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Suppose you have a brilliant business idea that you want to put into action. But you're short on capital (money) to finance your project. Fortunately, you've pitched your idea to some investors, and they want to finance your business. You and your investors decide to form a limited partnership (LP). As a general partner, you'll be in charge of the day-to-day business strategy and execution. As limited partners, your investors will be in charge of financial contributions.
An LP is a business entity that consists of at least one general partner and one or more limited partners. Typically, the general partner is an experienced businessperson who provides both financial resources and daily management skills to the partnership. A limited partner is an individual or business that offers only capital or financial resources to the business.
This business structure offers owners a unique opportunity. Some owners can be tasked with running the day-to-day operations and carrying out business obligations and objectives; other owners can take a back seat and fund those operations. This type of partnership can work well with a group where one person (the general partner) is personally invested in the business's success and the other people (the limited partners) see the partnership as an investment.
Partners in an LP don't just differ in what they contribute to the business. They also differ in their level of liability for the partnership's debts:
But a limited partner can lose their limited legal liability if they become involved in directing or operating the business. If a limited partner becomes more than an investor and contributes to the daily activities of the business, they can become a general partner and be personally liable for the LP's debts.
A general partner is subject to unlimited personal liability because of their authority over daily business decision-making. If there's more than one general partner in an LP, general partners are jointly and severally liable for the partnership's debts and liabilities and debts—that is, each general partner is entirely responsible for the company's debts.
For instance, suppose Lois and Lana are general partners in an LP. The LP has $100,000 in debts. Lois and Lana use the limited partners' investments to pay off some of the debt, leaving $70,000 to be paid. The LP's creditors decide to sue Lana, and the court orders her to pay $70,000 since she's a general partner.
Usually, partners have a partnership agreement that lays out how much of the business's debts each partner is responsible for. For example, the agreement might say that the general partners are equally responsible for the business's debts. If one partner is ordered to pay the business's full debt, but under their partnership agreement they're only responsible for half of that debt, they can recover the other half from their business partner.
In an LP, general partners have certain fiduciary duties to the partnership because they're responsible for the management and operation of the company. Limited partners don't typically owe these duties to the LP.
General partners have the following fiduciary duties:
For more information, read our article on fiduciary duties in partnerships.
General and limited partners in an LP don't share profits and losses equally. Traditionally, each partner's profits and losses are determined by the value or percentage of any capital contributions made to the business.
However, the partners could decide to deviate from this traditional approach through their partnership agreement. It's common for LPs to allocate a greater percentage of the business's profits to limited partners until they're paid back what they initially invested. Once limited partners get back their initial investment, partnerships often distribute the profits more evenly.
For example, suppose Fred is a general partner and Daphne and Velma are limited partners in an LP. Daphne and Velma each initially contribute $15,000 to the partnership. The partners decide to distribute a higher percentage of the profits to Daphne and Velma until they recover their initial contributions. So, at the start of the business, the partners decide on the following profit distribution:
A year into the partnership, Daphne and Velma have each received $15,000 in profit distributions—the same amount they each initially invested. Their partnership agreement states that once Daphne and Velma are paid back their investments, the profits will be distributed in the following way:
Though general partners don't generally contribute as much as limited partners financially, they pull their weight through their labor and personal liability risk. Therefore, it's not unreasonable for general partners to see the value they bring to the business returned to them in profits.
How Are Limited Partnerships Taxed?You'll need to pay taxes on the income and distributions you receive from your partnership. Because an LP is a pass-through entity, the company's profits and losses "pass through" the business to its owners. So, you'll report your share of the partnership's income on your individual tax return, but the partnership itself doesn't pay taxes. For more information, see our article on how partnerships are taxed.
As a pass-through entity, your LP can likely take advantage of the 20% pass-through tax deduction. This deduction, created under the Tax Cuts and Jobs Act, offers owners of pass-through entities a 20% deduction on their business income. Under this law, you could only be taxed on 80% of your income, which could reduce your tax obligations significantly. For example, if you made $100,000 through your partnership, you might end up only paying taxes on $80,000. This deduction could also qualify you for a lower tax bracket with a lower tax rate.
There are three main types of partnerships:
Each type of partnership differs in how owners share in the business's responsibilities, profits, and liabilities.
LPs vs. GPs. LPs have general and limited partners whereas GPs only have general partners. General partners in a GP, like those in an LP, are personally liable for the business's debts and are responsible for the company's day-to-day operations.
LPs. vs. LLPs. An LP has general and limited partners whereas an LLP only has limited partners. The partners in an LLP manage and operate the business and have limited liability for business debts. In contrast, partners in an LP either manage the business's daily activities or have limited liability. For more information, read our article on LPs vs. LLPs.
An LP's structure offers owners many benefits. But both general and limited partners face some drawbacks under this type of business. You should consider these factors when deciding whether an LP is right for you and your business.
An LP offers several benefits:
An LP isn't without its downsides:
Forming an LP is very similar to forming a GP. The main difference is that you'll need to submit formation filings to the state to form an LP. Whereas with a GP, you form it just by going into business with someone else—no paperwork is needed. To learn the steps necessary to form a partnership, read our article on how to form a partnership.
You should take the following steps to form an LP:
(For a checklist, see our article on how to start a business.)
To end your LP, you'll need to vote to dissolve the partnership and file the appropriate forms with your state. You'll also need to wind up your business by:
For more information, see our article on how to dissolve an LP.
Limited partnerships can be a good option for a group where one person is interested in managing the business while the others are only interested in collecting passive income. If you have experience with running a small business, you might be able to create and manage your LP on your own.
But because the roles in an LP are so varied, it might be helpful to talk to a business lawyer about your and your partners' responsibilities and liabilities. An attorney can help you decide whether an LP is the best choice for you. They can also help you negotiate and draft a partnership agreement, apply for the appropriate business licenses and permits, and assess your personal liability for your partnership's debts.