“In the business world, the rearview mirror is always clearer than the windshield.” – Warren Buffet
WHAT IS A LIMITED PARTNERSHIP?
Let’s imagine you’re starting a band. You have a friend who is a great drummer, but she doesn’t want to take part in the spotlight. She doesn’t want to make decisions about the band’s direction, what gigs to take, or how to spend the band’s money. But, she’s happy to provide the drumming that your band needs. And then there’s you, the band’s lead, ready to handle the day-to-day decisions, dealing with managers, booking gigs, etc.
In this scenario, your band is a lot like a Limited Partnership. In a Limited Partnership, there are two types of partners: general partners and limited partners.
General partners (that’s you in our example) have management control, share the business’s profits, and have personal liability for the business’s debts and obligations. This means they are involved in the day-to-day operations and decision-making of the business, but also bear the brunt of any financial risks.
On the other hand, limited partners (like your drummer friend) contribute capital (money or property invested in the business), share in the profits, but their losses are limited to the extent of their investment. They do not participate in management decisions and cannot be held personally liable for the business’s debts or obligations beyond their initial contribution. They are, in essence, passive investors in the business.
A Limited Partnership can be an attractive option when you need to raise capital for your business but want to maintain control over business operations. However, like all business structures, it comes with its own set of pros and cons that should be carefully considered.
Let’s discuss the pros and cons of a Limited Partnership in simple terms.
Pros of a Limited Partnership:
Attracts Investors: Picture this: you’re an excellent baker and decide to open your own bakery. However, to kickstart your business, you need more money than you currently have for things like renting a space, buying baking equipment, and purchasing ingredients.
Here’s where a Limited Partnership can help. In this business structure, you’re the “general partner,” the head chef of your bakery, making all the decisions and managing the day-to-day operations.
Then, you have a wealthy friend who loves your baking but doesn’t know the first thing about running a bakery and doesn’t want to learn. They do, however, have money to invest. In a Limited Partnership, this friend can become a “limited partner”. They provide the funding your bakery needs and in return, they get a share of the profits, much like getting a slice of the delicious cakes you’ll be baking. They won’t be involved in the daily operations, deciding what cakes to bake, or dealing with suppliers – that’s all your job as the general partner.
This setup is attractive to investors like your friend. They get the opportunity to invest in a business they believe in (and get a return on their investment if it does well) without having to worry about the daily management or operations. Plus, their personal risk is limited to their investment, meaning if things don’t go as planned, they won’t lose more than they put in.
So, the ability to attract investors is a significant pro of a Limited Partnership. It allows people with the skills to run a business to get the funding they need, while providing a hands-off investment opportunity for others. It’s a win-win situation, much like enjoying a delicious cake from your new bakery!
Limited Liability for Limited Partners: Consider this: you and a friend decide to put on a play at your local community theater. You are the director and play the lead role, while your friend contributes money for the costumes and stage design. Your friend is not involved in any other way – they don’t help choose the play, cast the actors, or direct the scenes. They’re just excited to see a good show and hope to get a share of the ticket sales.
In this scenario, your friend is a lot like a limited partner in a Limited Partnership. They provide capital (their money for costumes and stage design), but they’re not involved in the day-to-day operations or decisions of the play (the business).
Now, suppose the play doesn’t do well, and there’s not enough money from ticket sales to cover all the costs. Your friend, the limited partner, won’t have to pay more than they initially contributed for costumes and stage design. Even if the play’s debt is greater than their initial investment, they won’t be required to dig into their own pockets to cover the remaining costs.
This is what we mean by “Limited Liability”. A limited partner’s risk is limited to the amount they invested in the business. In contrast, as the director and lead actor, you would be like a general partner, bearing the full brunt of any financial losses.
So, “Limited Liability for Limited Partners” is a significant pro of a Limited Partnership. It allows people to invest in a business without the fear of being personally liable for the company’s debts or legal obligations. They can contribute capital with the comfort of knowing they won’t lose more than they invested, which is a very appealing factor for many investors.
Tax Advantages: Imagine you and your friends decide to start a neighborhood lemonade stand this summer. You’re the one running the stand every day, making the lemonade, setting prices, and dealing with customers. Your friend, on the other hand, just provides the money for the lemons, sugar, and cups but doesn’t help with anything else.
When it’s time to divide the profits, you wouldn’t want your friend to hand over a portion of their share to a third friend who did nothing to help with the stand, right? It wouldn’t be fair. That’s a simplified way to look at the tax advantage of a Limited Partnership.
In a Limited Partnership, profits are passed directly to the partners and are taxed only once – at the individual level. The partnership itself doesn’t pay income tax. This is called “pass-through” taxation. So, when your lemonade stand makes a profit, that money is divided between you and your friend according to your agreement. You each report your share of the profits on your individual tax returns and pay taxes accordingly. The “lemonade stand” (the partnership) doesn’t pay a separate tax before the money is divided.
This can be a significant advantage, as it avoids “double taxation” that occurs in some other business structures, like corporations. In those cases, the business entity pays corporate taxes on the profits, and then the individuals also pay taxes on the money they receive from the business (like our third friend taking a share).
So, the “Tax Advantages” of a Limited Partnership can mean more money in the pockets of the partners, which makes this business structure appealing to many business owners and investors.
