A partnership is either a formal or informal business type that allows two or more entrepreneurs to work together towards a common business goal.
But not all partnerships are created equal, as there are actually several different types of partnerships that all function a bit differently.
One such type is the limited partnership or the LP. In this guide, we’ll cover the basics of what this partnership type is, how it works, and how it’s different from other partnership structures. Should you form an LP for your company, or is another business type a better choice?
What Is a Limited Partnership?
A limited partnership is one of several popular American business entity types, and unlike some other informal partnership types, an LP is a formal business structure that registers with its Secretary of State. By registering this way, the partnership gains some liability protection for its owners.
The limited partnership is unique because it has two classes of partners: limited partners and general partners. Limited partners are often referred to as passive investors, as they contribute capital to the business, but they do not make active decisions in the day-to-day operations.
Managing the daily affairs falls to the general partner(s) instead. These partners may also invest some capital when starting out, but their main agenda is to help the business succeed by taking an active role in the managerial aspects. The general partner’s role is much more involved in making decisions for the company, like entering into contracts, hiring and firing employees, and more.
The other key difference between these two partner types is their personal liability: whether or not they have to pay up from their personal assets when the business defaults on a contract. Limited partners have limited personal liability, which means that they can typically be held liable only for the total amount of their initial investment.
General partners, however, can personally take the hit when things go wrong in the business. Their personal liability stems from the fact that they make the decisions. While limited partners won’t be harmed by the business decisions unless they overstep their role and start making decisions for the company, general partners have both more responsibilities and more risks than their limited partners do.
How Does a Limited Partnership Work?
Unlike a general partnership, which is an informal business entity that doesn’t even require the filing of formation documents, the limited partnership does have a formal startup process that includes preparing and filing a Certificate of Limited Partnership.
This document outlines the roles of your partners, as well as some other important aspects of your business, like the identity of your registered agent. This can be an individual or service.
As part of this formation process, the partners enter into a partnership agreement. This document is somewhat similar to the LLC’s operating agreement, and it establishes the details of the relationship between the company’s partners.
For example, a good partnership agreement should include a statement of how the profits are split between the partners. If the limited partners get a cut to compensate them for their investments, the partnership agreement establishes that procedure.
The partnership agreement should also dictate how decision-making works in the business. The general partner makes the day-to-day decisions, but for major decisions that affect the structure of the business, the limited partners may need to be involved as well. The partnership agreement should establish if and when these decisions should pass to all partners.
Advantages of an LP
1) Limited partner receives personal asset protection
Limited partners in an LP have minimal liability. In fact, if your business is sued or defaults on a debt, all that’s at risk for a limited partner is their investments into the LP. Meanwhile, the limited partner’s personal assets, including their house, car, personal bank account and investments, etc., are protected by the LP’s business structure.
2) Attractive for investors
One of the main reasons the LP is a popular business entity is because the limited partner model is quite inviting for outside investors. Because a limited partner has personal asset protection and lacks significant managerial responsibilities, investors are often interested in providing capital in exchange for a limited partner role.
3) Beneficial taxation model
The limited partnership has the same pass-through taxation model as a general partnership. This means that, instead of paying business taxes, the profits (and/or losses) of an LP “pass through” the business entity itself, and the partners pay taxes on this money according to their personal tax brackets. This eliminates the “double taxation” model that many corporations follow.
4) Relatively simple to form and maintain
Compared to corporations, limited partnerships are much easier to form, as the paperwork requirements are far lower for an LP. Furthermore, the maintenance process for an LP is quite simple, as there aren’t nearly as many recordkeeping requirements as a corporation has to deal with. In most states, LPs don’t even need to file annual reports.
5) Limited partners can be easily replaced
If one of your LP’s limited partners wants to leave the business, it’s a very simple process. The same goes for adding more limited partners. Especially compared to some other entity types that require ownership to jump through hoops to add or subtract owners, the LP makes it quite easy.
Disadvantages of an LP
1) General partner is liable for business transactions
While the limited partners enjoy personal asset protection, general partners have heavy liabilities in an LP. If your LP is sued, a general partner’s personal assets and business assets are up for grabs. While the general partner does have lots of power and control over the business operations, they also take on enormous amounts of risk.
