The Limited Partnership
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Terms:General Partner: Limited Partner: Capital Calls / Draw Downs: |
Introduction to Limited Partnerships
The “limited partnership” (often abbreviated LP) is a more modern form of partnership that is designed to address some of the shortcomings - both legal and business in nature - of a general partnership. The LP is characterized principally by two factors. Unlike in a general partnership, there are two specific subsets of partners: limited partners and general partners. An LP is formed by at least one general and one limited partner. The second major trait is the difference in the nature of liability of the GP(s) and the LP(s). More specifically, the general partners in an LP retain the unlimited liability characteristic of the general partnership, while the limited partners obtain the benefit of an upper limit on their potential liability set at the amount of their capital contribution to the partnership. See Delaware Revised Uniform Partnership Act § 15-1001.
(Note: In many states, limited liability partnerships are simply referred to as limited partnerships. Here, we are using the LP form in order to help remind us of this type of organization's most distinguishing characteristic.)
Businesses that might be limited liability partnerships:
- Large legal and accounting firms
- Organizations made up of doctors and healthcare professionals
- Venture capital and other, similar, investment funds
Characteristics
The LP is distinguished by the nature of the business organization and the limited liability of partners. See Fla. Stat. § 620.129. Otherwise, its daily operations and functions are identical to that of a general partnership.
Formation
The creation of an LP is a state regulated process where formal creation and filing (generally with the Secretary of State of the home state of the LP) is required. Additionally, while fairly prevalent today, LP's and their counterparts, Limited Liability Partnerships (a form of registered general partnership engaged in a professional service, such as a law firm) are not recognized in all states.
EXAMPLE: Martin, as GP, and Barry, as LP, decide to form an LP. They draft a partnership agreement, create and fund their capital accounts, and begin operations. Subsequently, a business deal goes bad and the partnership is sued. Does Barry retain limited liability as an LP? Unfortunately for Barry, he does not, as the pair failed to register the LP with the state.
The LP, like the general partnership, requires a minimum of two members - a general partner and a limited partner. Unlike the typical general partnership, however, the GP and LP can be something besides an individual person; each could be a person, corporation, perhaps even another partnership. Regardless of the nature of the general and limited partners, constituent members of each organization who will be dealing with the LP must have contractual capacity (meaning being of the majority - typically 18 in most states - and competent to understand the nature of the partnership / contract.)
Ownership and Operation
Ownership of the LP is split between the GP(s) and LP(s). Typically, the ownership of the firm will be spelled out explicitly in the documents governing the firm that are filed with the state. The percentage of ownership is typically based on the size of each partner's capital contribution. Absent such an agreement, ownership of the firm is divided equally.
There is an important rule regarding the operation of the LP that is critical for maintaining the liability shield that this business form offers to the limited partner. The distinction between the GP and the LP is based largely on the role that each party plays in the ongoing management of the firm. The GP has the responsibility of management of the company. Everything from long-term strategy to day-to-day operations is vested in the sole control of the GP. Conversely, the LP is relegated to a position of inactivity. By agreeing to be a limited partner, the LP assigns all rights of control to the GP.
While this may sound unfair, such an arrangement is to the advantage of both parties. The LP, who in the average case is simply an investor in the partnership, is subscribing to the partnership solely on the basis of the reputation and promises of the GP. In other words, the LP becomes a partner, for the most part, simply to take a financial risk on the GP's ability to perform as promised for the business. At the same time, the GP has the benefit of controlling the operations of the partnership itself and is able to make the decisions it deems appropriate without having to answer to each and every individual concern of its investors in the way the business is conducted.
EXAMPLE: Darrel and Donny decide to form an LP and perform all the necessary tasks for proper formation with the state. Darrel is to act as GP of the firm and is to make all business decisions. Donny, as the money man, will act as the LP and provide funding for the firm. Darrel, though he will probably have to consult with Donny from time-to-time about the firm's financial well being and management decisions, is generally free from Donny’s involvement and need not consult with him when he chooses to make certain business decisions.
