You may be fully invested with passive income.
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Understanding the nuanced world of partnerships and how they work can be a bit overwhelming, even if youâre a sophisticated investor and business person.
After all, thatâs why you pay your attorney and accountant. Still, although you might rely on financial professionals to help you navigate the nuances, if youâre involved in a business or investmentâincluding an alternative investment fundâwith general and limited partners, you should understand the basics, such as the limits of your risk and how your profits and losses might be taxed.
Key Points
- The type of partnership structure you choose will determine each partyâs rights, obligations, and liabilities.
- Tax treatment is a major factor in your choice of business structure.
- Another important distinction is whether your income is classified as passive or nonpassive.
Partnerships you might start as a new business
If youâre looking to start a new business venture, itâs often beneficial to take on a partner whose skills or assets can complement what you bring to the table.
Steve Jobs and Steve Wozniak began working together out of a garage and eventually founded Apple Inc. Although the company and their roles would change over time, from the start Mr. Wozniak was the technical guru and product guy, and Mr. Jobs was the âbusinessâ guy. No doubt there was overlap among their talents, and each would have been successful in his own right. But working together allowed them to focus on what they did best, and created the synergy and foundation for one of the incredible stories of American industry.
Of course, partnerships are also useful to everyday businesses and professional practices as well.
Professional services firms such as attorneys and CPAs may benefit from sharing overhead expenses, extended coverage for clients, and offering complementary services within a practice. Some businesses that require extensive machinery and equipment, such as landscaping or a tool and die shop, may take on partners for investment and working capital.
The nature of the business and the relationship of the partners will determine the type of partnership you form. Hereâs an overview of partnerships and LLCs:
- General partnership (GP). A general partnership is formed when two or more people work together to run a business. A general partnership is not recognized at the state level because itâs not a business organization, so no paperwork is needed. Each general partner is liable for the work performed by the business, including any losses over and above its assets.
- Limited partnership (LP). Limited partnerships are businesses in which one or more partners (called general partners) have all the risk in the business and the other partners (called limited partners) have limited liability. This type of business is regulated by state law.
- Limited liability partnerships (LLP). This partnership is structured such that all partners have limited liability. Only some states allow formation of LLPs. Typically, LLPs must comprise groups of professionals requiring licensing, such as accountants, doctors, or lawyers. Note that an LLP does not save its partners from personal liability in the case of negligence (such as malpractice). If the business goes bankrupt, though, the partners are not liable.
- Limited liability company (LLC). An even more specific type of limited liability partnership is a limited liability company (LLC), which is a structure formed at the state level. Owners of an LLC are called âmembersâ rather than partners. There is no personal liability to any member in an LLC, except in the case of their own personal negligence. Some states do not allow professionals requiring licensing to form LLCs. An LLC is treated as a partnership for federal tax purposes unless it files specific paperwork to be taxed as a corporation.
Partnerships you might invest in
If you invest in a partnership, you will often do so as a limited partner of a limited partnership (LP).
Alternative investments such as hedge funds, private equity, and real estate syndications (i.e., investment pools) are often structured as limited partnerships in which an investment company serves as a sponsor and general partner. The general partner will be responsible for the financing and operations of the business and assumes liability for all debts and other risks.
As a limited partner you are considered a passive investor. Youâll have no voting (or managerial) rights, but youâll also have no liability exposure beyond your investment.
As a limited partner, your investment will be âlocked upâ and unavailable for withdrawal for up to five years (or longer). You may receive payments over time that represent a partial return of investment or distribution of income, but these investments require long-term horizons.
Tax treatment for general and limited partners
Partnerships (whether they be GP, LP, LLP, or LLC) are not taxed directly. Instead, the income and expenses of the partnership are âpassed throughâ to the individual partners (or members) based on their ownership percentage. The partners are taxed at their appropriate individual tax rate.
As a general or limited partner, youâll receive a K-1 form reporting your share of income and expenses. Youâll include this information on your personal income tax return via the Schedule E, which flows to Schedule 1 and ultimately to Line 8 on the Form 1040.
Watch out: Your fund might be issuing a K-1 rather than a 1099
Did you know that a few exchange-traded funds (ETFs)âthose that use futures contracts as part of a commodity investment, for exampleâare actually structured as limited partnerships? Although you still enjoy the liquidity of an ETF (they are listed on exchanges and can be traded whenever the market is open), you wonât be receiving a 1099 at the end of the old tax year.
Instead, youâll receive a K-1. But because K-1s arenât distributed until mid-March, make sure you donât file too early in the tax season. No one wants to file a corrected return.
An important distinction of your K-1 income is whether itâs classified as passive or nonpassive.
If youâre a general partner or otherwise actively involved in the business, your income (or loss) will likely be deemed nonpassive, allowing you to deduct reported losses against all other income. Nonpassive income will also be subject to the self-employment tax.
If you are a limited partner, your income (or loss) will be classified as passive. Passive losses are deducted against passive income (losses that canât be used may be carried forward). Passive income is not subject to self-employment taxes.
IRS rules regarding exactly what constitutes material participation get a bit technical. They are laid out in IRS Publication 925, Passive Activity and At-Risk Rules.
Qualified business income (QBI) deduction
As of 2018, business income through a sole proprietorship, LLC, LLP, or S corporation is eligible for the qualified business income deduction (QBI). The QBI is the lesser of 20% of your qualified business income or 20% of your taxable income. Currently the QBI is set to sunset on December 31, 2025, when it will no longer be in effect.
LP, LLP, GP, LLC, general partner, member, limited partnerâit can all get pretty confusing, pretty quickly.
The important thing to remember is that if you start a business with a partner, and you run the operation, your share of the income (or loss) will be deemed nonpassive. Depending on your partnership structure, you may have limited personal liability, but you may still be liable for malpractice, particularly in a LLP or LLC.
As an investor, youâll likely be a limited partner in a limited partnership. Your income will be passive; youâll have no voting or managerial rights, and no liability.
This article was most recently revised and updated by Ted BarnhartThis article was most recently revised and updated by Nancy Ashburn