2) Limited partner doesn’t have much power
It’s true that a limited partner doesn’t take on much, if any, risk in a limited partnership. However, limited partners also don’t have much control over the business. Limited partners are typically only consulted on major decisions that affect the LP’s overall operations, and they often have no say at all in the day-to-day operations.
Steps to Forming a Limited Partnership
If you’ve decided that forming an LP is the right option for your business, it’s time to start tackling the formation process. Keep in mind that the exact steps will vary depending on your state, so make sure to dig into the specifics of your state to make sure you’re completing the process correctly. In general, these are the steps you’ll need to take to form a compliant LP in most states.
1) Name your LP
The first step in any state is to come up with the perfect business name for your new LP. Your LP’s name is important because it’s your company’s best chance to make a first impression with potential customers, and you need to make an impact. Choose something memorable that also highlights the purpose of your business.
Another crucial aspect of naming your LP is making sure the name you want is actually available and hasn’t already been claimed by another entrepreneur. Therefore, you should search your state’s business database to ensure that you can use your desired name. (It’s probably a good idea to come up with a few different options in case your first choice is taken!)
2) Designate a registered agent
Every LP operating in the United States must have a registered agent. This role includes receiving important document deliveries from the state (such as service of process paperwork and annual report reminders), informing you of the receipt, and forwarding the documents to your business. In short, the registered agent ensures that the state always has a reliable point of contact for every company operating within its borders.
Just about anyone can be your registered agent, as you can designate an individual or a professional service for this role. Most states don’t have any rules regarding who can serve as a registered agent, except the LP itself cannot be its own agent. (Colorado also requires that all registered agents be at least 18 years old, but you won’t find this restriction in other states.)
3) Prepare and file your Certificate of Limited Partnership
This next step is the one that actually registers your LP with the state. The information required for this document varies by state, but for the most part, you’ll need to include the name of your limited partnership, its principal office address, the name and address of your LP’s registered agent, the purpose of your LP, the value of each partner’s investments in the business, and the names and addresses of your LP’s general partners.
Again, the exact info can vary, and each state has its own processing times as well, so make sure you nail down all of the relevant details for your state before you get started.
4) Draft a partnership agreement
Not all states require LPs to draft and submit a partnership agreement to the state, but we think that every LP should have one regardless of whether it’s technically required. A partnership agreement is important because it outlines the details of how your business will be run, and it can help prevent ownership disputes.
Typically, the type of information you’ll want to include in your operating agreement includes details about the business structure, the business purpose, the role of each partner, capital contributions, distributions and withdrawals, management and voting rights, record keeping practices, the rights and duties of each partner, the procedure for meetings, conditions for ownership transfers, prohibited transactions, and more.
5) Obtain an EIN
The next step is to acquire a federal tax ID number (often referred to as an EIN or employer identification number) from the Internal Revenue Service. This is similar to a Social Security number for an individual, as the EIN is a nine-digit number that’s used to identify your business for taxation purposes. An EIN can help your LP accomplish many important tasks, including opening business bank accounts (more on this in a moment…), hiring employees, and more.
6) Set up the LP’s financial infrastructure
Next, you’ll need to set up a business bank account and an accounting system. The business bank account is simple enough — all you need to do is bring your EIN to the bank of your choice and tell them you’d like to set up a business account. Once the account is set up, make sure to use it exclusively for your business expenses and income. Commingling your business and personal assets is a highly dangerous practice that makes your LP susceptible to lawsuits, administrative dissolution, and more.
As for your accounting system, the easiest solution is to get accounting software like QuickBooks for your business. This allows you to keep track of all your business income and expenses in one convenient place, making tax time (and legal compliance) a breeze.
7) Acquire licenses and permits
Some states require LPs to obtain a general business license to operate in a compliant fashion, while others do not. Whether your state requires a general license or not, it’s likely that your LP will require at least one license or permit. There are quite a few industries that require either federal or state licensure (or both), such as agriculture, aviation, mining, firearms, broadcasting, and more.
