The Tax Advantages of Limited Partnerships
The main tax advantage of a limited partnership is that it is a flow-through entity — all profits and losses flow directly to the individual limited partners. The business itself pays no taxes on its income. Limited partners receive income in the form of distributions. Part of the distribution may be taxed as ordinary income, part may be treated as capital gains, and part may not be taxed at all if it is a return of invested capital.
However, because the limited partners do not participate directly in the business, the income from a limited partnership is considered passive income, and the losses can only be used to offset other passive income until the investor's interest in the partnership is terminated, after which, losses can be used to offset other types of income.
Compare this to owning stock in a corporation. A corporation must pay much of its profits for state and federal taxes. Some or all the net 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 must pay tax on it again — double taxation. Profits of a limited partnership are 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, U.S. Return of Partnership Income with the IRS, an informational return listing the profits or losses for the year and any distributions sent to the limited partners. The general partner will also send a (Form 1065) Schedule K-1, Partner's Share of Income, Deductions, Credits, etc. to each limited partner with the pertinent tax information, including gains and losses, and a copy of each partner's Schedule K-1 to the IRS. The limited partners use the information in Schedule K-1 to fill out their own tax forms.
Passive Income and Loss
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. Some of these tax shelters were advertising a 10-to-1 write-off, where $10 worth of losses could be accrued for each $1 invested. For someone in the 35% tax bracket, $3.50 could be saved for each $1 invested, netting the taxpayer $2.50 — 2½ times the amount invested, even though these limited partnership had no real economic value.
However, the Taxpayer Relief Act of 1986 eliminated the ability to deduct limited partnership losses from most other income by classifying limited 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 passive income. For instance, profits from stocks, bonds, and other securities is considered 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 gains from passive activities 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.
How Limited Partnerships Reduces Taxes
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, as you can see in the graph below.
The interest expense is fully deductible as a business expense, which provides much of the tax savings in the beginning. Although leverage increases profits, especially in real estate, it also magnifies losses.
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 and a tax deduction, 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 useful life, 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 that period. 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. (Actually, this is a simplification, because the computer is actually depreciated over 6 years, since only half of the annual deduction can be claimed in the 1st and last year, using the half-year convention.)
However, there are other 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. However, accelerated depreciation can only be used for personal property — meaning any property that is not realty — not real estate.
Depletion is like 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 taxable 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, such as the tax credits for the construction or rehabilitation of low-income housing, 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, a tax credit of $100 for an investor in the 35% tax bracket will save her $100 in taxes while a $100 deduction will only reduce her 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.
Limited Partnership Profits are Long-Term Capital Gains
When the limited partnership terminates, 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, 20% for upper-income taxpayers and, for those in the 15% marginal tax bracket or less, the rate is just 0%. Taxpayers who receive at least $200,000 of income may also be subject to the 3.8% Medicare tax on investment income that exceeds certain statutory thresholds.