Most limited partnerships are formed for a specific business venture for a predetermined length of time. Their limited lifetime is the distinguishing feature of limited partnerships, since otherwise, other continuous business entities would be more suitable, such as general partnerships, limited liability companies, and corporations. They are long-term, illiquid investments, but have significant tax advantages. There are many different businesses that are suitable as limited partnerships, and return does does not correlate with stocks and bonds; thus, they are a good way to diversify a portfolio. Most limited partnerships have terms of 5 years or longer. In the earlier years, most limited partnerships generate tax losses which the limited partners can use to offset other income, with most of the profits coming in later years, until the final termination of the partnership, which, if successful, will generate long-term capital gains that are taxed at a lower rate than ordinary income.
A limited partnership is a partnership which consists of a general partner, who contributes the management and expertise in running the business, and limited partners who contribute only money—they are not involved in the day-to-day operation of the business.
The general partner is the person who actually sets up and manages the business, and assumes all liabilities of the business. The IRS requires that the general partner have at least a 1% financial investment in the partnership, but, in most cases, the general partner does not contribute a significant amount of money. The general partner is remunerated by assessed fees and a percentage of the profit. Upon liquidation, the general partner frequently gets 50% or 60% of the profits, with the limited partners getting the rest as a capital gain.
The limited partners invest only their money by buying limited partnership units, and their liability, unlike that of the general partner, is limited to what they invest. Limited partners receive income, tax deductions, and capital gains directly from the business. Although the limited partners are not involved in running the business, they do have the right to vote on important issues.
The limited partnership is created by contract—the Agreement of Limited Partnership—between the general partner and the limited partners, which delineates the rights and duties of all partners. This contract stipulates that the limited partners have the right:
- to inspect and to receive copies of the partnership;
- to receive full information regarding the partnership;
- sue the general partner for damages;
- and to receive profits and other distributions of money.
The agreement also restricts the resale of limited partnerships. Any new partners must satisfy the requirements of the Agreement of Limited Partnership, and the general partner usually has the right to accept or reject any new partners. In any case, limited partnerships are illiquid investments because they are not listed on any exchange, so it would be difficult to value the partnership.
To operate, states require that the limited partnership file a Certificate of Limited Partnership that includes the name of the business, business purpose, its proposed lifespan, the name of the general partner, the names and capital contributions from the limited partners, and how the partnership will be terminated.
In certain cases, the Certificate of Limited Partnership must be amended, and any action that requires an amendment of the certificate also requires a majority vote of approval from the limited partners. Some of these actions include changing:
- the name of the business,
- either general or limited partners,
- the business purpose,
- the stipulated lifetime of the partnership, or
- any event that would cause a termination of the partnership.
Because the Agreement of Limited Partnership is considered to be an investment contract, the SEC classifies limited partnership units as securities. If the partnership is sold to the public, then they must be registered under the Securities Act of 1933. However, most partnerships are sold as private placements under Regulation D of the Securities Act.
The main tax advantage of limited partnerships is that they are flow-through instruments—all profits and losses flow directly to the limited partners. The business itself pays no tax on its business income. However, the income is considered to be passive income and losses are can only be used to offset other passive income until the investor’s interest in the partnership is terminated; then losses can offset any kind of income.
Prior to the Taxpayer Relief Act of 1986, limited partnerships were true tax shelters, which allowed wealthy people to write off losses that were larger than their investment, especially in the early years of the limited partnership. Nowadays, they still have tax advantages, but the write-offs have been limited by at-risk and passive income rules. To obtain the tax benefits, the structure and operation of limited partnerships is partly governed by tax rules.
The types of businesses that benefit from the structure of a limited partnership are those with a high initial investment, but a limited lifetime, such as:
- real estate development
- condominium conversions
- government housing projects
- oil and gas exploration and drilling
- equipment leasing
- cattle breeding
- raising thoroughbred horses
- research and development
- movie production.