Reasons to Form a Limited Partnership

Two businessmen shaking hands after forming a limited partnership

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Although they have fallen out of favor due in no small part to the rise of the superior limited liability company, the good, old-fashioned limited partnership is still one of the greatest inventions of capitalism. Just one of the benefits of forming a limited partnership is the fact that it can be owned by certain types of investors, such as trust funds, which isn't permitted with an S-Corp.

Key Takeaways

  • The partnership is not charged taxes; you report losses and profits when you invest through a limited partnership, and the taxes are passed on to you.
  • A limited partnership is less risky than other investments because you cannot lose more than you invest in a limited partnership.
  • Limited partnerships have estate and gift tax benefits and allow for flexibility in how it operates.

Allows Pass-Through Taxation

When investing through a limited partnership, the federal or state governments don’t tax the partnership itself. Instead, the individual investors report their share of any profits or losses and are responsible for declaring the income on their own tax filings. Each year, the partnership prepares a special form for the limited partners called a K-1. This allows investors to take advantage of their own tax planning and work to keep more money in their pockets.

Structure Can Make It Easier to Raise Capital

One of the key benefits of forming a limited partnership is that limited partners typically can’t lose more money than they invest (hence the term “limited”). This makes it much easier for new businesses or investment projects to raise money because nothing scares away potential investors more than the idea of being personally liable for a company’s mistakes. (After all, would you put your own house on the line to buy shares of a company such as BP during the oil well disaster?)

It's possible that certain limited partnership agreements may call for the ability of the general partner to issue an assessment, which could make the limited partners come up with additional money to kick into a firm. 

This used to be common for some stocks but has largely fallen out of favor, as market acceptance and cultural practices dictate investors want shares that are "fully paid and non-assessable." Make sure you read the limited partnership paperwork with extraordinary care and have your attorneys and accountants examine it, too.

Gives the Ability to Pool Money With Friends and Family

A limited partnership makes it easy for friends and family to pool money for major investments, such as starting a restaurant, building an apartment complex, or acquiring an existing company. This means economies of scale, access to better lawyers, accountants, bank services, and more. Managed well, this can lead to higher returns and more wealth over time.

One of the most famous family limited partnerships of all time was started by billionaire Warren Buffett when he was in his twenties. That partnership, along with a series of others, eventually culminated in Buffett Partnership, Ltd., which became the vehicle through which he acquired control of his present holding company, Berkshire Hathaway, and that gave him the foundation of one of the largest fortunes in American history. He used it for capital management purposes, taking a cut of the money he invested for friends and family.

Allows for Flexibility

Forming a limited partnership means you can work with a lawyer to customize an operating agreement, which is the contract that governs how the partnership is run. In fact, profits and losses can be allocated any way that complies with tax laws, even if it doesn’t equal the equity ownership balances of each investor.

For example, you could set it up so that the general partner, who manages day-to-day operations, gets paid a percentage of all dividends on top of their ownership stake. That way, they have an incentive to maximize the cash flow and create an additional passive income, that will benefit the limited partners.

Estate Tax and Gift Tax Benefits

The estate tax and gift tax benefits of forming a limited partnership are substantial. The short version is that you can pass a lot of money to your heirs without paying additional taxes through the use of a specially formed family limited partnerships.

The Ability to Hire Professional Management

When you form a limited partnership, you can hire professional management as employees of the partnership. Of course, depending on your needs, you will need to consult with an attorney to understand the risk management implications and employment laws.

This means that a family that had built a successful business over years could issue equity in the limited partnership to the younger generation but give them no voting power in terms of how the company is run, leaving those decisions up to the experienced elders or professions of their choosing.