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What are the limited partnership's tax ramifications?

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Another major advantage of limited partnerships, which also extend to multi-member LLCs, is the partnership tax treatment. First, subject to certain restrictions, partners may distribute partnership income, gain, loss, or credit among the partners however they see fit. In other words, one partner may contribute little or no capital to the partnership, but receive a disproportionately larger share of partnership gain or loss, along with the tax benefits or liabilities associated with this. Compare this to a corporation, where a stockholder may only receive company profits in proportion to the amount of shares they own.

Second, within certain limits, a partnership may distribute appreciated or depreciated property to a partner without recognizing gain or loss. For example, let's say an individual bought a lot of raw land for $10,000. Ten years later he contributed it to the partnership, and eight years after that it was redistributed to its original owner. At the time of distribution, the property's value had appreciated to $100,000. If the distribution had been made from a C or S corporation, the company (and also the shareholder, in the case of a C corporation) would have to recognize gain of $90,000, which means it would have to pay capital gains tax on $90,000 gain. Since there is no recognition of gain with a partnership in this instance, there is no requirement to revalue the property or pay the tax.

Third, any partner may make additional contributions of appreciated property to a partnership at any time without recognizing gain on the property. A new partner may also likewise make a contribution to an existing partnership without recognizing gain. If such contributions were made to a C or S corporation, however, a gain would be recognized unless the contributor belonged to a group who, collectively, owned at least 80 percent of the partnership. Recognizing gain, of course, is a term that means you have to pay capital gains tax to the extent your property appreciated in value.

Fourth, distributions to limited partners are not subject to the self-employment tax, which can be quite burdensome. Although C and S corporation distributions are also not subject to self-employment taxes; general partnerships and sole proprietorship profits are usually subject to this tax. Note that a general partner's interest in an LP may still be subject to self-employment taxes, however this exposure is often reduced by giving the general partner a smaller (1 percent or so) interest in the company (the general partner's management salary, however, is still subject to self-employment or the equivalent FICA/FUTA taxes).

Fifth, when a partnership partially or completely buys out a partner's interest, the remaining partners receive a step-up in basis of that partner's share; to the extent that partner recognized gain. In layman's terms, this means that the bought-out partnership interest, and the capital connected to it, is re-valued to its current fair market value without triggering capital gains tax. If the partner's interest is sold for more than what it was worth when he bought into the partnership, the partner will recognize gain, but the partnership will receive the step-up. Corporations do not receive this benefit, meaning that even if a shareholder sells his company interest for a profit, gain (with no tax break) will still be recognized when appreciated company assets are distributed. This step-up in basis also occurs if a partnership interest is transferred due to a third party purchase or death of a partner.

Sixth, in some circumstances, partnership losses may be used to offset the individual tax liabilities of each partner, and as we'll discuss later, limited partnerships may be used to reduce estate tax liability while passing company interests tax-free to one's heirs. These tax reduction strategies are not available to C or S corporations, general partnerships or sole proprietorships.

Although there are many benefits to partnership taxation, there are instances where other tax classifications are more desirable, or where partnership taxation is a hindrance rather than a benefit. However, most tax advisors consider partnership tax law to be the most favorable, in most circumstances, both to the entity and its owners.

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