January 4, 2022

Entity Choice - Limited Partnerships and Limited Liability Companies

When two or more like-minded individuals decide to launch a construction company, a partnership is often the most attractive entity choice. However, working in the building trade also involves a high degree of inherent risk that makes guarding against liability important. For this reason, many contractors look to either a limited partnership or limited liability company (LLC) as a business structure.

Limited Partnership Benefits

Indeed, a limited partnership is often an excellent entity choice for launching a new venture because it allows the business owners to raise capital from private investors while providing those investors with limited liability protection.

A limited partnership allows the general partners to manage and operate the construction business with little intervention from the other partners. In addition, general partners can raise equity capital from the investors, who receive limited partnership interests in exchange for their contributions. As limited partners, they’ll share the entity’s earnings without having to manage the company or risk personal liability for its activities.

General partners must exercise care to ensure that limited partners don’t inadvertently lose the liability protection by participating in the management of the business. Merely consulting generally doesn’t trigger personal liability so long as the general partners remain the decision-makers.

A limited partner may become personally liable by taking certain actions, such as guaranteeing a partnership debt. Of course, general partners must bear in mind that they’re personally liable for the company’s debt. (See “Two ways to minimize general partners’ liability”.)

The Tax Impact

Because a limited partnership is a pass-through entity for tax purposes, each partner must include his or her share of income, deduction, credit and loss from the construction business on his or her individual federal tax return.

Had the partners decided to form a C corporation instead of a limited partnership, their earnings would have been taxed at a higher effective tax rate. This is because they would have been taxed once on the corporation’s earnings and again when those earnings were distributed to shareholders.

Moreover, subject to various limitations, partners may qualify for the Section 199A “pass-through” tax deduction to the extent the income passed through to them is “qualified business income” under the tax code.

With proper planning, a 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 may be a better choice for some new ventures than an S corporation. To pass muster with the IRS, however, special allocations must have what’s known as “substantial economic effect.” (Your tax advisor can explain further.)

The LLC Difference

Similarly named but slightly different is an LLC. Think of an LLC as a hybrid entity that can be structured to resemble a partnership for federal tax purposes and a corporation for owner liability purposes.

Like the shareholders of a corporation, LLC owners (called “members” rather than shareholders or partners) generally aren’t liable for the debts of the business except to the extent of their investment. Thus, the owners can operate the business with the security of knowing that their personal assets are protected from the entity’s creditors.

This protection is greater than that afforded by limited partnerships. As mentioned, general partners are personally liable for the company’s debts, and even limited partners can become liable if the IRS deems that they’ve been actively participating in business management.

LLC Taxation

LLC members may elect to have the entity treated as a partnership for federal tax purposes. Doing so can provide several important benefits to the owners.

For example, partnership earnings aren’t subject to an entity-level tax; instead, they “flow-through” to the owners in proportion to the owners’ respective interests in profits. Earnings are reported on the owners’ individual returns and taxed only once.

To the extent the income passed through to a member is qualified business income, he or she may be eligible for the Sec. 199A pass-through deduction, subject to various limitations. In addition, because members are actively managing the business, they can deduct their ratable shares of any losses generated by the company on their individual tax returns. This, in effect, allows a member to shelter other income that he or she (and a spouse) may have.

An LLC that’s taxed as a partnership can provide special allocations of tax benefits to specific partners. For this reason, many business owners (construction and otherwise) opt for an LLC over an S corporation, an entity choice that provides tax treatment similar to a partnership’s.

Another reason for using an LLC over an S corporation is that LLCs aren’t subject to the tax code’s restrictions on S corporations, which include limits on the number of owners and the types of ownership interests that may be issued.

Many Choices

To be clear, limited partnerships and LLCs are but two of many entity choices. Whether launching a new construction company or reconsidering the business structure of an existing one, it’s important to consider all the tax, legal and administrative implications. Your professional advisors can help you choose wisely.

Two Ways to Minimize General Partners’ Liability

One drawback to a limited partnership is that general partners are 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 liability can be minimized somewhat by:

  • Creating a corporation to manage the partnership and serve as general partner, and
  • Procuring adequate insurance to cover potential liabilities arising from operating the business.

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