What is a Limited Partner
Also known as a silent partner, a limited partner is a business partner whose liability is limited to the amount of their investment in the company. Because the limited partner is not a material participant in business operations, the IRS considers their income as passive income. A limited partner who participates in a partnership for more than 500 hours in a year may be viewed as a general partner.
BREAKING DOWN Limited Partner
A limited partnership (LP) has at least one general partner and at least one limited partner. Some states allow limited partners to vote on issues affecting the basic structure of the partnership. Voting issues include removing general partners, terminating the partnership, amending the partnership agreement, or selling most, or all, of the company’s assets.
Liability for General and Limited Partners
A general partner typically receives payment for controlling the company’s daily operations and making legally binding decisions. A general partner is personally liable for business debts and legal proceedings. For example, if one general partner cannot pay a creditor’s debt, the creditor may collect from another general partner.
A limited partner invests capital in exchange for shares in the partnership. A limited partner has restricted interaction in the business's practices. As such they cannot incur obligations on behalf of the partnership, participate in daily operations, or manage the operations. For example, a limited partner may invest $100,000 in a real estate partnership but cannot engage in real estate transactions for the firm.
Because the limited partner does not control managing operations, they are not personally liable for the partnership's debts. For example, a creditor may seek recovery against the general partners' personally owned assets. However, claims against the limited partner's financial investment are truncated. Alternatively, a limited partner may become personally liable if they assume an active role in the business. To claim against the limited partner, the creditor must prove that they engaged in activities aligned with general partner duties. If it is confirmed, the limited partner may be fully liable for the creditor’s claims.
Tax Treatment for Limited Partners
Limited partnerships (LPs), similar to general partnerships, are pass-through or flow-through entities. Pass-through means each of the partners is responsible for taxes, rather than the business itself. Although the IRS treats LPs like general partnerships where all partners individually report and pay taxes on their share of the profits, limited partners do not pay self-employment taxes. Because they are not active in the business, the IRS does not consider limited partners’ income as earned income. The income received is passive income. The Taxpayer Relief Act of 1986 allows limited partners to offset reported losses from passive income.