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The main tax advantage of a limited partnership is that it is a flow-through instrument—all profits and losses flow directly to the individual limited partners. In other words, the limited partners directly participate in the profits and losses of the limited partnership, but not the business itself, which is why these limited partnerships are also called direct participation programs (DPPs). The business itself pays no taxes on its income.
However, because the limited partners do not participate directly in the business, the income from a limited partnership is considered to be passive income, and the losses can only be used to offset other passive income until the investor’s interest in the partnership is terminated.
Compare this to owning stock in a corporation. A corporation has to pay a large percentage of its profits for state and federal taxes. Some or all of the profit will be retained for expansion, to retire debt, and so on. The corporation may decide to distribute some of its earnings as dividends to the stockholders, and the stockholders will have to pay tax on it again—double taxation. If a limited partnership makes a profit, the entire profit is distributed to the limited partners untaxed. Although the limited partners must pay tax on the income, this income is taxed only once.
What if the corporation has a loss? The stockholders cannot benefit from this loss—indeed, it will probably hurt the stock price and the investor. The losses of a limited partnership are passed directly to the limited partners who can use the losses to offset other passive income. If they have more passive losses than passive income, the losses can be carried forward.
The general partner files a Form 1065 with the IRS, an informational return that will list the profits or losses for the year, and any distributions that have been sent to the limited partners. The general partner will also send a Schedule K-1 to each limited partner with the pertinent tax information, and a copy of each partner’s Schedule K-1 to the IRS.
Before 1987, investors in limited partnerships could deduct losses from other income, such as business income or income from investments, and since, they could deduct more than what they invested, they were considered true tax shelters. However, the Taxpayer Relief Act of 1986 eliminated the ability to deduct DPP losses from most other income by classifying partnerships as a passive activity, and that losses from passive activities could only be used to offset income from other passive activities. What defines a business investment as a passive activity is whether the investor materially participates in the business. Active income is income from a business or other source where the investor actively participates in the day-to-day operations of the business. Active income also includes income from wages, commissions, and other activities where the taxpayer had to materially participate to receive the income. Passive income is income from a business that the investor does not materially participate, which includes limited partnerships.
Note, however, that profits resulting from some investment activities that would seem passive are not classified as a passive income. For instance, profits from stocks, bonds, and other securities is considered to be portfolio income—not passive income. The key difference is that a limited partner is actually a partner in the business, even though they do not materially participate in the business, whereas an investor of securities is not a partner and does not materially participate in the business.
Losses can be carried forward to offset losses in passive income in future years, and can eventually be used even against active income when the partnership terminates or the investor terminates his ownership interest in the partnership.
Most limited partnerships have large losses in the early years of the business with most of the profits, if the business is successful, generated near the end of the limited partnership’s term. The main items that generate tax write-offs in the limited partnership are interest expenses, operating and maintenance expenses, depreciation or depletion, and tax credits.
Most limited partnerships use leverage—borrowing money—to increase profits, and, like a mortgage, most of the interest expense occurs in the early years of the project. Money is borrowed because it helps to greatly increase profits, especially in real estate, but it can also magnify losses. The interest expense is fully deductible as a business expense.
When the partnership buys buildings, motor vehicles, and equipment to conduct its business, it can take advantage of depreciation to save on taxes. Depreciation is the amount that can be deducted from income each year as the depreciable items age. Although depreciation is an expense, it does not require an actual cash outlay in the years following the purchase, because the money has already been spent in the 1st year to buy the item.
The IRS classifies each depreciable item according to its lifespan, which is the number of years of useful life for that item—as defined by the IRS—which allows the business to deduct the full cost of the item over its lifespan. A common method of depreciation is straight-line depreciation, which allows the deduction of equal amounts each year, the amount being equal to 1 divided by the lifespan in years.
For instance, the IRS classifies computers as a 5-year item, so if a computer costs $1,000, then $200 of its cost can be deducted from income each year.
However, there are depreciation methods, such as the Modified Accelerated Cost Recovery System (MACRS), that accelerate the deductions so that more of the total write-off can be taken in the early years, and this, like interest, creates more tax write-offs in the early years of the partnership. However, accelerated depreciation can only be used for personal property, not real estate.
Depletion is similar to depreciation, and allows limited partnerships that were formed to extract natural resources, such as oil and gas, to recover the cost of extracting the natural resources through depletion. Like depreciation, a portion of the total depletion can lower income for each year, and, therefore, taxes.
Operation and maintenance expenses for the business also creates deductions for the investors.
Some limited partnerships are formed expressly to take advantage of tax credits, which can be used by the limited partners to reduce taxes directly—dollar for dollar. Whereas tax deductions only reduce taxable income, tax credits can directly reduce the tax itself. For instance, suppose an investor in the 35% tax bracket has either a $100 tax credit or a $100 tax deduction. The tax credit will reduce his taxes by $100, while the tax deduction will reduce his taxable income by $100, which reduces his taxes by $35.
Tax credits may be available for low-income housing, particular research and development projects, or for the restoration of historic buildings, and whatever else the federal government sees fit to promote.
When the limited partnership terminates, then all profits, after paying the general partner, are distributed to the limited partners, which the IRS classifies as a long-term capital gain that is taxed less than ordinary income. Currently, the long-term capital gains tax rate is 15% for most people, and those in the 15% tax bracket or less, the rate is just 5%. If the asset is held for more than 5 years, and most limited partnerships are for more than 5 years, the maximum capital gains tax is currently 8%.
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