Limited partnership tax treatment is similar to that of a general partnership, wherein business profits and losses pass through to the partners, who include their share of profits and losses in their personal tax returns. However, the existence of limited partners in a partnership firm does have an impact on the individual tax liability of partners.

What Is a Limited Partnership?

  • A limited partnership (LP) is just like a general partnership, except for the fact that it has at least one limited or passive partner who does not actively participate in business operations.
  • The general partners look after the day-to-day functioning of the business, whereas the interest of the passive partners is limited only to the extent of their share in business profits (and losses).
  • For the purpose of federal taxes, the IRS does not distinguish between a limited partnership and a general partnership; both are treated as pass-through entities.

Pass-Through Taxation

  • A limited partnership is a pass-through entity. The partners report the profits and losses of the business in their individual tax returns.
  • Business profits (or losses) are distributed among the partners in the ratio of their ownership percentage. For example, if there are two partners holding an ownership of 30 percent and 70 percent and the business makes a profit of $100,000 in a given year, then the partners will receive $30,000 and $70,000 respectively as their share in profits.
  • However, a limited partnership can also opt for special allocation through its operating agreement. Its members may agree to distribute the profits in a ratio different from the ownership interest.

Limited Partnership Tax Benefits

Since a limited partnership is a flow-through entity, it does not have to pay taxes on its own. The business profits are distributed among the partners, who then include the income they receive in their personal tax returns. They may pay normal income tax on some portion of the income, while some portion may be taxed as capital gain. Some portion of income may even qualify for tax exemption such as when it's considered as a return of capital investment.

However, it's pertinent to note that the income received by limited partners is a passive income. So, their share in business losses can be set off only against other passive income.

If we look at the tax treatment of a corporation, it directly pays income tax on the business profits it earns. When it distributes the profits as dividends, the shareholders again pay taxes on the dividends they receive. This results in double taxation. Thus, unlike in case of corporation, the income of a limited partnership is taxed only once; there is no double taxation.

Similarly, when a corporation incurs a loss in a particular year, its members cannot get any tax benefit out of it. In fact, it may hurt them through a drop in stock prices. However, in the case of a limited partnership, the partners can set off the loss against other passive income and carry forward the excess loss to the next year.

Although a partnership firm does not have to pay taxes, it must file an informational return in Form 1065, listing out the profits and losses and the distributions made to each of the partners in a given year. The IRS uses this return to prevent tax evasion by individual partners.

Passive Income and Losses

Earlier on, limited partners were allowed to deduct their share of business losses from other income. This resulted in making limited partnerships as tax havens, since limited partners often deducted losses as high as 10 times the amount of their investment. Hence, in 1986, the Taxpayer Relief Act came up with a restriction that passive losses from limited partnership can be set off only against other passive income.

Active income includes salaries, wages, and commissions, where you need to participate in the business activities to earn the income. A business investment is considered as passive if the investor does not participate in the business operations. However, profits from some passive-looking investment activities may not be classified as passive income. For example, profits from shares and securities are treated as portfolio income and not as passive income.

The major difference between a limited partner and a corporate investor is that a limited partner is not just an investor; although he does not directly participate in the business operations, he has much more interest in them than a corporate investor would have in the operations of the company.

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