Small business owners often ask me questions about business partnerships, including the role of a limited partner.
Whether you’re forming a partnership, investing in one, or already part of one, it’s important to understand what being a limited partner means, especially when it comes to taxes. Today’s post will cover everything you need to know about limited partnership.
What is a limited partner?
A partnership is obviously a business structure where two or more people work together to run a business and share the profits. Within a partnership, there are two main types of partners:
- General partner: This person (or people) manages the business, makes the business decisions, and has personal liability for the business’ debts.
- Limited partner: This person takes a passive role in the business. They invest money in the business but they’re involvement is limited in two ways. First, they are not involved in day-to-day operations, and second, their financial liability is generally limited to the amount of money that they’ve invested in the business.
A limited partner is often referred to as a “passive owner,” “silent investor,” or “silent partner.” They contribute capital and share in the profits, but they don’t have the same responsibilities or take the same risks as a general partner.
What are the tax implications of being a limited partner?
Limited partners are also taxed differently than general partners, and it’s important to understand these tax implications before deciding to become a limited or silent partner in a business. Some important areas to understand are:
Pass-Through Taxation
Most partnerships, including limited partnerships, are pass-through entities. This means that the business itself doesn’t pay taxes. Instead, profits and losses “pass through” to the partners, who then report the income and losses on their individual income tax returns.
Limited partners will receive a Schedule K-1 at the end of the year. This form will list the partner’s share of the company’s earnings, losses, deductions, and credits. The partner will use the information on this form to complete their personal tax return.
Self-Employment Taxes
A perk of being a limited partner is that limited partners typically don’t have to pay self-employment taxes on their share of the business’ income. That’s because self-employment tax, which includes taxes for Social Security and Medicare, only applies to income that comes from active participation in a business.
One thing to keep in mind here is that this exemption only applies to income. If a partner receives guaranteed payments for services to the partnership, then those payments will still be subject to self-employment tax.
Capital Gains and Losses
When a limited partner’s income includes capital gains like profits from selling a partnership asset, then those gains are taxed at the lower capital gains tax rate. However, if the partnership has capital losses, a limited partner can only use their share of the loss to offset other capital gains.
Although, in some cases, capital losses from the business can also offset up to $3,000 in ordinary income each tax year. If you’re a limited partner with capital losses to report, make sure you speak to an accountant about whether this may apply to you.
Deductions
Limited partners can deduct their share of the business’ losses on their tax returns, but there are restrictions:
- At-Risk Rules: Limited partners can only deduct losses up to the amount they have “at risk” in the partnership. This generally includes any initial investment plus additional contributions or loans to the business.
- Passive Activity Rules: Since limited partners are passive investors, their income and losses can only be used to offset passive income and not active income like wages. For example, if a limited partnership incurs a $10,000 loss, but a limited partner only has $3,000 in passive income, then they can only deduct $3,000. The remaining $7,000 can be deducted in future years to offset other passive income.
What are the advantages of being a limited partner?
There are 3 main advantages to being a limited partner:
- Flexibility: Limited partners don’t have to be involved in day-to-day operations, so this role is ideal for someone looking to invest in a business without committing any time or energy to the business’ success.
- Tax Benefits: Limited partners can avoid self-employment tax and potentially use capital gains rates to their advantage.
- Limited Liability: Unlike general partners, limited partners can’t be held personally responsible for the business’ debts or legal obligations beyond the amount they’ve invested in the partnership.
What are the disadvantages of being a limited partner?
There are also disadvantages to being a limited partner:
- No Control: The flipside of having flexibility to not be involved in the day-to-day operations of the business is that a limited partner has very little say in how the business is run.
- Passive Loss Deductions: As I’ve discussed, deducting losses can be tricky since passive activity rules limit how much a limited partner can use to offset income.
Should I become a limited partner?
When deciding whether or not you should become a limited partner, you should first discuss the tax implications of your decision with your accountant. You should also consider the advantages and disadvantages I’ve discussed in this post.
Another important note here is that limited partnerships are becoming a less common business structure. In its place, many business owners choose to form a partnership Limited Liability Company (LLC) or a Multi-Member Limited Liability Company (MMLLC) with two classes of members: one class for general partners and one class for limited partners. Business owners often prefer this structure because limited liability protection is given to all members and there is more flexibility in the business’ management structure.
How do I become a limited partner?
If you’re considering forming a partnership or bringing in limited partners, you’ll want to work with a business attorney to make sure you have clear and legal documentation of each partner’s role in the agreement.
I also highly recommend that you work with a certified public accountant who can help make sure your partnership aligns with your financial goals while also minimizing your tax liabilities. Working with an accountant who specializes in small businesses can ensure that you explore all tax-planning strategies to make the most of your business structure and stay on the right side of the IRS.
