Limited partnerships are a form of entity in California that offers limited partners limited liability to the extent of their investments. A limited partnership has a few downsides that should be considered. This article explores the essential elements of Limited Partnerships, how they are formed and taxed and their drawbacks.
What are the Distinguishing Characteristics of Limited Partnerships?
- General Partnership is automatically formed when there are two or more co-owners who form a business for profit. Meanwhile, Limited Partnership is organized only when a certificate is filed with the California Secretary of State.
- Two or more parties are required for both a General and Limited Partnership to be treated as a partnership for tax purposes. A Limited Partnership requires at least one limited partner.
- In the case of Limited Partnerships, general partners are considered jointly and individually liable, whereas limited partners have only limited liability with some exceptions.
Some Advantages of Limited Partnership
- Limited Partnership allows owners to avoid double taxation of entities that are taxed at both corporate and individual levels.
- Limited Partnership allows owners to divide or allocate profits or losses not directly tied to their percentage of ownership interest
- Limited Partnership allows owners to place management in the hands of a few appointees
- Limited Partnership protects limited partners from general liability risk for the liabilities of the enterprise
Some Disadvantages of Limited Partnership
- A Limited Partner is still subject to passive loss limitations rules for federal income tax IRC §469(h)(2).
- Limited Partners and General Partners have relatively greater exposure to general liability by virtue of their participation in partnership affairs. Thereby, being left bereft of a wide shield that is available to shareholders of a corporation or members of Limited Liability Company irrespective of their membership or shareholder status.
- Limited Partnerships are not the most prudent option when it comes to relatively simple, non-sophisticated enterprises.
Limited Partnership Taxes Basics
Basics of Federal Taxes:
- For Federal Tax Purposes, a Limited Partnership is NOT a separate tax-paying entity. Accordingly, Limited Partnership is NOT subject to tax at the entity level. IRC §701.
- This means Partners, limited and general, reported their respective distributive shares of partnership income, loss, gain, deduction and credit on their individual federal income tax returns. This is called the “Pass-Through” treatment.
How to Protect General Partners Against Liability
- When a Limited Partnership is formed, a Corporation or Limited Liability Company can be formed to protect the General Partners.
- Forming either a Corporation or Limited Liability Company will require an additional financial commitment.
When Can Limited Partners Be Personally Liable?
The GENERAL rule is Limited Partners are NOT liable beyond their capital contributions in the Limited Partnership. Nonetheless, the following offers some circumstances under which a Limited Partner could be held personally liable:
- Limited Partner MAY be required to return distributions received from the Limited Partnership at a time the Limited Partnership is deemed to lack sufficient assets to satisfy its liabilities. Corp C §15905.09.
- Limited Partner MAY be held liable personally for satisfying a debt to a third party creditor or Limited Partnership.
- Limited Partner MAY be held personally liable for the debts and obligations of the Limited Partnership if the Limited Partner “actively” participates in management and control of the Limited Partnership. See Corp C §15903.03(a).
How to Form A Limited Partnership
A Certificate of Limited Partnership must be filed with the California Secretary of State on a form that they provide. The Limited Partnership is officially formed on the date the certificate is filed.
Partnership Income Tax Return
SCHEDULE K-1 (1065)
Generally, a partnership MUST file a partnership information return (IRS Form 1065) with the IRS for each year it receives income or incurs expenditures allowable as deductions.
The partnership must file a return on or before the 15th day of the 4th month following the end of each taxable year. An automatic extension may be obtained for 5 months by filing IRS Form 7004.
FRANCHISE TAX BOARD
Form 565 – Schedule k-1 (565)
Every partnership doing business in CA must file an annual partnership return (Partnership Return of Income i.e. FTB Form 565) with the Franchise Tax Board.
The partnership must file a return on or before the 15th day of the 4th month following the end of each taxable year. An automatic 6-month extension could be obtained.