-day management or operation of the business and are not liable for either the debts or obligations of the partnership or those of the General Partners. The LP is a “classic hybrid” of the General Partnership and the Corporation in terms of limited liability for investors.[i]
As the LP is a creature of state law, the partnership must file a “Certificate of Limited Partnership” with the Office of the Secretary of State. This form of partnership does not share the common law characteristics of a GP; that is, the fact that two or more persons agree to carry on as co-owners a trade, business, financial operation or other venture for profit does not create a LP even if the partners intended to do so.[ii] The LP does not come into existence until the Certificate is filed with the Office of the Secretary of State.
Moreover, most state statutes require the partners to draft a Partnership Agreement that, among other things, clearly designates the names of the Limited Partners. The individual names of the Limited Partners cannot appear in the name of the partnership, since such a naming convention could create confusion in the public’s mind as to who they are actually doing business with. Most state statutes also provide that Limited Partners can contribute only money or property but not services to the partnership.
Courts are generally very strict about the formal requirements of LP status, so partners must strictly comply with the requirements of the state statute. If partners stray too far from those requirements, Courts will treat their business as a general partnership instead, imposing unlimited joint and several liability for its debts and obligations among all the partners.
Like a GP, the LP is subject to only a single level of income tax; that is, the LP does not pay income taxes as a separate legal entity. Instead, the profit earned by the GP flows through to the partners who report it as income on their personal tax return – IRS Form 1041. The LP is a “pass-through” entity for federal tax purposes. For the individual partner, income and expenses are reported on Schedule C, “Profit or (Loss) from Business,” of the owner’s Form 1040. Since the partner is taxed at the individual level, her “tax bracket” applies to her share of the profit.
The ability to attract investors to the partners’ business enterprise is the chief advantage of the LP. As Limited Partners, their exposure to liability is restricted to the amount of their capital contribution. As investors, they can make a calculated judgment of the extent of their participation by being able to more accurately prepare a cost-benefit analysis of the business. So long as they exercise no control over the partnership, Limited Partners are shielded from personal liability for business activities. Finally, General Partners cannot act unilaterally in reaching a decision to dissolve the partnership, absent an agreement to the contrary in the Partnership Agreement.[iii] Unanimous consent among all partners is required for the LP to be dissolved before the end of its stated term (unless otherwise provided for in the Partnership Agreement). These rules combine to make for an efficient and flexible form of business organization:
“The limited partnership obtained credibility toward creditors by permitting limited liability only for those investors who exercised no control over the firm. The advantage of this rule was that the limited partners, while having an incentive to withdraw assets from the firm opportunistically, lacked power to do so. At the same time, the general partners, who did have the power to dissipate the firm’s assets, had little incentive to do so if that would threaten the firm’s solvency, as they would be personally liable for any shortfall.”[iv]
Returning to our example of Outdoor Hunting Gear, suppose Jane, John and Josh wish to attract even more capital with which to expand their retail outlets around the state. By restructuring their relationship as a limited partnership with Jane and Josh remaining as General Partners and John becoming a Limited Partner, they could now offer investors an ownership interest in the company, renamed Outdoor Hunting Gear, Limited Partnership. Now, Bambi could invest $10,000 to the partnership, become a Limited Partner in Outdoor Hunting Gear, and cap her exposure to personal liability for the debts and obligations of the LP. While enjoying a proportionate share of the profits of Outdoor Hunting Gear, Bambi’s liability is limited to her original $10,000 investment. Moreover, Bambi is protected against any decision by Jane and Josh to liquidate the partnership.
One disadvantage of the GP is that the General Partner(s) exercises nearly unfettered control and discretion over the management of the partnership. “Limited partners, like shareholders in the corporation, have no management rights and no personal liability. They trade their involvement in management for the security of limited liability.”[v] For instance, partnership earnings may be retained by the partnership for reasonable business needs at the discretion of the General Partner(s). General Partners must approve the admittance of a new or substitute Limited Partner, allowing them to act as gatekeepers in preventing the admittance of certain Limited Partners with whom they disagree. As noted, whoever controls the General Partner interest controls the day-to-day operations of the LP. In the event of dissension among all the partners, Limited Partners are subject to the whim of the General Partners (absent violation of statutory requirements).
Another disadvantage is that a LP interest cannot be pledged as collateral for another legal obligation. The Limited Partner can therefore be restricted in acquiring other assets or borrowing monies for other ventures, because she will be unable to reach her assets in the GP. The owner of a partnership interest (the Limited Partner) is dependent upon the General Partner to either make distributions in the ordinary course of business or, upon all of the partners’ consent to liquidate, to distribute the assets.
Partners to an enterprise can use the LP form of organization to
- raise capital by attracting investors while
- limiting the liability of a group of partners to the partnership.
[i] John H. Matheson and Raymond B. Eby, The Doctrine of Piercing the Veil in an Era of Multiple Limited Liability Entities: An Opportunity to Codify the Test for Waiving Owners’ Limited-Liability Protection, 75 Wash. L. Rev. 147, 162 (2000).