A California Limited Partnership can be an attractive business entity, particularly for income properties in California.

Real estate investors generally default to the California LLC when considering business entities for rental properties, which is usually the right choice, as we have explored in a recent article about using California LLCs for rental property that you can read here.

However, there is another option that often goes overlooked. A California Limited Partnership can, in certain circumstances, provide a more tax-efficient choice and many other benefits compared to a California LLC for owning real property. This potentially advantageous alternative for real property ownership warrants closer examination.

In this article, we will explore the structure of a California Limited Partnership, its benefits and considerations for real property, particularly in the context of income properties in California. Whether you are an experienced investor or new to the real estate market, this article will provide a comprehensive understanding of utilizing California Limited Partnerships for real property investments.

California Limited Partnerships vs. California Limited Liability Companies

What is a California LLC?

A California LLC is a business entity that combines elements of partnerships and corporations, providing its owners, termed members, with both operational flexibility and limited liability protection. This form of business structure is governed by the California Revised Uniform Limited Liability Company Act.

The members of a California LLC can be individuals, corporations (not that a corporation or S Corporation would be a wise choice when dealing with real property), or other LLCs, and there is no limit on the number of members that a California LLC can have.

The main advantage of a California LLC is the limited liability protection it offers. This means that the members are not personally responsible for the debts, liabilities, obligations, or legal judgments against the LLC, which can be especially beneficial for businesses with significant risk factors, such as real estate investments in income properties.

What is a California Limited Partnership?

A California Limited Partnership is a legal business structure where at least one partner, known as the General Partner, has unlimited liability, and the other partner or partners, termed Limited Partners, have liability only to the extent of their investment in the business.

The General Partner manages the operations of the business while the Limited Partners are passive investors. Under the California Revised Uniform Limited Partnership Act, the California Limited Partnership is distinct as a legal entity, separate from its partners. This structure provides limited liability protection for the limited partners, safeguarding their personal assets from the debts, liabilities, obligations, and legal judgments against the limited partnership. However, the General Partner bears the brunt of the liability.

A California Limited Partnership can be advantageous for real estate investments and operating rental properties that generate significant rental income and/or when raising capital from investors who prefer not to participate in the day-to-day operations of the income property.

Taxation of California Limited Partnerships versus California LLCs

Income Tax Considerations of California Limited Partnerships versus California LLCs

For the purposes of income tax, both California Limited Partnerships and California LLCs, provided they have more than one member, are partnerships for income tax purposes. This means that the income generated by these entities flows directly through to the partners or members, who then report this income and pay income tax on their individual tax returns, thereby avoiding corporate double taxation and enjoying the income tax benefits of pass-through taxation. This pass-through taxation model to pay income tax is a significant benefit of these business structures, particularly in the context of income property, where significant rental income may be generated.

Self-Employment Taxes for Owners of California Limited Partnerships versus California LLCs

For owners of California LLCs, self-employment taxes can be a critical financial consideration.

The entirety of the business income of a California LLC can be subject to self-employment taxes. These are calculated on the net earnings of each individual owner from self-employment, which includes their share of the income of the California LLC.

Because the California LLC is a pass-through entity, owners who are active in the business are required to pay self-employment taxes on their distributive shares, even if the income is not actually distributed to them. This can potentially lead to a higher tax burden for those LLC members who are actively involved in the management and operation of the LLC.

For owners of California Limited Partnerships, the self-employment tax scenario is different.

Limited Partners, who are not involved in day-to-day operations, are usually not subject to self-employment taxes on their share of the income of a California Limited Partnership because their income from the partnership is considered a return on investment, rather than earnings from self-employment.

General Partners, who actively manage the California Limited Partnership, are subject to self-employment taxes on their distributive shares. This distinction can lead to significant tax savings for Limited Partners in a California Limited Partnership. However, if the General Partner is another entity, such as a California corporation, California S-Corp, or California LLC, these entities may help the General Partner manage self-employment tax liability. Keep reading to find out why using another entity as a General Partner may provide more than just self-employment tax benefits.

Annual Franchise Taxes for California Limited Partnerships and California LLCs

Both California LLCs and California Limited Partnerships are subject to the mandatory $800 annual franchise tax.