In addition, there are many different licenses required by county and municipal governments, including liquor licenses and occupancy permits. Don’t forget to check with every government agency that has power over your business (federal, state, county, municipal) to ensure you’re complying with all relevant licensing and permitting requirements.
8) Obtain business insurance
If your business has employees, you will be legally required to acquire workers’ compensation insurance in most states. And, even if your business is located in Texas (the one state that doesn’t require workers’ comp), you should still absolutely obtain this coverage.
Beyond workers’ comp, there are many industry-specific insurance policies that might be advisable depending on the nature of your business, and a general liability policy is almost always a good idea, especially for businesses with retail locations that customers visit in person.
When Is the Best Time to Form an LP?
It can be difficult to tell when you should form your limited partnership. Every business has different priorities, and what makes sense for one entrepreneur might not make sense for you. However, in general, we think it’s always best to form your LP before you execute your first business transaction.
If you do business before forming your LP, those transactions will be performed by default as a general partnership. This means these transactions are not protected by the LP’s corporate veil, which is the layer of separation the LP provides between the general partner’s business and personal assets. Even if you form an LP later, your general partner(s) will have full liability for the transactions you executed before that business formation.
Especially considering the fact that you don’t have anything to gain from delaying your LP’s formation, we think it’s always a good idea to form your limited partnership as soon as you nail down your business concept and name.
Limited Partnership VS. Other Partnership Types?
As we’ve mentioned, the limited partnership is not the only type of partnership ― there are also general partnerships, limited liability partnerships, limited liability limited partnerships, and joint ventures. While this article isn’t dedicated to these types, understanding the differences between them will help you better understand a limited partnership.
General partnerships are the most basic partnership type, and they share much in common with the sole proprietorship. These partnerships don’t have to register with the state ― they form automatically when the partners begin conducting business together. The drawback to this type of partnership is that there is no personal asset protection.
Limited liability partnerships (LLP) are quite similar to professional LLCs, or PLLCs. LLPs as a business structure are only available to entrepreneurs in certain certified professional fields, including (but not limited to) lawyers, accountants, architects, dentists, chiropractors, and more. With a limited liability partnership, the partners receive personal asset protection, but this does not extend to issues of malpractice.
Another form of partnership is the limited liability limited partnership (LLLP), which is a much more recent development in the American business landscape. This business structure is a form of limited partnership and therefore has the same general partner/limited partner format. The difference is that the LLLP’s general partners enjoy the same level of personal liability protection as the limited partners do. The LLLP is only available in 29 states, so if you want to form one, you should make sure you’re doing so in a state that recognizes this business type.
Finally, you’ll sometimes see a joint venture referred to as a partnership. The joint venture is an agreement between two distinct business entities to collaborate on a project. For the most part, the joint venture only exists temporarily until work on that project is complete. The joint venture is not a business structure in itself, but it is not uncommon to see its partners form an LLC, corporation, or formal partnership to provide a framework for the project.
Things to Consider Before Forming a Limited Partnership
Is the limited partnership model the right choice for your business?
It’s important that you make sure the LP is the best entity for your company. The LP’s structure is best-suited for specific types of businesses that want to have an unbalanced ownership structure, consisting of heavily involved general partners and limited partners who mostly sit on the sidelines and act as investors. If you want a more balanced business structure, you might be interested in an LLC or corporation.
Are your company’s general partners okay with taking on so much risk?
Compared to other popular business structures, like the LLC and the corporation, the LP’s general partner(s) take on significantly more risk. That’s because general partners receive no personal asset protection, leaving all of their personal assets exposed to lawsuits. There are plenty of advantages to the LP as a business structure, but the liability of the general partner is a massive disadvantage. If your business involves a lot of risk, the LP might be a poor choice.
How much control do you and your partners want over the business?
This is another area where the uneven balance of the LP’s power structure comes into play. If all of your business partners want some level of control over the business operations, and no one is interested in being the “silent partner,” the LP might not be the right choice of entity.
Can you take advantage of the pass-through taxation model?
The limited partnership’s pass-through taxation model is best suited for business owners who are not already independently wealthy. That’s because this model relies on each partner’s personal income tax bracket. If you and your partners bring in big annual incomes already, the corporate taxation model (at 21%) could save you some money, even with the “double taxation” of the C corporation. For more information, consult with an accountant or tax attorney.
