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Editorial 7 MIN READ

The limited partnership in 2017: old form, specific jobs

Why real estate syndications and private-equity funds still use a century-old structure the rest of the market has mostly left behind

The Editors
Staff, Incorporator.org
7 min read Updated
Contents 5 sections
  1. The statute, in two flavors
  2. The general-partner problem
  3. Federal tax: Subchapter K, and why that is load-bearing
  4. Why real estate and private equity have not left
  5. Sources

limited partnership has one partner on the hook for everything and the rest of the partners on the hook for nothing beyond what they put in. That asymmetry, written into American statute books since 1916, is the reason the form exists. It is also the reason almost no one forms one today unless they are raising a fund or syndicating real estate.

This is a working guide to the LP in early 2017: what the statute says, how the tax treatment runs, and why the two remaining natural habitats for the form have not migrated to the LLC.

The statute, in two flavors

Most states follow a version of the Uniform Limited Partnership Act. The current model is ULPA (2001), last amended in 2013, and by early 2017 it has been enacted in roughly twenty states and the District of Columbia, including California, Florida, Illinois, Iowa, Hawaii, Kentucky, Minnesota, Nevada, Washington, and New Mexico. The rest are on an older Revised ULPA (1976/1985) vintage, with Delaware running its own non-uniform statute.

The Delaware statute is the one that matters if you are forming a fund, because most sponsors form there. It is codified at 6 Del. C. Chapter 17 and is formally titled the "Delaware Revised Uniform Limited Partnership Act" by § 17-1102. Formation is a two-page job: under § 17-201 you file a Certificate of Limited Partnership with the Division of Corporations, listing the name of the partnership, the registered office and registered agent in Delaware, and the name and business address of each general partner. That is it. The partnership agreement — the document that actually runs the thing — is private and is never filed.

The filing fee for the Certificate is $200. The annual LP tax is $300, due June 1 every year, with a $200 penalty and 1.5% monthly interest for late payment. There is no proration for formation mid-year. These are the same mechanics Delaware applies to its LLCs, which is not a coincidence: the Division of Corporations runs them through the same back office.

The general-partner problem

Section 17-403(b) of the Delaware statute says the general partner has "the liabilities of a partner" under Delaware's partnership law — which is to say, unlimited personal liability for partnership debts. The limited partners, under § 17-303(a), are liable for partnership obligations only if they are "also a general partner" or, in participation by a limited partner, "the limited partner participates in the control of the business."

Delaware's version of the control rule is narrow. Section 17-303(b) lists a long safe harbor: a limited partner can consult with the general partner, act as a contractor or employee of the partnership, serve on a committee, guarantee partnership debt, and vote on major matters — dissolution, sale of substantially all assets, incurring debt, admission or removal of partners, amendments — without losing the shield. The frequency of those activities does not matter either (§ 17-303(f)). In practice, a Delaware LP's control rule bites only when a limited partner holds itself out as a general partner to a third party who reasonably relies on that representation.

ULPA (2001) went further and abolished the control rule outright. In adopting states, a limited partner has a status-based shield regardless of participation in management — which brings LPs into rough parity with LLC members and corporate shareholders. The practical effect in either statute is the same for a passive investor: the limited partner's downside is capped at committed capital.

The remaining exposure is at the GP level, and it is the reason almost every serious fund general partner is an LLC rather than a person. The GP entity eats the unlimited-liability role on paper; the individual principals sit behind that LLC's own shield. Most states also let an LP elect to be a "limited liability limited partnership" so the general partner gets an LLP-style liability shield of its own. Delaware codifies that election at 6 Del. C. § 17-214. The typical private fund does not use it, because the GP is already a separate LLC and the layering suffices.

Federal tax: Subchapter K, and why that is load-bearing

A partnership does not pay federal income tax. IRC § 701 — the first section of Subchapter K — says it directly: "A partnership as such shall not be subject to the income tax imposed by this chapter. Persons carrying on business as partners shall be liable for income tax only in their separate or individual capacities." The partnership files an information return on Form 1065 and issues each partner a Schedule K-1 showing that partner's distributive share of income, gain, loss, deduction, and credit.

For the LP form specifically, three features of Subchapter K are the reason it survives. First, partnerships can make special allocations under IRC § 704(b), as long as those allocations have substantial economic effect. That is the statutory hook that makes the waterfall and promote economics of a private-equity fund actually work: carried-interest allocations, preferred returns, catch-up tranches, and clawbacks all depend on § 704(b) flexibility that S-corporations do not have. Second, capital-account accounting — the mechanics under Treas. Reg. § 1.704-1(b) — is the native language of the fund-accounting world. LPs have been tracking partners' capital accounts on this basis for decades; the industry's back offices, auditors, and software are built around it. Third, a partner's share of recourse and nonrecourse partnership debt is included in that partner's outside basis under IRC § 752, which lets real estate investors deduct depreciation and losses beyond their cash contribution in a way a corporate form cannot replicate.

Limited partners also generally escape self-employment tax on their distributive share under IRC § 1402(a)(13), though this is less settled than the industry assumes and has been the subject of ongoing Tax Court attention.

Why real estate and private equity have not left

Real estate syndications use the LP for the same reason they used it in the 1970s: the sponsor takes an active role and bears the exposure, the investors are genuinely passive and want to be, and the § 752 debt-basis rules matter in a way they do not for a software company. An LLC could do the job, and in many single-property deals it does. But the LP is the familiar vocabulary — "general partner" and "limited partner" carry a precise meaning to every real-estate lawyer and every seasoned investor — and the statutory separation of control from capital is a feature rather than an accident.

Private-equity and venture funds use the LP because their limited partners — pension plans, endowments, sovereign funds, family offices — have decades of internal policy and tax machinery built around the LP form. ERISA plan-asset analysis, UBTI blocker structuring, state-by-state unitary-tax treatment, non-U.S. investor withholding — all of it assumes a partnership. Switching to an LLC would not change the substance (an LLC taxed as a partnership runs on the same Subchapter K), but it would invite questions from every LP's counsel that the fund sponsor has no interest in answering. The LP is the Schelling point.

What the LP is not good for, in 2017, is a normal operating business. If two people are starting a firm together and both will work in it, the GP's unlimited-liability role is a liability the LLC does not impose. If one person runs the business and the other is a passive investor, that economic arrangement is better expressed in an LLC's operating agreement with a non-managing member class. The LP's remaining advantage — the Subchapter K flexibility — the LLC already has.

The form survives because of where it is embedded, not because it is the right answer. If you are forming one this quarter, you almost certainly know why. If you are considering one and you are not in real estate or fund management, the default answer is no.

Sources

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