What is a limited partner?

Limited partnerships can benefit some startups by providing additional capital that general partners may not have early on. The limited partner is only responsible for debts up to the amount they invested in your startup and helps founders realize their dream sooner.

Limited partners have a limited say in how the business operates, giving some business entities the best of both worlds by allowing general partners to build the business they want with the capital they need. Limited partners have the nickname “silent partner” because they don’t have a say in how the business operates, or if they do, it’s to a limited extent.

Keep reading to find out exactly how limited partnerships work in this page.

What is a limited partner and what is their role?

Limited partnerships consist of a general and limited partner. General partners handle the day-to-day operations and are fully financially responsible for all the partnership's activities and debts. 

In contrast, the limited partner only provides a certain financial backing amount.

According to the IRS, limited partners have passive income but don’t have as much say in your startup’s operations and voting power as a general partner. Limited partners should believe in your startup’s mission and goals but aren’t looking to become involved in daily operations.

Taxes

Is a limited partner subject to self-employment tax? The answer may surprise you. 

Unlike general partners, limited partners don’t pay self-employment taxes. The IRS considers income from a limited partner as passive income. Limited partners can offset their tax liability with certain losses, but not those that a general partner can deduct.

Limited partnerships face different tax rules than general partners, who must claim the income earned from their share of the partnership on their tax returns. The IRS requires this because a general partnership pays pass-through income, or the income 'passes through' to your individual tax returns. However, general partners don’t pay taxes on the total amount earned in the partnership, only their share.

Compliance

Limited partnerships include investors and must follow strict securities laws. Limited partnership units are stocks from your startup similar to those issued by a corporation. All LPs must conduct regular investor meetings and provide ample access to all financial documents. 

Each state has different compliance rules for LPs, so be sure to research your state’s laws and talk to your attorney about the requirements. 

Liability

Limited partners are like investors in a start-up business or company; they are only liable for the liabilities up to their investment amount. So, for example, if a limited partner invested $10,000 in your startup, they are only responsible for up to $10,000 in debts or any other liabilities the startup may have.

Guaranteed payments

Some limited partners have access to guaranteed payments, which do not relate to the startup’s profitability. Guaranteed payments ensure partners receive fair compensation for goods or services provided to your startup, which pertains only to additional services or capital.

LLC vs. a limited partnership

An LLC can be a partnership but has more protective factors than a general or limited partnership. For example, LLC partners aren’t personally liable for any business liabilities. 

However, filing as an LLC requires stricter filing requirements, including the Articles of Incorporation and any other state requirements.

How do I start a limited partnership?

To start a limited partnership in business, you’ll need to provide the paperwork and pay the filing fee with your state. You’ll also need your startup’s name, registered partner, and all general partners' names and addresses.

After filing with the state, you should create a Limited Partnership Agreement. You don't have to file this agreement with the state; however, it shows ownership percentages and any other terms of the partnership which are essential to your startup.

Does a limited partnership require a written limited partner agreement?

A limited partnership should have a written agreement to determine ownership percentages and other terms of ownership. This holds each partner accountable and leaves little room for any confusion. However, most states don't require that you file the agreement with them.

What are the pros and cons of a limited partnership?

Consult with your tax advisor or attorney when choosing your startup’s business structure, but here are some of the pros and cons of a limited partnership to consider.

Pros

• You have access to adequate capital and labor by combining the efforts of limited and general partners. Limited partners back a portion of the startup, while general partners do the work.
• You are a limited liability partner only up to the amount you invest.
• Limited partners have an easy exit strategy without disrupting the startup’s operations.
• Without much of a say in its operations, general partners have more freedom.

Cons

• Limited partners may not have any say in the startup’s operations even though they invest funds.
• The required paperwork is more complex for an LP than a general partnership.
• General partners take on a more significant portion of the risk.

Limited partner: Key takeaways

A limited partnership can help founders build their dream business before they have all the necessary capital. Limited partners have a limited say in your operations, and they have limited liability capped at their investment.

Understanding each partner’s role in the business relationship, how taxes are treated according to the law, and how limited partnerships work can help you make the best choices for your startup. However, this is one of those decisions you should discuss in depth with your accountant or tax advisor, as it will determine the financial stability of your startup.

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Disclaimer: LTSE is neither a law firm nor provides legal advice. Before making decisions on matters covered by this post, readers should consult their legal adviser.