Liability
Even more important than the daily operations of the firm is the impact that the GP/LP distinction has on the liability of the partners. As was described above, the distinguishing characteristic between the GP and LP, as far as operation of the firm is concerned, is the nature of control of the organization. This factor defines the distribution of liability between the constituent partners.
The law ascribes liability to the control of the GP, who makes all the decisions regarding the operations of the firm and who takes risks with the company’s assets. Ultimately, it is this ability to control that places on the GP liability for those actions. The liability of the GP is unlimited (i.e., not limited to her capital contribution) and is personal in nature (meaning that creditors could attach the GP's personal assets as well as her partnership interests.) In this way, the GP is much like a partner in a general partnership. See Fla. Stat. § 620.125.
On the other hand, LPs, as passive members of the partnership, face only a limited liability for the debts and obligations of the LP. The LP's liability is only to the extent of his or her capital contribution to the firm. Thus, the LP has the benefit of protecting his personal and internal assets while simultaneously garnering the benefits of membership in the partnership.
A note of caution, however, needs to be addressed to LPs. As liability in the LP is a function of control, actions which suggest control on the part of the LP may have dire consequences. In other words, if an LP acts as a GP by in some way controlling the daily or long-term operation of the firm to a degree typical of a GP in a similar partnership, that LP might be said to be exercising a management and control capacity. If a lawsuit or similar action results, the LP may find herself facing the same extent of unlimited liability as the GP if the court infers from the LP's actions that he was, in essence, acting as would a GP.
EXAMPLE: In our example above, with Darrel and Donny’s LP, the situation begins to change over time. Donny, increasingly angered by Darrel’s poor business decisions, begins to base his continued contribution of funds to the LP on whether Darrel accepts Donny's suggestions. Over time, Donny himself begins to source deals and make decisions about the management of the firm. If the LP is subsequently sued, a court may treat Donny as a GP, removing his liability shield, since he has exercised a degree of control in the LP greater than that which is allowed for a LP.
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Taxation
Taxation of an LP is generally identical to that of a general partnership. This means that profits and losses are passed through to both the GP(s) and LP(s) on the basis of the LP agreement. If the agreement does not specify how the tax liability is to be apportioned, the liability will be assessed based on percentage of ownership in the partnership. It is worth noting that in most cases, distributions made by the LP to the partners are at the sole discretion of the general partner. However, in order to create the most tax-beneficial system, the general partner will often consider the tax considerations of the constituent limited partners when allocating and timing losses and profits.
EXAMPLE: Mabel and Marvin’s partnership has been doing great business this year and it has earned huge profits. Mabel, as the GP, would like to keep the funds in the firm in order to provide operating capital for new investments. However, she knows that Marvin, as the LP, has had problems with his other businesses this year and has generated huge losses from those activities. Given this situation, Mabel might choose to make a distribution to Marvin this year, knowing that the tax liability from the partnership’s gains will be offset in Marvin’s tax bill by his other losses.
Capitalization and Fund Raising
Capitalization of an LP is made in the same manner as that of a general partnership. The LP, and frequently the GP, make capital contributions to fund the firm. As additional funds are needed, they may be raised through traditional funding mechanisms, such as banks, or through additional requests for capital (so-called "capital calls") from the LP's.
Liquidity
Both GPs and LPs are empowered with the right to transfer their interests (i.e. capital accounts) in the partnership. See Fla. Stat. § 620.152. The result, while not dissolving the partnership explicitly, is a situation where the new owner of the interest has financial rights in those interests, but does not have the resulting rights of control, and is not, in fact, a partner.
Well, a partner can’t transfer his or her entire transferable interest, or that would be grounds for expulsion. So, the example below, while correct, I think gives the wrong idea about transferring interests, because Ryan sold his entire transferable interest and left.