What is a Limited Partnership And How is it Taxed And Reported In The US?

Arin V., EA , MBA

Arin is an Enrolled Agent (EA), authorized to represent taxpayers in front of the IRS, and holds a BA and MBA (Management) degree from California State University, Northridge.

Last week, we discussed foreign partnerships and the tax implications for such entities when transacting business in the United States. As alluring and in some cases as crucial as it may be to partner up with others when starting a new business (indeed, famed venture capitalist Paul Graham has written in detail about startups being too demanding to go it alone), sometimes it may just be a better choice to become a limited partner. This article will highlight what a limited partnership is, what the benefits and drawbacks are, as well as explain what the tax filing requirements are for such partnerships. 

To recap from last time, a partnership is formed when two or more people engage in a business and each person contributes time, money and/or resources to the partnership and in turn shares a portion of the income and expenses of the partnership.

A limited partnership is no different in this regard, as it must be comprised of two or more people. In this scenario, however, there must be at least one general partner who actually runs the business, and at least one limited partner, who is not typically involved with the day-to-day operations of the business. 

But what is the advantage of such an arrangement? A limited partnership is useful in scenarios in which one or more of the partners does not want to be involved with operations but does want to benefit from the success of the company. This scenario is especially beneficial for partners who have complementary skillsets, where one partner might be more adept at running the business, while the other partner has more financial assets to contribute to the partnership, for instance. Additionally, limited partners are not liable for paying self-employment tax on their earnings from the partnership (unless they receive guaranteed payments), given that they are not involved with actively running and managing the business.

But perhaps one of the biggest benefits of starting a limited partnership is that the limited partners do not have the unlimited liability that general partners do. What does this mean? If the partnership is sued, then limited partners are liable only up to the amount of the investment they have made in the partnership. Their personal assets are not at risk in this situation. However, at the same time, given that a limited partner generates passive income from the partnership, since they do not materially participate in running the business, they can only deduct these passive losses against passive income. Additionally, limited partners must be willing to relinquish control to the general partners, who are responsible for making the operational decisions that may significantly affect the future of the partnership. 

In terms of taxation, a limited partnership is taxed just like a foreign partnership doing business in the United States, in that it is a pass-through entity. This simply means that the income and expenses of the partnership flow through to each partner based on their ownership percentage. This information, of course, is reported on a Schedule K-1 for each partner, who must then include the partnership profits or losses on his/her personal tax return. As for the partnership itself, it will need to file a Form 1065 with the Internal Revenue Service, as well as, potentially, a state partnership tax return, depending upon which state(s) the partnership is doing business in. The due date for Form 1065 is generally March 15, with the possibility of extending six months to September 15. 

If you are considering starting a limited partnership and need guidance on how to structure the business in a tax-advantageous way while at the same time protecting your personal assets and remaining compliant with the filing requirements, please get in touch today to discuss your options. Indeed, even though you might have a general partner managing the day-to-day affairs of the partnership, you are still no doubt very much interested in the longevity and success of the partnership. In the same way, it is beneficial for you to take an active role in ensuring that the taxation and compliance around the partnership is taken care of by professionals who are well-versed with assisting such entities.