Cons of a Limited Partnership:
Unlimited Liability for General Partners: Imagine you and your friend decide to start a band. Your friend buys all the instruments, while you, a multi-talented musician, play all the instruments and write all the songs. You’re essentially managing the whole band, but your friend’s investment made it possible to start in the first place.
However, suppose the band doesn’t quite make it big, and you’re left with a lot of debt – from studio rental fees to marketing costs. Unfortunately, as the one who managed the band (akin to a general partner in a Limited Partnership), you’re responsible for paying off all these debts. Your friend, who simply provided the initial funding for the instruments (the limited partner), is not responsible for paying off these debts. Their liability is limited to their initial investment.
This scenario illustrates the “Unlimited Liability for General Partners” aspect of a Limited Partnership. As a general partner, you’re fully liable for all the partnership’s debts and obligations. In the case of our band, if it incurs more debt than it can pay off with its income, you as the general partner could potentially have to use your personal assets (like your car or even your house) to pay off these debts.
This unlimited liability can pose a significant risk and is one of the main disadvantages of being a general partner in a Limited Partnership. It means you bear the full burden of any financial losses the business might experience, which can be a daunting responsibility. It’s an important factor to consider when deciding if this business structure is the right choice for you.
Limited Control for Limited Partners: Let’s clarify the concept of “Limited Control for Limited Partners” in a Limited Partnership using a simple example.
Think about a situation where you and a friend decide to go on a road trip. You’re an experienced driver, and your friend, although not very confident behind the wheel, has a shiny new car and is excited to be part of the adventure. In this case, your friend provides the car (the investment) and you do all the driving (manage the operations).
In this example, your friend is like the limited partner in a Limited Partnership. They provide something crucial for the journey – the car, or in business terms, the capital – but they don’t actively participate in the driving, the actual journey itself.
In reality, they’re not allowed to grab the wheel or dictate the route. If they do, they could potentially lose their “limited partner” status and become liable for the partnership’s debts, much like if they were to cause an accident by grabbing the wheel.
So, while your friend gets to be part of the adventure and will share in the excitement if you discover beautiful new places (profits), they don’t get to decide the route, when to take breaks, or how fast to drive. This is what we mean by “Limited Control for Limited Partners”.
While this lack of control might be fine for some who just want to enjoy the ride and share in potential discoveries, it can be frustrating for others who might want a more hands-on role in the journey. This is one of the key drawbacks of being a limited partner in a Limited Partnership – having the capital at risk, but not having a say in how it’s used.
Complexity and Cost: Let’s delve into the concept of “Complexity and Cost” as a con for Limited Partnerships with a clear and relatable example.
Imagine you’re planning to build a treehouse in your backyard. You’ve decided to team up with a friend to make this dream come true. You have the ideas and the skills to build the treehouse, but your friend has the funds to buy the materials.
In a perfect world, you would simply start building right away. However, before you can start, you need to make plans for the treehouse, figure out what materials you need, get the right tools, maybe even get permission from your local council, and then buy the materials. These steps add complexity and cost to the project.
In a Limited Partnership, it’s similar. It’s not as simple as just deciding to go into business with someone. There are legal requirements to meet. You need to draft and sign a partnership agreement, which often requires the help of a lawyer. The agreement should detail things like the percentage of ownership, distribution of profits and losses, the roles and responsibilities of each partner, what happens if a partner wants to leave the business, and so on.
This legal and administrative work adds to the complexity of forming a Limited Partnership. It’s more complex than a Sole Proprietorship or a General Partnership, where you could essentially just start operating.
And with complexity comes cost. Lawyer fees can add up quickly, especially if the partnership agreement is complex. There might also be filing fees associated with registering the partnership with the state or other regulatory authorities. Plus, because Limited Partnerships are less common, you might find fewer resources to guide you through the process, which can lead to more time and money spent on professional advice.
So, the “Complexity and Cost” of a Limited Partnership can be a significant con. It requires more upfront work and cost than other business structures, which can be a barrier for some people considering this type of structure.
In conclusion, choosing to structure your business as a Limited Partnership can bring with it both significant advantages and some notable challenges. The key to making an informed decision lies in understanding these aspects fully and considering how they align with your specific business goals and personal risk tolerance.
The Limited Partnership structure can be an attractive option for those seeking to attract investors without ceding control of the business. It offers a clear delineation of roles and responsibilities, with general partners managing daily operations and limited partners providing capital investment. For those willing to take on the role of a general partner, the ability to maintain control of the business’s direction is a significant plus.
At the same time, the advantages for limited partners, such as limited liability and tax benefits, can make this structure appealing for individuals or entities looking to invest in a business without being involved in its day-to-day running.
However, there are also some challenges associated with a Limited Partnership. General partners shoulder unlimited liability, potentially putting personal assets at risk if the business struggles. On the flip side, limited partners often have little say in the business’s day-to-day operations, which can be frustrating for some.
Moreover, setting up a Limited Partnership can be more complex and costly than other business structures. This involves creating a detailed partnership agreement, usually with legal assistance, and possibly facing additional regulatory requirements.
Given these pros and cons, it’s clear that a Limited Partnership is not one-size-fits-all. It can be the perfect fit for some business situations and ill-suited for others. The decision should be made carefully, ideally with the guidance of legal and financial advisors. Understanding your business, your future plans, and your comfort with risk can help you make the right choice.
Remember, the choice of business structure is a significant decision and one that can have lasting implications for your business’s success. It’s always advisable to consult with professionals before making such a crucial decision.
Written by: John Reyes