Why the Use of Limited Partnerships? (Did I mean Limited Partnerships or did I mean Limited Liability Companies?)

Confusing question? To understand whether it is or not, we need to recognize there are three, not just two, balls in play. This is a matter of first addressing A vs. B, and then moving on to either A or B vs. C.

After 2006, the questions are the same for Texas transactions as they are in most other states, but many business and real estate people in Texas get some of the A vs. B vs. C issues mixed up, so let’s take a step back to, say 2005, and then move forward, and all will be clear.

If you asked the first question then—why the limited partnership entity is the favored means of structuring investment vehicles, your advisor might have answered with another question, namely, “Why would a corporation ever be used for investments?” Of course there are answers to be found in history, but to keep to fundamentals, assume the classic corner candy store.

“Ma and Pa” opened the store with their own capital, and what was left in the till was the profit, which they banked. The income and the expenses of the business were their income and expenses, from the FICA costs for the part time help, to the depreciation, to the interest payments etc. Whatever benefited the business tax-wise benefited them directly. We do not speak of tax and income attributes “flowing through” because there is an absolute identity of business and “sole” proprietor. Ma and Pa might get worried about “liability” to their customers for accidents etc., and so they might be inclined to assure a limitation of liability, but this can be accomplished in a variety of ways, through a variety of different entity types.

For purposes of this discussion, therefore, liability protection, as well as other ancillary planning elements (foreign persons, estate planning, creditor protection and many others), are not addressed here.

When the venture gets larger (i.e. more stores, perhaps more investors) there can be no identity of the enterprise with the investors/principals. This identity stops at the level of the largest family-run Chinese restaurant. Because of the principal that “it is a lot easier to get money into a corporation than to get it out”, the next level of business organization (all involving passive investors) seeks out forms of “flow-through” vehicles, in which the entity itself is not taxed, and all attributes of income, loss, capital gain and loss, flow through to the participants.

Assume for a moment that the concept of a corporation was unknown, this is the “natural” result one would expect of a joining or pooling of money to achieve an objective, every bit the same as the consequence of an office soliciting $5 from all interested persons to participate in the lottery, or kids joining a team in order to attain a championship. There is no intermediary, except in name only. (By “name only” we mean that “passive” or “flow-through” entities such as limited partnerships and limited liability companies file reporting tax returns only—they state the amount of net income of the entity but pay no taxes. Rather, they file K-1 statements for each of the partners or members—generally the percentage of the total each is responsible for in accordance with their respective percentage interests—and send out the K-1’s to each of those partners or members who account for that income or loss on their own individual tax returns.)

Because (we’ll pretend for another moment) the corporation is unknown, there is no reason that anyone would long for it. Pooling your money and sharing directly in the results is the “normal” thing one would expect. It should also be noted that any benefits resulting from “tax-advantaged” investments would likewise flow right through to the investors (hence the rise and history of “tax shelter syndications”). In fact every attribute at the entity level is passed on through (hence the alternative name, “pass-through entities”) to the investors.

The types of pass-through vehicles are numerous:

  • General partnerships
  • Limited partnerships (“LP’s”)
  • Limited liability companies (“LLC’s”)
  • Limited liability partnerships
  • Subchapter S corporations
  • “Check the box” corporations
  • Unlimited liability companies (used in some provinces of Canada)

Without too many complications, the greater the number of investors, the greater the likely use of an LP; the use of Sub S corps has, after the advent of LLC’s, very limited utility (but some for small business owners). As for LLC’s, until 2006, they were more widely used outside Texas than inside. Before seeing the effect of some legislation in 2006 in Texas, we can settle the issues between A vs. B, namely flow through entity vs. non-flow-through entity, which is a so-called “C” corporation (taking its name from an applicable subpart of the Internal revenue Code).

Businesses all around you are organized in flow-through forms: The Dallas Cowboys and the overwhelming majority of sports franchises, land developments, e.g., the Perot Alliance Airport enterprises, clothing stores, vacant land holdings, venture capital firms, restaurants and every other imaginable enterprise. Except one major category noted below.

So, to the question as to why anyone would use a corporation, more specifically the so-called “C” corporation, the nature of which is that it is itself, as opposed to all the entities noted above, a taxable person. Only after it pays taxes on what is left in the till can any money go to the owners. But then it goes out as dividends, to be taxed again. And if there are any tax benefits, they do not reach the owners.

So Again, Why Do It?

Two principal reasons. Both having to do with “Wall Street.” For historical reasons, the investment banking industry, world finance and trade, the stock exchanges, the Securities and Exchange Commission and the public markets are not geared to handle and deal with investment interests of pass-through vehicles. They are too new and still, to the markets, unfamiliar, and furthermore present difficulties in terms of fitting them into the public trading and regulatory format.

Hence, a new venture, e.g., a technology company hoping to make it to the public markets with an IPO, will organize itself as a corporation on the advice of its investment bankers in order to have its financial statements and organization ready to go for the public offering of stock. But more important is the nature of the market place itself. Once there is in fact a public market for the investment interests, which is what the world of Wall Street entails, the nature of the investment changes. No longer does one pool money to share in results. The game is entirely changed. There is separation between the enterprise and the investor. The benefits accruing to the business do not flow through to the investor.

Rather, through the interposition of an intermediate entity, the benefit to be realized by the investor is a result of not only the actual operating results of the entity, but all sorts of perceptions, predictions, coming developments, fears for the future, and history surrounding the entity, all as reflected in the value which the market ascribes to the corporation, a fraction of which is then attributable to each share. The shares themselves are independently valued, based on a variety of factors related to the enterprise to be sure, but no longer as a simple fraction of the pooled and aggregate value of that enterprise.

This is only possible where there exists a public market. Absent a market and the ability to readily transfer shares in the enterprise, there can be no market consensus as to the value of the interest in the enterprise. And absent the market, there is no reason to separate the enterprise from its owners. On the contrary, there are many reasons to avoid the interposition of another taxpaying level.

So What Happened in 2006 in Texas?

Until then, LLC’s were treated under the State’s Franchise Tax (a sort-of income tax) as corporations, and therefore subject to the tax, whereas LP’s were not. When such public corporations as Dell and AT&T organized their activities as LP’s in order to escape the tax, the Texas Legislature, faced with other deficit issues as well, reorganized the Franchise Tax into something called the Margin Tax (another sort-of income tax) which covered both LLC’s and LP’s. So Texas legal advisors no longer had to turn their clients away from the LLC form and towards the LP form, and in that respect, business planning in Texas became like most other states.

One question then remains, which is our B vs. C issue: Why choose an LP over an LLC once the tax playing field has been evened out? There are in fact numerous reasons weighing in favor or against either of those options. These can have very material consequences for the organizer of the enterprise and for the other participants. Some of these factors involve the nature of the planned business enterprise, the different types and categories of participants, possible tax and even liability issues which may be at risk, the way in which the entity’s decision making apparatus is conducted, the rights of the various participant types, and of equal importance in planning and preparing the structure, the ease of drafting one type of entity form as opposed to the other, given all of the foregoing circumstances.

This can have an impact on legal costs, as well as the on the ability of the participants to easily understand what the structure is, no small consideration. Suffice it to say that while it is possible to get to the same result using either the LLC or LP form, there are a slew of convenience factors as well which dictate the use of one for over another.

Going over these elements and deciding on the best structure is what we have done for over three decades of practicing business planning and strategy and preventative commercial law. Please feel free to contact us at 972.294.0200 to discuss your legal matter with an experienced business attorney.