A partnership is an agreement between two or more people to either preserve money or make money by joining together in a business venture to try to make a profit. There are all kinds of different partnerships and ways to operate the partnerships. For example, in a general partnership, you could walk up to someone and say to them that you want to enter a partnership with them. If this agreement is done orally without having anything in writing, then it is called a general partnership. All you really need is an oral agreement to have a legal partnership. In fact, an oral agreement between two people will stand up in court in certain circumstances. The bad thing about a general partnership is that the general partners have unlimited liability for anything done by the partnership or by the partners acting in their capacity as partners. So, if your partner goes out and does something in the name of the partnership, which they have authority to do, and if it was wrong and it caused damage to somebody, the person who was damaged can sue you and go after your individual assets. There are also limited liability partnerships, which is a relatively new creature of law. Lastly and most importantly, you can set up a limited liability company, which is sort of a hybrid between a corporation and a partnership.
Corporations have always been known to provide their shareholders with limited liability, but partnerships have not. The well-established body of partnership law is always looking through the partnership to the partners for unlimited liability. A limited partnership by contrast is a creature of the statutes of all 50 States and has a general partner who has unlimited liability and limited partners who are viewed as passive investors and are not involved in the management of the assets. The general partner, if it’s an individual, has unlimited liability for the liabilities of the partnership. Creative planners have devised structures to insert a limited liability form of entity to serve as the general partner in the limited partnership. For example, some people use corporations to serve as general partners in limited partnerships, others use limited liability companies, while others use S-corporations and irrevocable trusts to serve as general partners. Different fact patterns necessitate different types of entities, but all those entities can yield limited liability protection for the general partner.
State statutes (not federal law) govern limited partnerships. Partnerships have been around in the United States for as long as we’ve had case law in the United States. The law surrounding partnerships dates to the late 16th century and early 17th century, and the statutes surrounding limited partnerships have been around for 70 years in many states. There’s a well-established body of case law that tells us what happens if limited partnerships do something wrong. Limited partnerships and limited liability companies have proliferated over the last 70 years. First, limited partnerships, particularly in real estate investment and real estate development areas, have multiplied exponentially and now limited liability companies are springing up everywhere.
The idea behind limited partnerships is we do have an established body of law so that we can at least predict how you should draft your agreements and how you should operate your limited partnership to avoid getting challenged by creditors and having them try to pierce through the limited partnership and go after the partners of that entity. By contrast, LLCs are a new form of entity that didn’t start in the United States until 1987 in Wyoming, when it enacted the first LLC statute. Since 1987, every state and the District of Columbia has enacted limited liability company statutes. Because the statutes were only recently enacted, we don’t have a lot of case law interpreting them. In some states, the courts probably are going to construe these statutes as more like a partnership. So they may continue to apply partnership law principles to an LLC situation. If the courts apply general partnership law to the governance of LLCs it could be dangerous because it may expose members to unlimited liability. By contrast, other states look at LLCs as being more synonymous to corporations, so they may apply more case law related to corporations in the LLC context. From there, the courts interpret how the members should or should not be protected for liability purposes.
You want to protect the assets that you put into an LLC, while also protecting your personal assets. There are some tax benefits that can flow through to the owners for income tax purposes and estate tax purposes. LLCs and limited partnerships are flow-through entities, which means they’re not taxed separately except in certain States for income tax purposes. All the income earned generally flows through to your individual income tax return and it’s reported in a specific way. For estate planning, you can get valuation discounts if you transfer an LLC ownership interest to one of your spouses and children or to a trust for their benefit. If it’s a minority or non-marketable interest in the LLC, you can discount the value of the interest transferred. Discounting is beneficial because it reduces the value of the assets for gift tax purposes and therefore saves estate and gift taxes. The more value you can transfer out when you’re alive, the lower your estate tax is. If you’re over the lifetime exemption (currently, $12,060,000 per person in 2022, but scheduled to drop by half in 2026) and you have significant assets, then that planning technique is compelling. (Note that the IRS or Congress has been trying to eliminate valuation discounts for intra-family transfers for years and may attempt to do so again.)
People in risky businesses need asset protection, but not when the claim has already been made because somebody could challenge the transfer to the LLC or the LP as a fraudulent conveyance. So, you need to transfer the assets before a claim has arisen or you have any knowledge that the claim exists.