Thinking about putting money into your friend’s business? Want to raise money from investors without going through the process of forming a corporation? Then you should consider starting a limited partnership.
Here we’ll break down what a limited partnership is, whether it’s the right business entity type for your business, and how to form one.
What is a limited partnership?
A limited partnership is an unincorporated business consisting of at least one general partner and one limited partner (also sometimes called a silent partner).
General partners share in the profits and losses of the business, are involved in the day-to-day management of the company, and are personally liable for the partnership’s debts.
Limited partners, on the other hand, don’t participate in the day-to-day management of a business—they usually just contribute money. They also enjoy something called limited liability.
What is limited liability?
One of the biggest risks of entering into a business partnership with someone is that things might not work out, and that you might be on the hook for someone else’s mistakes.
If you start a general partnership with someone and it goes into debt, for example, creditors can come after your assets, even if the debt isn’t your fault.
Limited partnerships get around this problem by allowing limited partners to invest in a business, and limiting their liability to the amount of their initial investment.
For example: let’s say you become a limited partner in your friend’s Alex’s new pizzeria, and you invest $10,000. If the pizzeria ever goes into debt, creditors will only ever be able to come after that initial $10,000 investment. The rest of your assets are protected.
How do I form a limited partnership?
Step 1: Pick a state to register in
Ever wonder why so many companies decide to register in Delaware? It’s mainly because of the state’s flexible rules around forming businesses and generally business-friendly environment.
Read up on your state’s rules around forming partnerships, compare tax rates across state lines, see what the general trend is in your industry, read up on the benefits of filing in Delaware, and most importantly, talk to a lawyer to find the best fit for you.
Step 2: Pick a name that isn’t taken yet
You’ll have to pick a name for your limited partnership that hasn’t been taken by any other business in the state you’re filing in. Use that state’s business registry to look up whether the name you’re considering is taken (here’s Delaware’s registry and here’s California’s).
Run a Google search too, especially if you expect to do any business out of state. Double-check to see that it doesn’t include any words that are restricted by your specific state (you’re not allowed to have the word “insurance” in your name in certain states, for example).
Step 3: Write up a partnership agreement
Also sometimes called an operating agreement, a partnership agreement is a lot like the bylaws of a corporation.
At minimum, a partnership agreement should establish four things:
- The name of the partnership
- How the profits of your partnership will be distributed
- How its losses will be shared
- What happens when someone wants to sell their stake in the partnership
A well-written partnership agreement should also cover:
- The nature of your business
- How long the partnership will last (if it has an expiry date)
- What kinds of partners it will contain (more on that below)
- What each partner is expected to contribute in terms of capital, time and resources
- Rules for what happens when it’s time to dissolve the partnership
- How disagreements should be resolved
LawDepot’s handy partnership agreement generator should give you a sense of what goes into a typical partnership agreement.
As tempting as it might be to write one up yourself, never sign a partnership agreement without first having a lawyer look at it.
A lawyer can help you craft an agreement that fits your business’ specific needs, anticipates any problems your business might run into later, and save you a lot of trouble if one of the partners ever decide to sue one another (heaven forbid).
Step 4: Register with your secretary of state
In most cases, you’ll have to file your partnership agreement with the Secretary of State. Where you file will vary by state, so consult your state government’s website for information about where to file and any fees you might have to pay.
How are limited partnerships different from other partnerships?
Limited partnerships are different from the other three other kinds of business entities you can form with multiple partners: general partnerships, limited liability partnerships, and corporations.
A general partnership is a partnership where each partner is a general partner, each partner has equal management rights, and each partner is equally liable for the debts of the partnership. You can form a general partnership with a simple verbal agreement. Compared to all the other entity types, general partnerships are cheap, fast and easy.
Limited liability partnerships
Limited liability partnerships (LLPs) have at least one limited liability partner, who is like a limited partner that also participates in the day to day management of the company.
The one other kind of business entity you can start with multiple people is a corporation, where no one is liable for the debts of the company.
Why do people form limited partnerships?
They make raising money easier
Becoming a limited partner lets you put money into a business without risking any of your personal assets in the process. That can be attractive to friends and family members who want to become investors in your business, but who might not want to risk more than their initial investment.
You don’t have to pay self-employment tax
Because they receive dividend-like payments in exchange for their investment in the business, limited partners don’t have to pay self-employment tax like general partners do.
What are the drawbacks to forming a limited partnership?
There are a few reasons why you might want to consider forming a general partnership or a corporation instead of a limited partnership:
They’re not as easy to form as general partnerships
The rules around forming limited partnerships vary widely by state and can get complicated. Some states require you to secure a partnership agreement, a Certificate of Limited Partnership, a state ID number and workers’ compensation insurance to form a limited partnership. Some states don’t require any of those things.
Look up your state and industry on the U.S. Small Business Administration website here to figure out which licenses and permits you need to submit to establish a limited partnership.
You’re still on the hook if you’re a general partner
There’s no limited liability for a general partner in a limited partnership. If you get into trouble with your creditors, they can still come after your LP’s assets.
You could lose your limited partner status
If a limited partner starts taking an active role in a limited partnership—which can happen if they ever disagree with how the general partner is running the business—they risk losing their limited status and being held responsible for the business’ liabilities just like a general partner.