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Limited Partnerships – What, Why, and How?

Updated: Feb 15

I rarely recommend a client form a limited partnership (“LP”). I can’t remember a single time that I have made that recommendation. But, on occasion, an investor (or a few investors) or some other party may insist that you form an LP. Before agreeing, take the time to learn what it is, and why those other parties might insist.

What is an LP?

An LP is a partnership in which at least one partner has general liability and at least one partner has limited liability.

It's a combination of a general partnership (no owners have limited liability) and a corporation (all owners have limited liability). But there must be at least one partner with limited liability, and at least one partner without limited liability.

Why form an LP?

Prior to the development of LLCs, the big draw here was the limited liability. You could invest in a partnership. By your investment, you could have equitable ownership in the entity. But you didn't have to worry about general liability (unless you were the general partner).

But then, in 1977, Wyoming created the LLC. By 1996, all 50 states had statutes allowing for the creation of LLCs. So what's the point of an LP when the LLC is available?

Well, investors like them. Here are a few reasons from their perspective:

  1. Investors can obtain equity ownership in a partnership in which they want to invest (this is often more valuable than debt ownership);

  2. Investors can go after the general partner rather than after the partnership that is their actual investment;

  3. Investors are not expected to be involved in the management of the LP (and, actually, may not be allowed to);

  4. As limited partners, their income is passive for tax purposes;

  5. The roles of the general partner and limited partners are usually clear simply by the fact of using an LP; and

  6. Potential and actual creditors can go after the general partner instead of the limited partners.

But what about from the general partner's perspective? Why not just create an LLC or other entity? In my experience, existing limited liability entities (LLCs, corporations, etc.) use them to attract investors quickly, relatively cheaply, and with defined roles that, in general, everyone understands before it is created.

Can you give an example?

An existing LLC has four potential investors. The investors want to invest in the LLC, but don't want to be involved in its operations and don't want the threat of litigation against them personally. And the LLC does not want the investors trying to step in and operate the LLC.

In this example, the existing LLC could set up an LP where the LLC is the general partner. And the four investors become limited partners of the LP. Rather than spend time negotiating and drafting a complex operating agreement, the partners agree to a comparatively simple partnership agreement.

Notice, in this example, the members of the LLC still have limited liability as members of the LLC. But the LLC itself does not have an extra layer of limited liability. It is unusual (at least today) to have an individual as a general partner of an LP; the general partners are more typically LLCs or corporations.

How do you form an LP?

As with LLCs, formation is fairly simple. In California and Texas, you register your LP with the Secretary of State by filing a certificate and paying the fee. Although neither state explicitly requires a partnership agreement, the partners should set forth their agreements and understandings in a writing.

Any other uses?

Families often use LPs as an estate planning device (or pseudo-estate planning device, depending on whom you ask). If a family has a business (no matter the entity type: partnership, LLC, etc.), those operating the business may form a family limited partnership ("FLP"), in which the business is the general partner, or the parents are the general partners, and the children or other family members are the limited partners. This can get complex, especially if the goal is to avoid tax liability, so consulting with an estate planning attorney and an accountant is critical.

Historically, they've been common for real estate developers. Apparently, they are also fairly common in film production, Disney's Silver Screen Partners being the most prominent of which I'm aware.

Quick Summary: LPs are often attractive to investors, and sometimes to families as a wealth transfer device. And you can always form an LLC or corporation to act as the general partner (that is, you can form an entity to serve as the general partner, while you still have limited liability).

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