What is a limited partner? An overview of the rights and obligations

For many entrepreneurs, a partnership can be an attractive way to bring a business idea to life. Unlike corporations, limited partnerships typically have fewer formal requirements and no mandatory minimum capital contributions. However, one major drawback is that general partners face unlimited liability for the company’s debts. This article goes into more detail on the subject.

What is a limited partner?

A limited partnership (LP) is a business structure that consists of two types of partners:

• General Partner (GP) – Responsible for managing the business and personally liable for all debts and obligations.
• Limited Partner (LP) – Contributes capital but has no management authority and limited liability, meaning they are only at risk for the amount they invest.

A limited partner’s liability

Unlike general partners, limited partners are only liable for company debts up to the amount of their capital contribution. However, this protection only applies if they do not participate in management. If a limited partner actively engages in business decisions, they risk being legally treated as a general partner and losing their liability protection.

Before an LP is legally registered with the state (typically through the Secretary of State), the business may be treated as a general partnership, meaning all partners—including limited partners—could face full liability. To avoid this risk, limited partners should ensure the LP is properly formed and registered before conducting business.

State-specific regulations

Each U.S. state has its own laws governing limited partnerships. Business owners should consult state-specific regulations and seek legal advice to ensure compliance.

Joining and leaving a limited partnership

When someone joins an existing LP as a new limited partner, they assume liability only up to the amount of their capital contribution. However, if they invest before being officially added to the state registry, they could face liability risks. It is common practice to ensure that a limited partner’s membership is fully documented and registered before they are financially involved.

If a limited partner decides to leave the LP, they must:

• Draft and sign a separation agreement to define exit terms.
• Ensure their name is removed from formal records to avoid future liability.
• Confirm they are not listed on any outstanding debts associated with the business.

If these steps are not properly completed, the limited partner could remain legally responsible for debts, even after leaving the business. Consulting a legal professional is strongly advised when exiting an LP.

What rights does a limited partner have?

Limited partners generally have a passive role in the business, meaning they have no right to manage day-to-day operations or make strategic decisions, and their voting rights are limited unless specified in the partnership agreement. While they have the right to financial transparency, they do not have direct access to company records but are entitled to review annual financial statements for accuracy. If a limited partner is granted certain managerial rights in the partnership agreement, they may have expanded voting or objection powers similar to general partners; however, this could also expose them to greater liability.

What are the duties of a limited partner?

A limited partner’s primary duty is to contribute capital to the business while refraining from management involvement. Their contribution may be in the form of cash, material assets, or services, as agreed upon in the partnership agreement. Unlike general partners, limited partners do not manage the business and have no decision-making authority in daily operations.

Limited partners also have a general duty of loyalty, meaning they must act in good faith, promote the business, and avoid actions that could harm the partnership. However, they are not automatically subject to a non-compete clause, since they do not control the business. If the partnership agreement grants a limited partner certain management powers, it may also include a non-compete clause, restricting their ability to engage in competing businesses.

Profit and loss for limited partners

Limited partners share in profits and losses of the limited partnership, but their participation differs from that of general partners. Profits are typically distributed in proportion to capital contributions, unless the partnership agreement specifies otherwise.

Losses are allocated based on capital contributions, but limited partners can only lose up to the amount of their initial investment. They are not required to cover additional losses beyond this amount. If a limited partner’s capital account falls below their initial contribution due to losses, future profits may first be used to restore the balance, depending on the partnership agreement.

Unlike corporations, where dividends are distributed to shareholders, limited partnerships distribute profit shares to their partners based on the agreed-upon structure in the partnership agreement.

What withdrawal options does a limited partner have?

Profit distributions to limited partners depend on the partnership agreement and are not automatically paid out annually. Some agreements allow regular distributions, while others specify lump sum payouts. If a limited partner’s capital share falls below their liability contribution due to losses, future profit distributions may first be used to restore their capital account. Once paid out, profits do not need to be repaid, even if the partnership later incurs losses.

When and how can a limited partner be removed?

Limited partners may resign or be removed, triggering their withdrawal from the business. The process for withdrawal is usually outlined in the partnership agreement. If no specific terms exist, state laws may provide default rules for resignation. It is crucial to sign a separation agreement and ensure the limited partner’s name is removed from business records to avoid future liability for the partnership’s debts.

The removal of a limited partner depends on the partnership agreement. Some agreements require a valid reason for termination (e.g., misconduct or failure to meet capital commitments), while others allow removal under specific conditions agreed upon in advance.

Please note the legal disclaimer for this article.