Choice of Partnership Equity

Choice of Partnership Equity

Some people looked at the previous post, and said “Wow, that seems to be right for me!” You might be wondering what is the next step?


Before going on to the next step, allow me to say a couple of things. 1) Before deciding that this is a good choice for you, please read up on the corporations blog post. You might find that it is a better fit for you. 2) Before you run out and set up an organization, please, please, please, please contact your CPA, EA or attorney. I cannot emphasize this enough. There are multiple tax consequences to forming a partnership and many that are not tax consequences. Only a CPA, EA or attorney will be able to tell you what is the right fit for your specific situation.


Now for general information, I have provided the following descriptions of different entities, which qualify for partnership treatment. The most important thing to remember is that there are state and federal considerations of each of the following. I am only going to discuss the federal consideration as that focuses on the taxation of the entity, but each state is different. Again, consult with your CPA, EA or attorney for more information.


General Partnership


General partnerships are the most vanilla form of partnership. In a previous blog post, I discussed that joint ventures can be formed through unintentional or intentional actions. According to IRS regulations, a partnership is “a business entity that is not a corporation under paragraph (b) of this section and that has at least two members.” [1] Section (b) defines what a corporation is and that will be discussed in a later blog post.


In a General Partnership, partners are responsible for all liabilities assumed by the partnership (except as a matter of law), and each general partner can bind the partnership into agreements. They are also subject to unlimited liability.


If the previous paragraph does not give you reason enough to be concerned, you should be. Liability is a primary concern in a business as if you are responsible for all debts and liabilities, and the partnership cannot pay, debtors can come and sue you personally for your personal assets, including, but not limited to, your home, your car, your golf cart, your motorcycle, livestock (if you own any), jewelry, even your kid’s bicycle (again, subject to state legal limitations).


If the previous paragraph did not spell it out, I am not a fan of individuals using the General Partnership format. Is there a time that this will be a good fit? Sure, but again, talk to your CPA, EA or attorney about this before you execute it.


Limited Partnerships


Prior to the advent of LLCs and LLPs, discussed later, Limited Partnerships were good vehicles for real estate partnerships, where one partner wants to limit their involvement. Good example of this is that you decide to leave the military and get into real estate investment, because you used to do building management in the US Navy (Army, Air Force or Marines, not to leave anyone out). You found the building, but you have no money. You have Uncle Ed (Good ‘ole Uncle Ed), who thinks of you as a hero for your time in the military and he loves bragging about your service. Uncle Ed is rich (not Hilton, rich, but gives your Aunt an Aston Martin for Valentine’s Day, rich). Uncle Ed agrees to invest $250,000 into the building, but does not want any additional liability, nor any participation in the building. You both become 50/50 partners, but he is a limited partner.


The good: Uncle Ed is afforded some protection in his liability (state laws apply). You can do all of the work and take a salary, referred to as a Guaranteed Payment, the rest can go 50/50. You don’t have to worry about Uncle Ed coming in and risking the partnership by signing some agreement that is bad for the partnership, because he is limited.


The bad: while Uncle Ed is limited, you aren’t! Someone slips and falls on the nice, new marble floors (they looked nice, but not so nice when wet), and they sue the partnership for the medical bills, Ed’s liability is limited to his investment. If that does not cover it, you could be on the hook for the rest.


This vehicle was a good deal, especially when there are lots of limited partners. You could have one general partner and 300 limited partners, for example. Now, you can have people invest smaller amounts ($10,000 for instance), but pooled together, major real estate investments deals could be possible (3 million dollars could buy a lot of real estate). Nowadays though, with the advent of LLPs and LLCs, this is less often used.


Limited Liability Partnerships (LLP)/Limited Liability Companies (LLC)


In my opinion, LLPs and LLCs have been the biggest thing to hit since the advent of the corporation! Since the IRS granted LLCs partnership treatment through Rev. Rul. 88-76, LLCs and LLPs have been used frequently by business owners to start businesses. They are easy to get into, with most states simply requiring the filing of an Articles of Organization/Formation.[2] They are flexible, with the ruling of 99-5, single member LLCs can become partnerships, simply with the joining of a second member. [3] Want your LLC to be taxed as a corporation? Check the box regulations under §301.7701-2(c)(2), §301.7701-3(a) and §301.7701-3(b)(1)(ii) allow you to file a Form 8832, and you can ask to be taxed as a corporation (limitations apply, of course).


The bigger question, what is the difference between the LLP and the LLC? At the federal level, relatively none, other than the LLP is going to be a partnership, because it is a Limited Liability Partnership; but the differences really exist at the state level. Each state determines what an LLP is and how it differs from an LLC. In some states, LLPs don’t exist. In others, only professional services (lawyers, accountants, architects, etc.) can form an LLP. In other states, professional services HAVE to form LLPs and cannot form LLCs, unless they are single-member. The point here is, it depends on your state and this is another reason to discuss this with your CPA, EA or attorney.


The good: The main good thing is limited liability from the activities of the company. Partners (often referred to as Members) can serve in active or passive capacities. Members are limited in their liabilities of the firm. Take the above example of slipping and falling on the new marble floors: EVERYONE is limited in their liability. They cannot come after your home or other personal assets.[4]


The bad: Loans owned by the organization are not available to provide debt basis to the members, without personally guaranteeing the loan. We haven’t talked about this yet, but debt basis is a good thing, especially in the beginning of the organization’s life. Another bad is that the limited liability only reigns true if the “corporate veil” is not pierced. The best way to explain this (without all of the technical babble), separate business assets from your personal assets and treat the business as a business in terms of actions and business practices. The best way to learn about this is to talk to your local CPA, EA or attorney.


Other forms of Partnerships


There are many other forms of partnerships. Most of them are out of the scope of the readers of this blog post, except as an investor. Before investing in any of these vehicles, please talk to your investment adviser as they can involve risk and may not be for everyone.


Real Estate Investment Trusts (REITs) are partnerships, which are regulated by the government and are normally publicly traded. It is a good way to invest in real estate, without the large cash requirements (sometimes as little as $10,000) REITs income flow through just like a partnership and picked up on your taxes, just like any other partnership.


Publicly Traded Partnerships (PTP): PTPs are a sort of hybrid between stock companies and partnerships. They tend to be very popular with oil and mineral operations as they allow for flow-through of the incomes to the owners, but can be traded like stock.


Check out these related posts on the subject:


[1] Reg §301.7701-2


[2] Schwartz and Lathrope. Fundamentals of Partnership Taxation. New York. Foundation Press, 2012. Print.


[3] Ibid


[4] One exception to this is if the harmed are able to “pierce the corporate veil.” In order to protect against this, talk to your CPA, EA or attorney and they will provide strategies to reduce the risk of this from happening.