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Nuts and Bolts of Limited Partnerships
Thursday, May 17, 2012 by Doron F. Eghbali
Limited Partnerships are one of the forms of entities available to form in California. Limited Partnership offers limited partners limited liability to the extent of their investment in the business. Nonetheless, Limited Partnership has several salient drawbacks. This article explores the building blocks of Limited Partnerships, its formation, taxation and some of the drawbacks associated with such business entity.
WHAT ARE THE DISTINGUISHING CHARACTERISTICS OF LIMITED PARTNERSHIPS?
- General Partnership is formed regardless of partners intending to create one as long as there is an association of two or more co-owners to carry on a business for profit. On the other hand, LIMITED PARTNERSHIP MAY BE ORGANIZED only if, a CERTIFICATE of Limited Partnership is FILED with CA Secretary of State on a form PRESCRIBED by CA SECRETARY OF STATE.
- Both GP and Limited Partnership require at least 2 partners to be treated as partnership for tax purposes. Nonetheless, for Limited Partnership, there must be at least 1 limited partner.
- For Limited Partnership, only general partners may be held jointly and severally liable while the limited partners, as the name correctly indicates, have only limited liability with some exceptions.
SOME PREDOMINANT ADVANTAGES OF LIMITED PARTNERSHIP, GENERALLY
- Enables owners to avoid double taxation of entities taxed at both corporate and individual level
- Enables owners to divide or allocate profits or losses not directly tied to their percentage of ownership interest
- Enables owners to place management in the hands of a few, presumably expert hands
- Enables passive investors (limited partners) from general liability risk for the liabilities of the enterprise
SOME PREDOMINANT DISADVANTAGES OF LIMITED PARTNERSHIP, GENERALLY
- Limited Partner is still subject to passive loss limitations rules for federal income tax purposes. IRC §469(h)(2).
- Both Limited Partner and General Partner 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.
- Simply put, Limited Partnerships are not the most prudent option for relatively simple, non-sophisticated enterprises.
SOME BASICS OF LIMITED PARTNERSHIP TAXES
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 the so called “Pass-Through” treatment.
HOW TO PROTECT GENERAL PARTNERS AGAINST PERSONAL LIABILITY
If practitioner still wants to form a Limited Partnership and wants to protect General Partners should seriously consider
establishing a Corporation OR Limited Liability Company as General Partner.
Nonetheless, forming a Corporation and a Limited Liability Company as a General Partner of a Limited Partnership would require spending additional financial resources.
WHEN LIMITED PARTNERS COULD BE HELD PERSONALLY LIABLE?
The GENERAL rule is Limited Partners are NOT liable beyond their capital contributions in the Limited Partnership. Nonetheless, the following offer 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 LIMITED PARTNERSHIP
Certificate of Limited Partnership MUST be filed with CA Secretary of State on the form prescribed.
The Limited Partnership is considered formed on the date the certificate is filed.
PARTNERSHIP INCOME TAX RETURN
1. 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.
2. FRANCHISE TAX BOARDForm 565 – Schedule k-1 (565)
Every partnership doing business in CA must file a 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.
This article NEITHER supplants NOR supplements the breadth and depth of such esoteric topic. In fact, this article ONLY provides a rather RUDIMENTARY synopsis of such esoteric subject matter.
Fundamentals of Limited Liability Company
Thursday, May 24, 2012 by Doron F. Eghbali
Limited Liability Company offers the best of two worlds: LIMITED Liability aspect of corporations and PASS-THROUGH income-tax aspects of partnerships. Generally, a Limited Liability Company is formed with 1 or more members to carry on a
business while none of the owners have personal liability for the obligations of the business.
FORMATION OF LIMITED LIABILITY COMPANY
Under Beverly Killea Limited Liability Act of 1994 (Corp C §§17000-17655), a Limited Liability Company is formed when:
- ARTICLES OF ORGANIZATION is filed with CA Secretary of State on the CA Secretary of
State Form LLC-1 (ATTACHED TO THIS HANDOUT). AND,
- Members enter into an Operating Agreement. The Operating Agreement could be oral OR written. Operating Agreement could be entered into BEFORE filing the Articles of Organization or AFTER filing the Articles of Organization.
- The name of a Limited Liability Company MUST contain AT THE END the words “Limited Liability Company”, or “LLC”, or “L.L.C.”
SOME ADVANTAGES OF LIMITED LIABILITY COMPANY VIS-A-VIS LIMITED PARTNERSHIP AND S CORPORATION
a) SOME ADVANTAGES OF LIMITED LIABILITY COMPANY vs. LIMITED PARTNERSHIP
- General Partner MUST be personally liable for the obligations of the business. On the other hand, each member, generally, has limited liability.
