Limited Partnerships Chapter 27 Tools & Techniques of Investment Planning Copyright 2007, The National Underwriter Company 1 What is it? • A specialized form of business organization • An association or combination of one or more “general” partners with at least one or more “limited” partners – Typically, there is a single general partner and a substantial number of limited partners. • In a typical limited partnership, one general partner manages and operates the business – The limited partners contribute capital and share in the profits. – The general partner’s major contribution is in the form of management expertise, not capital. – General partners are personally liable for the debts of the partnership.
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Limited Partnerships Chapter 27Tools & Techniques of
Investment Planning
Copyright 2007, The National Underwriter Company 1
What is it?
• A specialized form of business organization• An association or combination of one or more “general”
partners with at least one or more “limited” partners– Typically, there is a single general partner and a substantial
number of limited partners.
• In a typical limited partnership, one general partner manages and operates the business– The limited partners contribute capital and share in the profits.– The general partner’s major contribution is in the form of
management expertise, not capital.– General partners are personally liable for the debts of the
partnership.
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What is it?
• Limited partners have no liability beyond their contributions of capital to the partnership.– They cannot participate in the management of the enterprise.– Individuals are encouraged to invest without risking more than
the capital they have contributed.
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What is it?
• The death, disability, or withdrawal of a general partner normally dissolves the partnership.– Due to his/her unique role and set of personal responsibilities
in terms of participation in the organization and running of the business.
– The partnership agreement can specify if the partners wish to prevent the partnership from dissolving in this case
– The partners can also agree in writing to substitute a new general partner after the event
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What is it?
• Private Limited Partnerships– Limited partnerships having no more than 35 limited partners– Avoids registration with the U.S. Securities and Exchange
Commission
• Master Limited Partnerships– An investment that combines the tax benefits of a limited
partnership with the liquidity of publicly traded securities
• Public Limited Partnerships– A limited partnership that is registered with the SEC– Offered to the general public through broker/dealers
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What is it?
• Venture Capital Limited Partnerships– Limited partnerships that are formed to invest in small startup
businesses
• A corporation may be formed to serve as the general partner.– Spreads the risk of a general partner
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When is the use of this tool indicated?
• When an investor wants to participate in an enterprise but does not want the responsibility and legal liability of a general partner
• When an individual wants to invest in a business but lacks the knowledge or experience to take an active role in the management of the business
• When an investor has limited capital and desires the investment diversification that a limited partnership can provide
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Advantages
• Limited Liability– Limited partners in a limited partnership are at risk only for the
amount of money they have invested in the business• Similar to the purchase of stock in a publicly-traded corporation
• The general partner has unlimited liability.
• Pooling of Resources– Limited partnerships offer a means by which investors can
combine their resources and achieve a level of diversification and risk reduction that they would not be able to enjoy individually.
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Advantages
• Professional Management– Investing in specialized assets requires a degree of professional
knowledge and experience that most investors do not have.– A limited partnership, employing a qualified general partner, permits
individuals to take advantage of a wider range of investment opportunities than they might be willing to consider on a personal basis.
the cash flows of their investment.• Proportionate to their share of the partnership• Taxable to the limited partners as ordinary income
– The general partner will frequently earn a reduced fee until the limited partners have recovered their initial investment.
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Advantages
• Capital Gain Potential– Appreciation of the partnership’s assets– Provides an additional source of return for limited partnership
investors– Capital gains are typically shared with the general partner
according to a clearly defined formula in the partnership agreement.
• Leverage– The use of borrowed funds to finance a significant part of the
limited partnership’s investments can add significantly to the returns earned by the limited partners.
– The partnership may be able to borrow more than any single individual.
– Can also increase the risk of the investment as well
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Disadvantages
• Lack of Control– Limited partners must rely on the management abilities,
experience, and ethics of the general partner.– Terminating the general manager and/or selling their interests in the
partnership may require lengthy and expensive legal procedures.
• Lack of Ready Marketability– An interest in a limited partnership may be difficult to sell or
liquidate.– Some arrangements allow for investors to offer their interest for
sale to other partners (or the general partner)• There is no guarantee that others will be interested in buying it.• In some states, limited partnership interest may not be salable prior to
dissolution of the partnership.– Master Limited Partnership (MLP)
• Publicly traded limited partnership
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Disadvantages
• Leverage– Both potential gains and potential losses for limited partners are
magnified when borrowed funds are used to finance the partnership.
– Limited partners may be liable for their proportionate share of any loans taken out in the name of the partnership.
