There are many reasons that people start a business. The top three are dissatisfaction with corporate life, the opportunity to pursue your passion and the chance to be your own boss. Small businesses make up nearly all (99.9%) of U.S. businesses, and it’s growing! In 2020, there was an increase of 3.15% in the number of small businesses compared to 2019.
One of the first steps to making a business official, is deciding what type of business entity to form. Previously, we discussed Sole Proprietorship and General Partnership. Today we’re going to define a Limited Partnership. The goal is to educate business owners so they can better determine which business entity is the best fit. Rules vary by state, so for the purposes of this article, we are discussing setting up a Limited Partnership in New York State.
The Definition of a Limited Partnership
A Limited Partnership is a business that is owned by two types of partners: A general and a limited partner. There must be at least one general partner, who will own and handle the daily management of the business, and one limited partner. The general partner(s) is fully liable for the company’s debts and obligations incurred by the business. The limited partners, which are sometimes called silent partners, have limited liability since they are strictly investors in the business, with limited influence or control over the business decisions. When a limited partner exercises significant control over the daily business operations, such as serving the partnership’s operation for 500 hours or more a year, he or she could lose the limited partner status and be regarded as a general partner; hence, he/she would also become personally liable for the business debts and obligations. Limited partners are permitted to vote to influence the partnership without losing the limited partner status on some areas, which may include:
- The dissolution of the limited partnership agreement
- Disposal of corporate assets
- Amendment to the partnership agreement
- Admission or removal of partners, either limited or general
- Any fundamental changes in the scope of the partnership
The limited partner does not have power to dissolve the partnership except on court order, and the death or withdrawal of a limited partner does not dissolve the partnership. A Limited Partnership may dissolve when there is 1) termination of the partnership as per the certificate’s provisions; 2) termination upon an event specified in the partnership agreement; 3) the unanimous written consent of the partners; 4) the withdrawal of a general partner, unless at least one remains and the agreement says one is enough or unanimous consent of the partners to continue within 90 days of the event; 5) an event that causes the business to be illegal; and 6) judicial decree of dissolution when it is not reasonable to carry on.
The Advantages and Disadvantages of a Limited Partnership
Similar to a General Partnership, a Limited Partnership provides many advantages, which includes:
- A general partner receives financial support from silent investors who will not interfere with daily business decisions or operations.
- Limited partners have the advantage of limiting their liability in the company while potentially benefiting financially.
- A limited partners’ liability for the firm’s debts cannot exceed the amount they invest in the company as long as their involvement in the business is limited.
- Business profit and loss are not taxed at the business level. They are being passed-through to the partners, and reported on their personal income tax returns, accordingly.
- A limited partnership can have an unlimited number of partners.
However, there are disadvantages, such as:
- The general partner(s) is personally liable for the debts and obligations of the business. For example, if the partnership cannot pay creditors or goes bankrupt, the creditors can go after the general partner’s personal assets. Because the general partner is taking all of the risks and running the business, he/she usually receives additional compensation.
- General partners are personally liable for each others’ actions.
We should note, it might be seen as a disadvantage that limited partners cannot take part in day-to-day management or operations of the business.
How to Form a Limited Partnership
You will need to create a partnership agreement that clearly describes the responsibilities of the general and limited partners. The agreement will outline what will happen if the general partner is unable to perform his/her duties. Finally, it will lay out how the profits will be divided among the partners.
In addition, you’ll need to file a Certificate of Limited Partnership with the secretary of state. In New York State, within 120 days after the filing of the Certificate of Limited Partnership, the Limited Partnership must publish in 2 newspapers a copy of the Certificate or a notice related to the formation of the LP and submit a Certificate of Publication.
What Tax Forms Does a Limited Partnership File?
The profits and losses earned by the partnership will pass-through to the partners. Income taxes are paid by the partners in proportion to their share of the business at the partner’s personal tax rate. A general partner can take a loss to reduce their taxable income. A limited partner may not be able to take a loss. Since they don’t manage the business, their income is considered passive (not earned) income. The passive loss can only be offset with the passive income and carries over until in the year that a limited partner withdraws from the partnership.
The Partnership will file Form 1065 on the Federal level, which is an information return, so there is no income tax imposed at the partnership level. Each partner will receive Form 1065 Schedule K-1, which contains each partner’s share of activities for the taxable year. Each partner then reports the information on the Schedule K-1 on his or her Form 1040 and pays taxes at each partner’s individual income tax rate. The ordinary income passed-through from a limited partnership to general partners is usually treated as self-employment income hence subject to FICA taxes, which is similar to social security and Medicare taxes for wage earners. The ordinary income passed-through from a limited partnership to limited partners is considered investment income. Therefore, it is subject to 3.8% Net Investment Income Tax for income above $200K for single and $250K for married filing jointly.
The partnership will be required to file state tax returns in the state where they are doing business. In New York State, the partnership will file a Form IT-204, which is again an information return. Each partner receives Form IT-204 IP, which shows each partner’s share of income and losses reported on the Federal information return, as well as income and losses that are apportioned to New York for NYS non-resident partners. The Form IT-204 IP also provides partners’ New York adjustments to Federal amounts due to the decoupling from Federal law by NYS and some other state additions and subtractions that are required by NYS. Partners then report appropriate information on Form IT-204 IP on their NYS individual income tax return, such as NYS Form IT-201 for NYS residents. Additionally, IT-204 IP lists the partner’s share of income earned in the Metropolitan Commuter Transportation District (MCTD) that is subject to the .34% Metropolitan Commuter Transportation Mobility Tax (MCTMT). If the partnership has income and losses from other states, non- resident K-1s will be prepared for those states.
If you have any questions about whether a Limited Partnership is the right entity for your business, or about the requirements, please contact us. We’re here to support you and make it easier to pursue your dream.