Section 6.2: Partnerships & Limited Partnerships

  • A partnership is a business organization where two or more people share management responsibilities and profits.

  • Key Tax Principle

    • Partnerships are tax-reporting entities, not tax-paying entities.

    • The partnership files an information return with the IRS, showing:

      • Total profits and losses

      • Each partner’s share

    • Each partner reports their share of the income or loss on their individual tax return and pays income tax accordingly.

  • Types of Partnerships

    • General Partnership (GP)

    • Limited Partnership (LP)

1. General Partnership (GP):

  • Definition:

    • All partners share management duties, profits, and losses.

  • Key Characteristics

    • All partners are general partners

    • All have management authority (specific duties may be in the partnership agreement)

    • Ownership can be equal or unequal, as defined in the partnership agreement

    • Profits/losses distributed in proportion to ownership

    • Unlimited liability: Partners are personally liable for business debts and lawsuits

    • Partners may be personally sued for actions of the partnership

GP & LP

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GP & LP 〰️

2. Limited Partnership (LP)

  • Definition:

    • A business with at least one general partner and one or more limited partners.

Role / General Partner (GP) / Limited Partner (LP)

  • Management Role / Manages day-to-day operations / Passive investor; no management role

  • Liability / Unlimited personal liability / Limited to amount invested

  • Tax Treatment / Reports income/losses on personal return / Reports passive income/loss

  • If Participates in Management / Normal operations / Loses liability protection

  • Income Type / Active income / Passive income

Limited Partnership (LP) as a Direct Participation Program (DPP):

  • LPs are often referred to as Direct Participation Programs (DPPs) because investors directly participate in the results (income, losses, tax benefits).

  • Ways LPs Are Sold

    • Private Placements

      • Offered to a small group of wealthy investors

      • Each contributes a large amount of money

      • Disclosure document: Private Placement Memorandum

    • Public Offerings

      • Offered to many investors

      • Each contributes a smaller amount

      • Disclosure document: Prospectus

Common Industries for LPs:

  • Real Estate

  • Energy (Oil & Gas)

  • Equipment Leasing

    • These programs often experience initial losses, which pass through to investors and may offset other passive income from other programs.

Tax Treatment of LPs:

  • LPs are tax-reporting, not tax-paying entities

  • Profits and losses flow through to investors’ tax returns

  • Investors may use passive losses to offset passive income, but not ordinary income

  • Passive Income and Loss Rules

    • Passive Income: Earnings from an LP (part of ordinary income)

    • Passive Loss: Losses from an LP (can offset only passive income, not active or portfolio income)

Depreciation and Cash Flow Example

Description / Amount

  • Revenue / $300,000

  • Maintenance / -$50,000

  • Loan Investment / -$70,000

  • Operations / -$160,000

  • Depreciation / -$50,000

  • Profit/Loss (for taxes) / -$30,000

Since depreciation is not an actual cash expense:

Cash Flow = Profit/Loss + Depreciation
Cash Flow = -$30,000 + $50,000 = $20,000

If an investor owns 10%, they would record:

  • $3,000 passive loss (for tax purposes)

  • But would still receive cash distributions, since the partnership had positive cash flow

Liquidation of an LP:

If dissolved (at predetermined date or earlier), proceeds are distributed in this order:

  1. Secured lenders

  2. Other creditors

  3. Limited partners:

    • First, claims to profits

    • Then, return of capital contributed

  4. General partners

Risks of Limited Partnerships:

  • Liquidity Risk

    • LP interests are illiquid

    • Transfers require GP approval

    • Investors should expect to hold until dissolution

  • Audit and Tax Recapture Risk

    • If the IRS disallows a tax deduction (like depreciation), limited partners may face:

      • Increased taxable income

      • Back taxes, penalties, and interest

    • Example:

      • IRS disallows $30,000 depreciation → investors must pay taxes on that $30,000 plus penalties.

Benefits of Investing in LPs:

  • Managed by general partners (no need for investor involvement)

  • Limited liability (for LPs only)

  • Pass-through taxation (income/losses flow through)

  • Tax advantages via depreciation and depletion deductions

Next Section

✺ Review questions ✺

  • A tax-reporting entity, but not a tax-paying entity.

  • The general partners manage the business.

  • They lose their limited liability protection and may become personally liable.

    • Private LPs involve few wealthy investors (large contributions, private placement memorandum)

    • Public LPs involve many small investors (smaller contributions, prospectus)

    • Secured lenders

    • Other creditors

    • Limited partners (profits, then capital)

    • General partners

  • Passive income and passive losses

  • No – they can only offset other passive income

  • Liquidity risk and IRS audit/tax benefit recapture risk

  • $20,000

  • $3,000