Choosing the Type of Partnership Formation – GPs, LPs & LLPs

This article will discuss the formation of a partnership. Included are descriptions of the different partnership types, including the partnership features, roles of partners, and partnership taxation. In addition, the partnership agreement will be discussed.

There are three types of partnership that will be discussed. These are a general partnership, limited partnership (LP), and limited liability partnership (LLP). Participants in all three forms of partnership may include individuals, corporations, trusts, estates, partnerships, and limited liability corporations. Following is detailed discussion of each partnership type.

General Partnership (GP)

A general partnership is a business entity in which two or more co-owners engage in business. The partners own the business assets together. Unless a partnership agreement states otherwise, business profits and losses are shared by the partners equally, and each general partner has an equal right to participate in management and control of the business. However, a partnership agreement “will usually provide for the manner in which profits and losses are to be shared” (General Partnerships).

The partnership itself does not pay income tax. Instead, the partnership files Form 1065, U.S. Partnership Return of Income, which is an annual information return that lists all taxable income and deductions. Included with Form 1065 is Schedule K-1, Partner’s Share of Income (Loss) From an Electing Large Partnership, which reports each partner’s share of the partnership income, deductions, credits, etc. A copy of Schedule K-1 is sent to both the IRS and the partner. Each partner is liable for taxes on their portion of the partnership income, regardless of whether it is distributed or not. Each partner must report their share of partnership income on their personal tax return. Each partner in a partnership is responsible for paying self-employment tax (Social Security and Medicare taxes).

In a general partnership, each partner is personally liable for business debts, torts, and other liabilities. Each partner is, jointly and severally, personally liable for the debts of the partnership. If the partnership cannot pay its debts, the partners’ personal assets are subject to attachment and liquidation to pay the business debts. Partnerships do not have a perpetual existence, because the partnership terminates upon the death, disability, or withdrawal of one partner, unless a partnership agreement provides for substitution.

Limited Partnership (LP)

Like a general partnership, an LP is a business entity in which two or more co-owners engage in business. However, in an LP, “one or more “general’ partners manage the business while “limited” partners contribute capital and share in the profits but take no part in running the business” (Limited Partnership). In an LP, “there must be at least one general partner who has unlimited personal liability” (Limited Partnerships).

One advantage to forming an LP is the pass-through tax treatment, in which the LP itself does not pay income tax, but instead files an information return (Form 1065) only. Each partner is taxed on the net profits of the company and must pay self-employment tax up to the FICA limits. However, it is important to note that a partner may “own and be employed by…[the] LP at the same time, thus, eliminating the Schedule “C” self-employment return from…[that partner’s] list of filed IRS tax documents” (LP – Limited Partnership). This may be advantageous, because “it is reported [that] the group with the highest percentage of tax audits is the one that includes the Schedule “C” form filed by the self-employed” (LP – Limited Partnership).

In an LP, the general partners are personally liable for business debts, torts, and other liabilities. The limited partners are only liable for partnership obligations to the extent of their capital contributions. Limited partners cannot actively participate in management of the business. LPs do not have a perpetual existence, because the partnership is terminated upon the death, disability, or withdrawal of a general partner, unless the partnership agreement provides for substitution. “Death or incompetence of a limited partner has no effect on the partnership” (Limited Partnership).

Limited Liability Partnership (LLP)

A Limited Liability Partnership (LLP) is another name for a Limited Liability Company. LLPs are often used by professional associations. In an LLP, all partners are limited partners. However, unlike the limited partners in an LP, in an LLP “all of the owners can participate in management” (Limited Partnerships).

An LLP is generally treated as a partnership for federal tax purposes, meaning that income, losses, deductions, and tax credits flow through the LLP to the individual members, who report this on their individual income tax returns. The IRS provides a special rule for the limited partners of an LLP. “They pay self-employment tax only if the… [LLP] pays them for services” (Tax Issues for Limited Liability Companies).

An LLP combines the tax advantages of a partnership with the liability protection of a corporation. Partners of the LLP have limited personal liability for business debts, torts, or other liabilities, because each partner’s liability is limited to the amount that partner has invested in the business. However, “in many states, owners of an LLP have only a reduced form of limited liability from the claims of the business’s creditors. This “limited shield,” as it is sometimes called, does not afford the owners the same protection they would enjoy in either the LLC or the corporation” (CCH Incorporated, 2006b). LLPs do not have a perpetual existence.

Partnership Agreement

A partnership may be legally formed solely with a verbal agreement between the partners. However, a written partnership agreement will protect all partners by specifying each partner’s rights and responsibilities. The agreement should establish each partner’s share of profits or losses, the responsibilities of each partner, and what happens to the partnership if a partner leaves. More specifically, the partnership agreement should:

– Establish the partnership name

– Determine the type of partnership

– Name the managing/general partners

– Determine each partner’s share of profit or loss

– Determine each partner’s share of capital gain or loss

– Outline procedures for admission and retirement of partners

– Specify what officers can and cannot do

– Specify the methods of accounting

– Establish the election of officers

“Each state (with the exception of Louisiana) has its own laws governing partnerships, contained in what’s usually called “The Uniform Partnership Act” or “The Revised Uniform Partnership Act” (or the “UPA” or “Revised UPA”). These statutes establish the basic legal rules that apply to partnerships” (Partnership). Creating a written partnership agreement will protect all partners and prevent the partnership from being bound by state laws that were written as a general guideline but may not be in the best interest of a specific partnership.

References

“General partnerships.” Intuit website. URL: http://www.mycorporation.com/Genpart.htm

“Limited liability partnership (LLP).” CCH website. URL: http://www.toolkit.cch.com/text/P12_4265.asp

“Limited partnership.” Intuit website. URL: http://www.mycorporation.com/Limpart.htm

“Limited partnerships.” CCH website. URL:http://www.toolkit.cch.com/text/P12_4235.asp

“LP – limited partnership.” Companies Incorporated website. URL: http://www.companiesinc.com/lp-limited-partnership.asp

“Partnership.” Nolo website. URL: http://www.nolo.com/article.cfm/ObjectID/8380AD8C-866C-4B9B-8DC1AA0B46CE2CF4/catID/DA9428C8-2E99-47F2-A24C1190FE5F24E7/111/182/275/ART/

“Tax issues for limited liability companies.” IRS website. URL: http://www.irs.gov/pub/irs-pdf/p3402.pdf

Reference:

• www.irs.gov