There are many decisions to make when forming a business, one being the choice of entity. There are many choices available including C Corporations, S Corporations, Limited Liability Corporations, Partnerships, and Limited Partnerships, to name the more popular ones. I recently engaged in a conversation with an entrepreneur who has raised substantial capital from private investors. In the end, the Limited Partnership was the most suitable entity for the new business venture because it allowed them to raise capital from private investors, while providing the investors with limited liability protection.
If one of the major goals is to raise capital to fund the venture without giving up control of the business and without being saddled with considerable start-up debt, a limited partnership will allow the entreprenuer, as the general partner, to manage and operate the business with little intervention from the other partners. In addition, it will enable the entrepreneur to raise equity capital from investors who receive limited partnership interests in exchange for their contributions. As limited partners, they will be able to share in the entity's financial results without having to manage the business or risk personal liability for it.
Care must be exercised to ensure that the limited partners do not inadvertently lose the protection of limited liability by participating in the management of the business. If the limited partner merely consults with you it will probably not result in personal liability as long as you, the general partner, remain the ultimate decision-maker. A limited partner may become personally liable because of his own acts such as guaranteeing a partnership debt.
One drawback to a partnership is that the general partner will be personally liable for the entity's debts. This is the "price" a general partner must pay in exchange for the right to operate and manage the enterprise. The risk of this liability can be minimized somewhat by: (i) creating a corporation to manage the partnership and serve as general partner, and (ii) procuring adequate insurance to cover potential liabilities arising from operation of the business.
Since the partnership is a pass-through entity for tax purposes, each partner must include his share of partnership income, deduction, credit, and loss, on his individual tax return. You should note, however, had we decided to use a "regular" corporation rather than a partnership, the earnings would be taxed at a higher effective tax rate. This is because they would be taxed once when earned by the corporation and again when distributed to shareholders.
With proper planning, the limited partnership can be structured to provide special allocations of various tax benefits that make the venture more attractive to prospective investors. For this reason, a limited partnership is a better choice for your new venture than an S corporation. Special allocations, in order to be respected by the IRS, must have what is known as "substantial economic effect." This is a discussion point that should be addressed by the entrepreneur and the other partners before entering into business together.
Although the formation of a limited partnership generally only requires the filing of a certificate of limited partnership with the state, it is normally a good idea to negotiate and execute a written partnership agreement. As always, check with your CPA on the impact of such decisions as they relate to your personal circumstances.
Required Disclaimer: Pursuant to IRS Circular 230, the Internal Revenue Service requires us to inform you that any tax advice included herein is not intended or written to be used, and it cannot be used by any taxpayer for the purpose of avoiding penalties that may be imposed by the IRS on the taxpayer.