Limited partnerships can be a very effective entity when used properly although they have specific rules, regulations and require tax treatment that is specific as well. In general terms, a limited partnership is an entity that allows an organization to take on “partners” who have a limited amount of liability for the financial state of the organization.
A limited partnership has two separate classes of partners within the organization. General partners manage the organization and have complete authorization and authority to make decisions as they see fit. However, they also carry complete personal liability for the activities and financial state of the partnership entity.
Limited partners have a limited amount of personal liability for the finances of the partnership and it is restricted to the amount of their total investment. Furthermore, limited partners are not allowed by law to have any participation in management or control over the partnership entity.
A general partner is allowed to be either an individual person or it may also be a corporation. A very common structure for many limited partnerships is having silent partners who are the limited partners that only provide financing requirements. The entity then also has one or more general partners that take the responsibility of utilizing the financing to carry out the daily management and activities of the partnership in whatever venture it is committed to. This allows the profits or gains of the partnership to be passed onto the limited partners while their liability remains limited and they have no involvement in the management activities.
Operating agreements are often a requirement for limited partnerships and almost always they are in writing. The operating agreements are similar to the agreements for general partnerships except they also contain a specific set of rules, stipulations and agreements between the partners that tend to be more complicated than most general partnership agreements.
Because of the potential complications involved with the operating agreements and relationships of the partnership members, it is common for the initial and ongoing legal costs to be higher or limited partnerships. Additionally, depending on what type of activity the entity is involved with, they are many times overseen by several securities governing authorities and the laws that apply to investment and securities related businesses.
In some cases, a limited partner may be classified as a passive investor by the IRS. In these cases, they may be liable for taxes that are specific limited partnership activities and these can many times affect other potential tax advantages. The IRS makes these determinations on an entity by entity basis according to a wide array of regulations that are specific to the type of business or investment the limited partnership is involved with.
However, regardless of how the limited partners are classified, Form 1065 must be filed every year by each limited partnership. This form is separate from the personal tax filing of general and limited partners, as they file information about income and shares involved with the partnership on their personal annual tax returns. There can be some exceptions to this in the case of real estate limited partnerships which has their own specific set of regulations they must adhere to.
Provisions included in the Tax Reform Act of 1986 put limits on the total amount of losses that a limited partner may deduct each tax year. These limits are still in place in 2015 and what is and is not allowed depend heavily on the exact structure of your personal situation and the limited partnership itself. If you are anticipating consistent losses from involvement in a limited partnership it is best to get the help of a CPA or automated tax preparation software to help you determine what you may deduct for the year.
The tax regulations, particularly for limited partnerships involved in complex investments, can be extremely detailed and complicated. The specifics on what you will be allowed to deduct and at what rate any gain or income is taxed will be directly connected with all the other factors involved with your tax and financial situation.