- Limited Partners MAY NOT take part in control of the business without losing their limited liability. On the other hand, each member regardless of their respective contributions may participate in the control of the Limited Liability Company without losing their limited liability.
b) SOME ADVANTAGES OF LIMITED LIABILITY COMPANY vs. S. CORPORATION
- S Corporation limits the ability of shareholders to structure their financial arrangements because of its limitation on only 1 class of stock and the distribution of income, gain, losses should be in accordance with the shareholder’s prorate share of the corporation’s stock.
- S Corporation shareholders MUST be US citizens or Resident Aliens.
- S Corporations HAVE NO special allocations, only 1class of stock.
A Limited Liability Company MAY have different classes of ownership. Income, gain, loss and other items could be allocated disproportionately without affecting the Limited Liability Company’s pass-through treatment. In addition, ANY individual or ANY partnership, trust, estate, association, corporation or other limited liability company whether domestic or foreign can be a member of an LLC. See Corp C §17001.
LIMITED LIABILITY COMPANY STATE TAXES AND FEES
A Limited Liability Company MUST pay a tax of $800 per year for being a Limited Liability Company regardless of gross receipts or net income. This $800 is equal to the amount corporations, including S Corporations, Limited Partnerships, and Limited Liability Partnerships have to pay.
Despite the fact new corporations are exempt from paying $800 for the first year, new Limited Liability Companies are not accorded the same privilege.
MANAGEMENT AND FIDUCIARY DUTIES
Limited Liability Company is by far the most flexible type of business entity in CA in structuring control and management for its members.
Limited Liability Company could be managed by ALL the members (“Member-Managed LLC”) or by 1 or more managers (“Manager-Managed LLC”). The manager could be a member or non-member. The default rule is LLC is considered to be member-managed. Nonetheless the default rule is superseded by the Articles of Organization Item 6 of Secretary of State Form in which it requires selection of whether the Limited Liability Company is member-managed or manager-managed, and Articles PREVAIL over any conflicting provision in the operating agreement (Corp C 17005 (5)).
MEMBER-MANAGED LIMITED LIABILITY COMPANY
In a Member-Managed Limited Liability Company, each member is an agent of the company and any act of the member for the apparent purpose of carrying on in the usual way of doing business BINDS the company. Even if the members among themselves have stripped a member from having the authority to bind the company with third parties, third parties are NOT BOUND by such internal agreement, UNLESS the third parties know about it.Corp C §17157(b)(2).
MANAGER-MANAGED LIMITED LIABILITY COMPANY
In a Manager-Managed Limited Liability Company, members are NOT agents of the Limited Liability Company for just being a member. Corp C §17157 (b)(1). On the other hand, the managers whether members of the Limited Liability Company or not BIND the company in actions or transactions for the apparent purpose of carrying on the usual affairs of the Limited Liability Company. Corp C §17157(b)(2). Again, a manager’s lack of authority is not binding on third parties, UNLESS the third parties had actual knowledge of such lack of authority. Corp C §17157(b)(2).
OFFICERS OF LIMITED LIABILITY COMPANY
A Limited Liability Company may have officers: President, Chief Financial Officer and Secretary. Corp C §17154. Officers, similar to managers, could be members of the Limited Liability or not. Corp C §§ 17151(a), 17154 (a).
FIDUCIARY DUTIES OF A MEMBER OR MANAGER OF LIMITED LIABILITY COMPANY
A member of a Limited Liability Company has similar fiduciary duties as a manager. Corp C §17150. In turn, the fiduciary duties owed by a manager to the Limited Liability Company and its members are similar to those of a
partnership and its partners. Corp. C § 17153.
VOTING RIGHTS IN A LIMITED LIABILITY COMPANY
Voting rights are spelled out in Articles of Organization or Operating Agreement. Right to vote could be predicated upon: the amount of investment and corresponding share of profits or losses. Some members of the Limited Liability Company could have voting rights to the exclusion of other members.
The default rules for voting rights, if the Articles of Organization and Operating
Agreement are silent, are:
- A member may vote in proportion to the member’s interest in profits. Corp C §17103(a)(1).
- Unanimity of all members is required for a vote to amend the Articles of Organization or
Operating Agreement. Corp C §17103(a)(2).
- Vote of a
“majority in interest of the members” is sufficient for all other matters requiring a vote. Corp C §17103(a)(3).
SOME DISADVANTAGES OF LIMITED LIABILITY COMPANIES
a) Not Suitable for Existing Incorporated Businesses: Converting an existing corporation, even an S Corporation, into a Limited Liability Company would trigger a TAXABLE liquidation of the corporation. The tax cost of a merger or conversion of an existing corporation into a Limited Liability Company should be considered before such conversion.
b) Not Suitable for Professional Practices: There is no Professional Limited Liability Company. In
fact, a Limited Liability Company in CA is NOT authorized to practice a
This article NEITHER supplants NOR supplements the breadth and depth of such esoteric topic. In fact, this article ONLY provides a rather rudimentary synopsis of such esoteric subject matter.
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