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1 What is the difference between a limited partnership and a limited liability limited partnership?Limited partners in a limited partnership do not participate in management, whereas those in a limited liability limited partnership do.General partners in a limited liability limited partnership have limited personal liability.All the partners in a limited liability limited partnership have more protection from the liabilities of the partnership than in a limited partnership.Limited partners in a limited liability limited partnership have limited personal liability.
Layers of taxation
From a tax perspective, the primary benefit of forming as a partnership (or an LLC treated as a partnership) rather than a corporation is that partnership income is subject to only one layer of taxation at the federal level.4 Partnership income is allocated to the partners each year and taxed on their returns. It is important to note that partners must pay tax on their shares of partnership income whether or not that income is distributed to them. Indeed, because partnership or LLC income is taxed to the partners or investors as it is earned by the entity, subsequent distributions of that income are tax-free. This scheme is quite unlike the corporate tax system in which corporate income is taxed at the corporate level, and subsequent distributions of that income are taxed again to the shareholders as dividend income.
Dawn is a one-half partner in Sunrise Partnership. This year, the partnership reported taxable income of $100,000, of which Dawn's share was $50,000. The partnership made monthly distributions to Dawn of $2,000 ($24,000 total). When Dawn files her individual tax return for the current year, she will include her $50,000 share of the partnership's income (on Schedule E of her Form 1040). The distributions will not affect her taxable income. Therefore, her involvement with the partnership will increase her taxable income by her full $50,000 share of partnership income, even though only $24,000 of this income was distributed to her during the year. In effect, the remaining $26,000 of undistributed taxable income has been reinvested by Dawn in the partnership's business activities.
Losses also flow through to the partners and can be deducted by them on their own tax returns. Again, this is a departure from the corporate tax scheme, in which losses can be carried forward to offset future corporate income but provide no tax benefits until actually offset against positive corporate taxable income. In contrast, partnership losses are reported by the partners on their own tax returns, and if deductible, provide immediate tax benefits in the form of a reduced tax burden on the partners' other income in the year of the loss.
Robert is an attorney with current-year income from his law practice of $175,000. In addition, he owns a 25% general partnership interest in an oil and gas partnership. The oil and gas partnership drilled a number of dry holes this year and reported a net taxable loss of ($200,000). Robert's one-fourth share of this loss is ($50,000). Assuming his share of the loss is fully deductible, and that he is in the 35% tax bracket this year, the loss will reduce his current-year tax liability by $17,500 ($50,000 × 0.35). He does not have to carry the loss forward to be offset against partnership income which may be reported in a future year. Rather, he can deduct the loss this year against his other business or personal income. As a result, he receives the full benefit of the partnership loss in the current year, when the loss was actually incurred.
Flexibility
Another important advantage of the partnership and LLC form of business is its flexibility. Unlike the corporate form of organization, in which each share of stock (within classes) must provide for its owner an identical interest in the corporation's assets and income, investors in a partnership or LLC can share in entity assets, or entity income, in any way they see fit. Investors' interests in different partnership assets or activities may differ, and these differences may change from one year to the next.
J, D, and R are individual general partners in an oil and gas drilling partnership. The partners each own one-third of the first well drilled by the partnership, which was successful. However, when D and R wanted to invest a portion of the income from well 1 to drill an additional well on an adjacent property, J opted not to participate. As a result, he or she has no interest in the second well, or in any income generated by that well. That is, J has a one-third interest in the first well and zero interest in the second one. D and R each have one-third interests in the first well, and one-half interests in the second well. If the partners decide to drill a third well, they may have still different interests in that well. They might even decide to bring in another partner to the partnership to participate in drilling the third well, and the new partner may or may not be allowed to share in the profits associated with the first two wells. Each partner's share of partnership profit or loss in each property will be governed by the partnership agreement signed by all the partners. This agreement can be changed with the consent of the partners, and the sharing ratios of the partners can be revised after the fact. This degree of flexibility would be very difficult to obtain if the company had been organized as a corporation and would not be possible at all if the corporation opted to be taxed as an S corporation.5
Similarly, a partnership or an LLC may allow its investors to share differently in the risks and rewards of entity operations. Investors with varying tastes for risk may be willing to assume a greater portion of the risk of losses, while sharing profits in accordance with their contributions to capital. One partner, for example, may be willing to be allocated 50% of partnership losses, while sharing in only 33% of partnership profits. Partnerships or LLCs offer complete flexibility to the partners to enter into these kinds of arrangements. The result is that it is often easier to bring investors with different backgrounds together into a partnership or LLC than in other forms of organization.
Lynn owns a large tract of ranch land that she would like to develop into a dude ranch. Unfortunately, she does not have sufficient cash resources to develop the property herself, and she cannot obtain bank financing with favorable terms. She decides to approach the owner of a dude ranch in another state whom she met while on vacation last year. The other ranch owner is interested but is a little wary about investing in an area with which he is unfamiliar. Lynn, however, is confident that a dude ranch on her property would be successful. She is so confident that the venture will succeed that she offers to bear 75% of the risk of loss, while taking only 50% of the profits from the venture, if the other partner will invest the $250,000 needed for improvements to make the dude ranch operable. Assume the other partner makes the necessary investment, and that the dude ranch loses ($50,000) in its first year of operations. Lynn will be allocated 75% of this loss, or ($37,500). Her partner will bear only ($12,500) of the loss. If the dude ranch turns around in its second year, and generates taxable income of $40,000, Lynn's share of the second-year profit will be $20,000 (50%). Therefore, although the partnership's net profit or loss for the two-year period is ($10,000), Lynn has been allocated a loss of ($17,500) [$37,500 - $20,000], whereas her partner has been allocated profits of $7,500 [$20,000 second-year profit less ($12,500) first- year loss]. Lynn is indeed assuming a much larger portion of the risk of loss from their joint activities than is her partner.