The Real Cost of Forming a Limited Partnership
Another of the most common questions we hear from entrepreneurs is how much it actually costs to form a limited partnership.
There are often additional expenses involved with the LP formation process, other than the fee you pay the state for your formation document filing. It’s important to note that, much like each state charges its own rates for LP formations, the additional costs can vary from state to state (and industry to industry, in some cases) as well.
Let’s quickly break down some of the other potential costs. One that isn’t usually required is a name reservation fee, which is required by law in Alabama but is optional elsewhere. In most states, a name reservation only has a nominal fee — in many, this will only cost you $10-20.
Another variable that can add expenses is whether you choose to use a business formation service or not, as most of these companies charge their own service fees in addition to the state’s formation fee. Similarly, whether you want a registered agent service will also affect your new LP’s bottom line. If you opt for assistance from an attorney instead, your expenses will obviously grow.
Then, there’s the issue of annual reports. The vast majority of states don’t require limited partnerships to file annual reports, but there are exceptions. Namely, Kansas, North Dakota, Oklahoma, and Washington require annual reports, so in these states, you’ll need to factor this into your yearly budget.
Finally, even though LPs are pass-through entities, there can be state-specific tax responsibilities like franchise taxes for the right to do business in the state. All told, there are quite a few associated costs for some LPs, while others can get by with much lower expenses. It all depends on where your company is located and what line of business it’s in.
Frequently Asked Questions
How long does it take to form a limited partnership?
The answer to this question varies considerably based on your state of formation. There are some states that have online business formation portals where you can form an LP immediately. Meanwhile, some states require you to mail in paper forms that can take a matter of weeks. Additionally, many states offer some sort of expedited service that can dramatically speed up your formation process. For more details, ask your business formation service or your state’s Secretary of State office.
Should I use an online business formation service, hire an attorney, or form my own LP?
All three of these options have their own advantages and disadvantages, depending on your priorities. Forming your own LP will always be the cheapest option, although it doesn’t involve any professional assistance. On the other end of the spectrum, hiring an attorney can be prohibitively expensive for many startups, although the expert advice you’ll get can make it worthwhile. Finally, an online LP formation service splits the difference, providing professional help while charging a fraction of an attorney’s fees.
What types of bonus features can I expect if I use a formation service?
This all depends on which company you choose to form your LP, and which of its formation packages you opt for. In general, it’s common to see these companies include perks and features like registered agent service, partnership agreement templates, annual report service, binders embossed with your company’s name, and more.
Can I form an LP with a limited lifespan?
Yes, you can. In fact, most limited partnerships are not perpetual entities, and many are formed solely for work on a specific project.
Which industries most commonly use the limited partnership structure?
While the LP can be useful in a wide variety of industries, there are a couple where it’s especially common. These include real estate investment vehicles and film and television production companies. These businesses often work on projects with limited timeframes, and they also frequently have an unbalanced management structure, making the LP an excellent fit.
Can I form a limited partnership by myself? Or do I need co-owners?
The limited partnership, by definition, requires at least two owners. There must be at least one limited partner and at least one general partner.
Do I need to hold regular meetings for my LP?
Corporations have strict requirements to hold shareholder and board of directors’ meetings on a regular basis, and also to take detailed minutes from those meetings. Limited partnerships are not required to hold these meetings (or, obviously, to take notes on them). That said, you are welcome to hold meetings anytime you’d like, or not at all!
Is there anything I need to do after forming my LP?
Limited partnerships typically have minimal ongoing compliance requirements. In most states, they don’t even need to file annual reports. The ease of operation is definitely one of the LP’s strong points.
A limited partnership isn’t uncommon in any industry, but it’s especially popular for real estate businesses, film production companies, law firms, accounting businesses, and financial investment firms.
This is because the LP’s structure allows for highly experienced entrepreneurs to team up with investors in the form of limited partners to create a flexible business structure that provides mutually beneficial roles and responsibilities for all parties. It’s also a great choice for one-off projects between business partners.
Overall, the limited partnership model isn’t for everyone, but if your business can benefit from the uneven partnership structure, you should give the LP a look.