They’re back, Limited Partnerships. They were popular in the 1980s but the Tax Reform Act of 1986 took away most of their benefits and I seldom saw them. But they are making resurgence and are hooking unwary investors again.
First, an example. Sally and Kurt form a partnership to manufacture widgets. Each year their tax pro prepares the business’s partnership return and gives both Sally and Kurt a K-1 showing their share of the income and deductions to be included on their personal returns. Sally and Kurt are general partners since they actually run the company and are responsible for the debts of the business. The company is doing well and they want to expand. Instead of borrowing money for new equipment, they decide to each give up 5% of the share of the business and sell shares to investors. For $5000, an investor will receive a 1% share of the partnership as a limited partner. When the partnership tax returns are prepared, each of the limited partners receives a K-1 breaking out their 1% share of income and deductions to be reported on their personal tax return.
Income and losses from limited partnerships are passive income. While this doesn’t affect reporting income, it can limit what losses a limited partner can deduct. A limited partner can only deduct their passive losses up to the amount of their passive income. If the only passive investment a taxpayer has is as a limited partner, they can’t take the loss and can only carry it forward until they have passive income or dispose of the activity. To further complicate matters; if the limited partnership is a Publicly Traded Partnership (PTP) they can only take losses against passive income from that partnership. To sum up, the losses from a limited partnership may have to be carried forward but the income is always reported.
The income from a limited partnership can also cause state tax issues. If the partnership’s income is not from the taxpayer (investor’s) resident state, they may be required to file a tax return for an extra state or states.
Why would an investor put their money in a limited partnership if they may not be able to deduct the losses and may have to prepare extra state tax returns? Because sometimes they do make a good return on investment or because they look like they are making money. Some partnerships are set up to make regular distributions to the partner. So an investor in Sally and Kurt’s partnership might be told they will get a check for at least $100 a quarter. But if the partnership is not making enough money to cover the distribution, the money will come from the original investment. On the K-1, there is a section that breaks down the investor’s capital account. That section for the first year would show a $5000 investment and $400 in quarterly distributions along with any income and losses. If the net income for the year is -$245, the capital account will look like - $0 + $5000 investment - $245 net losses - $400 quarterly distributions (return of capital) = $4355. Since it’s a passive loss, the taxpayer won’t be able to use the loss against regular income.
Limited partnerships are not for most investors. They are tax complicated and too often the broker selling them really doesn’t understand what they’re selling. It’s easy to get drawn in by the guaranteed distribution and assume that your investment is increasing in value when it’s actually decreasing because you’re just getting your money back.