• Investment Suitability– Limited partnerships tend to be relatively risky investments and
can be highly illiquid.• Not suitable for the average investor
– Limited partnerships often restrict potential investors to:• Persons with a certain level of income, wealth, or both
• Persons subject to a certain federal income tax bracket
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Tax Implications
• Limited partnerships may be taxed either as corporations or partnerships.– If it is a publicly-traded partnership:
• It will be taxed as a corporation• The owners of the limited partnership interests will be taxed as if they were
holding stock in a corporation.
– A limited partnership that is not treated as a corporation for tax purposes is treated as a “pass-through” entity.
• The income (or loss) of the limited partnership “passes-through” to the general and limited partners.
• Generally the partnership agreement determines how the income or loss is allocated among the general and limited partners.
• Usually, the partnership agreement will provide for allocations to the limited partners until their contribution to the limited partnership is recovered.
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Tax Implications
• Loss limitations may apply to partners in one of three ways:– The partner’s basis in the partnership– The at-risk rules– The passive loss limitation
• Almost by definition, an investor in a limited partnership is engaging in a passive activity.– The generic definition of a passive activity is one in which the
investor does not “materially participate” in its management or activity.
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Tax Implications
• A partner’s basis is generally the amount that was paid for the partnership interest, with adjustments.– Increased by:
• Any further contributions to the partnership• His/her distributive share of taxable income, tax-exempt income, and the
excess of the deductions for depletion over the basis of the property subject to the depletion
– Reduced by:• Distributions from the partnership• His/her distributive share of losses the partnership may suffer
• A limited partner may not deduct partnership losses in excess of his basis in the limited partnership as of the end of the year.– Any excess losses may be carried forward to future years.
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Alternatives
• Real Estate Investment Trusts (REITs)– Operate as publicly-traded, closed-end investment companies– In the real estate area, they generally own and operate a
diverse portfolio of investments that may include assets such as shopping centers, apartment complexes, and construction loans.
– Offer certain tax advantages and benefits of limited liability similar to limited partnerships
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Alternatives
• Mutual Funds– Offer many of the same advantages of limited partnerships,
including:• Diversification• Professional management• Tax benefits
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Where and How do I get it?
• Financial newspapers and major daily newspapers regularly carry announcements concerning limited partnerships– Wall Street Journal– Barron’s– New York Times
• Securities and Exchange Commission (SEC)– Provides information on large-scale master limited partnerships
or publicly-traded limited partnerships
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Where and How do I get it?
• Stockbrokers and other licensed security dealers– Sell publicly-traded partnerships– Potential investors must be given a copy of the partnership’s
prospectus with information such as financial data, management information, transaction costs, and legal costs associated with the offering.
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What fees or other costs are involved?
• An individual who purchases an interest in a limited partnership can expect to pay the promoters of the partnership:– A sales commission– Legal fees– Management fees
• The charges should be carefully spelled out in the partnership agreement.
• Some limited partnerships are structured so that a large proportion of their gains go to the management and the general partners.– Rather than to the limited partners
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How do I select the best of its type?
• Nature of the Investment– Limited partnerships are formed to invest in a wide range of
business fields with varying degrees of risk.• Common areas include real estate, energy resources, and
equipment leasing
– An investor should be familiar and personally comfortable with the types of investments that the partnership has made in the past and plans to make in the future.
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How do I select the best of its type?
• Partnership Terms and Conditions– A careful reading of the partnership agreement is essential.
• If needed, the investor should rely on legal and accounting expertise.
– Critical factors that must be specified in detail and understood by all parties:
• The relationship between the general partner and the limited partners
• The purpose of the partnership
• How and when payments are to be made
• How cash is to be handled
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How do I select the best of its type?
• Track Record of the General Partner– The real success or failure of the enterprise depends almost
exclusively on the skills and expertise of the general partner.• Limited partners are passive investors who only contribute funds to
the partnership
– Every investor should be familiar with:• The general partner’s background
• His ability to engage in the proposed business activities
• His prior experience in similar partnership arrangements
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Where can I find out more about it?
• There is very little information available to potential investors beyond the partnership agreement itself.– Due to the unique nature of each limited partnership– Particularly true when the general partner is an individual
• Investors can ask:– To see the partnership agreements and financial records of the
general partner’s previous operations– For both personal and bank references– To be put in contact with investors in previous limited
partnerships operated by the general partner
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Where can I find out more about it?
• Information on master limited partnerships or publicly-traded partnerships can be obtained from the SEC or the exchange where shares in the partnership may be traded.
