Jul
30
2019

The Perfect Business Entity For Passive Investors

Business entities are some of the most misunderstood legal tools on the market. Many people just form them because it is something you are supposed to do. In truth, the various entities are designed for specific purposes. Let’s consider a common scenario.

You’ve come up with the greatest business idea since sliced bread. The only problem is you need some capital to get the business off the ground. You’ve found a few investors who are willing to pony up some money so long as they are not put in a position of risk. Now what?

This happens all of the time. The passive investors are usually friends and family members. They are willing to help out, but remember some of the more “interesting” events of your youth and don’t want to risk their homes and so on. Is there any particular way to go about meeting the goal of getting your funding without putting them at risk? Of course.

Our magic entity is known as the limited partnership. To understand the value of this entity, we first have to step back and discuss the concept of a general partnership.

A general partnership is a business venture undertaken by two or more people for a profit so long as no other business entity, a corporation or limited liability company, has been designated as the official business. A general partnership may exist even if the two parties don’t put anything in writing. The classic scenario of two kids selling lemonade in the front yard is an example of a partnership.

The advantages of the general partnership are two fold. First, they are not formal entities. You can pretty much do everything orally and not run afoul of any laws regulating how a business entity should work. Second, you can pass the tax liability directly down to your personal taxes, which lets you avoid double taxation issues that arise with other entities.

The downside to a general partnership, however, is found in the liability area. Basically, a general partnership provides you with none. If the business gets sued, your home, car, bank account and so on are all on the line. This represents a huge risk and is one of the reasons a general partnership is frowned upon by most people when it comes to selecting business entities.

A limited partnership takes the best aspects of the general partnership and mixes them with a dash of the advantage of incorporating. It works like this. There is a general partner. That partner then sells limited partnership interests. People who buy the interests cannot participate in the running of the partnership. The can only collect profits when the general partner decides to do distributions. In exchange for this passivity, the limited partnership can only lose their investment in the limited partnership and nothing else. In short, they get the same protection afforded a shareholder in a corporation.

So, why is our limited partnership such a magic entity? Well, go back to our initial scenario. We have passive investors who are willing to pony up money, but do not want to put their personal assets at risk. If you form a limited partnership, this can be accomplished by having them by limited partnership interests. You get the money and the only risk they face is the loss of the money they paid for the interest.

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