Partnership with Multiple Partners: The Good and the Bad

The generally favorable federal income tax rules for partnerships are a common reason for choosing to operate as a partnership with multiple partners instead of as a corporation with multiple shareholders. The most important partnership tax benefit rules can be summarized as follows:

• You get pass-through taxation.
• You can deduct partnership losses (within limits).
• You may be eligible for the Section 199A tax deduction.
• You get basis from partnership debts.
• You get basis step-up for purchased interests.
• You can make tax-free asset transfers with the partnership.
• You can make special tax allocations.

Partnership taxation is not all good stuff. There are a few important disadvantages and complications to consider:

• Exposure to self-employment tax
• Complicated Section 704(c) tax allocation rules
• Tricky disguised sale rules
• Unfavorable fringe benefit tax rules

Limited partnerships are obviously treated as partnerships for federal income tax purposes, with the generally favorable partnership taxation rules mentioned above.

Limited partners generally are not exposed to liabilities related to the partnership or its operations. So, you generally cannot lose more than what you’ve invested in a limited partnership—unless you guarantee partnership debt.

So far, so good. But you must also consider the following disadvantages for limited partners:

• Limited partners usually get no basis from partnership liabilities.
• Limited partners can lose their liability protection.
• You need a general partner.

On the plus side, limited partners have a self-employment tax advantage.

Since your partnership will have multiple partners, multiple issues can come into play. You’ll need a carefully drafted partnership agreement to handle potential issues even if you don’t expect them to arise. For instance, you may want to include

• a partnership interest buy-sell agreement to cover partner exits;
• a non-compete agreement (for obvious reasons);
• an explanation of how tax allocations will be calculated in compliance with IRS regulations;
• an explanation of how distributions will be calculated and when they will be paid (for instance, you may want to call for cash distributions to be made annually in early April to cover partners’ tax liabilities from their shares of partnership income for the previous year);
• guidelines for how the divorce, bankruptcy, or death of a partner will be handled;
• and so on.

Key point. No type of entity (including a limited partnership in which you are a limited partner) will protect your personal assets from exposure to liabilities related to your own professional malpractice or your own tortious acts.