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Editorial 7 MIN READ

The limited partnership, reappraised

An old form quietly upgraded in Delaware this summer, and still the default where real money and real risk have to coexist

The Editors
Staff, Incorporator.org
7 min read Updated
Contents 5 sections
  1. When to pick an LP at all
  2. Formation mechanics after SB 115
  3. Tax treatment and the SE-tax question
  4. Where the LP fits in 2023, and what is coming
  5. Sources

he Delaware limited partnership is the form that runs American private capital, and this summer the state quietly patched one of its oldest embarrassments. Senate Bill 115, signed June 30 and effective August 1, 2023, gives LPs a statutory way to ratify defective filings, the same cure the corporate code has offered under 8 Del. C. § 204 for a decade.

That is the news peg. The reason anyone is reading is that limited partnerships still dominate real-estate syndication and the fund side of private equity and venture capital, and the calculus of when to pick one is worth rewriting every few years as the case law moves.

When to pick an LP at all

The LP survived the rise of the LLC because two of its features are load-bearing for capital-raising vehicles and awkward to replicate.

The first is the clean split between a general partner who runs the business and limited partners who do not. Under 6 Del. C. § 17-303, a limited partner does not become liable for partnership obligations by reason of being a limited partner, provided the limited partner does not participate in the control of the business. The statute then lists a safe-harbor menu of activities that do not count as control: voting on amendments, consulting with the GP, approving changes to the line of business, and so on. A passive investor in a Delaware LP has a clearer statutory shield than an LLC member whose protection depends on the operating agreement the members happened to sign.

The second is the economic architecture. Partnership taxation under Subchapter K (IRC §§ 701 to 777) lets a GP take a promote, a waterfall, and a carried interest without any of the awkwardness that the corporate form would require. Special allocations that have "substantial economic effect" under IRC § 704(b) and the Treasury regulations at 1.704-1(b)(2) are the plumbing of every fund distribution waterfall on the continent. You can technically do the same thing in an LLC taxed as a partnership, and many sponsors do. But the LP is the form institutional LPs and their counsel expect.

The GP's unlimited liability is the price of admission, and the standard move is to form the GP itself as an LLC. The sponsor then holds the GP LLC, which holds the GP interest in the LP, which holds the assets. Double-wrap. Boring. Bulletproof enough that the IRS, the courts, and your LPs' lawyers all know the shape on sight.

Formation mechanics after SB 115

You form a Delaware LP by filing a Certificate of Limited Partnership under 6 Del. C. § 17-201. The certificate names the partnership, its registered office, its registered agent, and at least one general partner. The Division of Corporations charges a $200 filing fee. The LP then owes an annual tax of $300 to Delaware, due June 1, under 6 Del. C. § 17-1109. There is no annual report for LPs; the tax is the whole obligation on the state side.

SB 115 added three provisions to Chapter 17 that mirror the corporate ratification regime. New §§ 17-1201 through 17-1208 now let a Delaware LP ratify a defective act or a defective filing, adopt a corrective filing, and bring a Court of Chancery proceeding to validate or invalidate the result. Before August, a bad filing in the LP chain was cleaned up by a combination of common-law argument, nunc pro tunc filings, and hope. Now it is a statutory procedure with a clear path through Chancery. This matters most for funds mid-raise discovering that an amendment or a GP admission was signed by the wrong person or filed in the wrong order. The fix is now mechanical.

The partnership agreement is where almost all of the actual governance lives. Delaware LP law is relentlessly contractual. Section 17-1101(c) states the policy explicitly: to give maximum effect to the principle of freedom of contract and to the enforceability of partnership agreements. Fiduciary duties can be expanded, restricted, or eliminated by agreement (subject to the implied covenant of good faith and fair dealing, which cannot be waived). That is the feature. It is also the trap for any LP who did not read the document their counsel negotiated.

Tax treatment and the SE-tax question

An LP is a partnership for federal income tax purposes by default. Income, deductions, credits, and basis flow through to the partners on Schedule K-1. The fund itself files Form 1065 and pays no federal entity tax.

The question that has been moving in recent years is self-employment tax. IRC § 1402(a)(13) carves out "the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in section 707(c)" from net earnings from self-employment. In other words: a true limited partner does not pay 15.3% SE tax on the fund's operating allocation, only on any guaranteed payment for services.

For decades, sponsors read that carveout broadly. The Tax Court narrowed it in Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. 137 (2011), holding that partners in a law firm organized as a Kansas LLP could not claim the § 1402(a)(13) exclusion because they were acting in the capacity of self-employed persons running the business, not as passive investors. The court read "limited partner, as such" as a functional test: what is the partner actually doing.

Since Renkemeyer the IRS has pushed the functional test into state-law limited partnerships. Several cases involving hedge-fund and private-equity sponsors are sitting in the Tax Court now, turning on whether a person holding a state-law LP interest who also works at the management company can claim the carveout for the LP distributive share. The service's position is that if the partner is effectively a service partner, the state-law label does not control. The sponsor position is that the statute says "limited partner," Delaware says this is a limited partner, and the inquiry should end there. As of this writing the open question is live and the Tax Court has not produced a definitive opinion in the fund context.

The practical posture for an LP being formed this quarter: assume the IRS will apply a functional test to any limited partner who also draws compensation from an affiliated management entity, and structure the compensation as a guaranteed payment rather than gambling on the carveout covering it. The clean cases are true passive investors, whose distributive share has always sat well inside § 1402(a)(13).

Where the LP fits in 2023, and what is coming

The LP remains the default for two very different transactions.

Real-estate syndication is the first. A sponsor raises from accredited investors under Regulation D Rule 506(b) or 506(c), drops the equity into a Delaware LP, the LP takes title or owns a special-purpose LLC that does, and the waterfall follows a preferred return plus promote shape that partnership taxation handles without deformation. An LLC would do the job, but the LP reads faster to institutional investors and to lenders' counsel.

Private equity and venture funds are the second. The fund is an LP, the GP is an LLC, the management company is usually a separate LLC taxed as a partnership or an S-corporation, and the carry flows through the GP entity. The structure has hardened into a template, and deviations cost money in legal review.

The Corporate Transparency Act adds a new chore on top of all of this. Under 31 U.S.C. § 5336, any entity created by the filing of a document with a secretary of state is a reporting company, and a Delaware LP is created exactly that way. Beginning January 1, 2024, new LPs will have to report beneficial ownership information to FinCEN within 30 days of formation (existing LPs have until January 1, 2025). The carveout for "large operating companies" will not reach most funds or most syndicate LPs. Sponsors who are used to the LP as a low-maintenance form should plan to add BOI filings to the formation checklist.

If you are forming an LP this fall for a syndication or a fund, the form still works. The Delaware statute just got better. The partnership agreement is still the document that matters. The SE-tax exposure on service-partner interests is still unresolved, and it is still the one thing a careful sponsor hedges around. For the shape of the state-side filing itself, our Delaware formation guide covers the mechanics that Chapter 17 shares with Chapter 18, including the registered-agent market and the June 1 annual-tax trap.

Sources

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