This tax is required by the California Franchise Tax Board, a government agency responsible for managing the state tax systems. The annual franchise tax is due each taxable year regardless of whether the entity is actively conducting business or generating income, even if it is operating at a loss.

The obligation to pay this tax commences the year the California LLC or California Limited Partnership is formed and continues each subsequent year until the entity is formally dissolved.

The California LLC Fee

In addition to the annual franchise tax, California LLCs are subjected to the California LLC Fee.

The California LLC Fee, imposed by the California Franchise Tax Board, is based on the total annual gross revenue of a California LLC, not the net profit of a California limited liability company. The LLC fee comes into effect if the gross revenue is at least $250,000. The fee scales with income level, starting at $900 for incomes between $250,000 and $499,999, and can reach up to $11,790 for incomes of $5 million or more.

In the case of a California LLC with high gross revenue from rental income and other sources, it is important to note that that California limited liability company might be liable to pay the California LLC Fee even if its net profits are modest or if it is operating at a loss because the California LLC Fee is determined based on the total annual gross revenue of the California LLC, not on the net profit.

Understanding the California LLC Fee is important when deciding between a California LLC and a California Limited Partnership because a California LLC may still be obligated to pay the California LLC Fee when rental income is substantial while expenses related to property management and maintenance can also be high, leading to modest net profits or even operating losses.

No California LLC Fee For California Limited Partnerships

The California LLC Fee is unique to LLCs in California; it does not apply to Limited Partnerships.

In the context of real estate investing in California, particularly when annual gross revenues are anticipated to surpass $250,000, a California Limited Partnership can be a strategically advantageous entity choice because the California LLC Fee would significantly increase tax liabilities if a California LLC was used, but the California LLC fee does not apply to California Limited Partnerships.

Overcoming the Perceived Limitations of a California Limited Partnership

Despite the tax benefits of California Limited Partnerships for high-revenue real estate investments, California LLCs continue to be the preferred choice for a few reasons. California LLCs are great when they are the best choice, but when they are not the best choice, it is important to understand how to overcome the limitations of a California Limited Partnership.

Liability Limitation

Roles of General Partners and Limited Partners

In a California Limited Partnership, the General Partner is primarily responsible for the day-to-day management and operation of the Limited Partnership, while the Limited Partner is a passive investor. The General Partner makes executive decisions regarding the direction of the business, including decisions related to property acquisitions, sales, rentals, and maintenance in the context of real estate investments.

Liability of General Partners and Limited Partners

Unlike Limited Partners who are essentially investors with their risks limited to the value of their investment in the California Limited Partnership, the General Partner has unlimited personal liability. This means that in the case of debts, liabilities, obligations, or legal judgments against the California Limited Partnership, the personal assets of the General Partner may be used to satisfy these obligations.

Limiting Liability through Entity Formation

To overcome the lack of limited liability for a General Partner, a California corporation, California S-Corp, or California LLC can be formed to act as the General Partner of a California Limited Partnership. As a separate legal entity, the general partner entity will have its own assets and liabilities, shielding the personal assets of the individuals behind it. This may also reduce self-employment tax liability for the General Partner in addition to helping limit the personal liability of the General Partner.

Increased Cost and Complexity

Forming and managing a California Limited Partnership can be perceived as being more complex than a California LLC, primarily due to the roles and liability associated with the General and Limited Partners.

Perceived Complexity

The perceived complexity in a California Limited Partnership revolving around the roles of General Partners and Limited Partners, however this is often overstated.

In essence, the division between General Partners and Limited Partners is no more complex than the distinction between being a member versus a manager in an LLC. In a manager-managed LLC, there is a clear delineation between a managing member, who takes on an active role in the daily operations of the company, and an ordinary member, who is more of a passive investor.

This is remarkably similar to the structure of a Limited Partnership. A California LLC can be structured to allow for both active and passive roles just like the structure inherent to a California Limited Partnership.

A California LLC Operating Agreement is no more or less complex than a California Limited Partnership Agreement. Just as a California LLC Operating Agreement outlines the guidelines, rights, responsibilities, and processes of its members and managers, a California Limited Partnership Agreement serves the same purpose for the General Partners and Limited Partners.

Both a California LLC Operating Agreement and a California Limited Partnership Agreement need to be detailed and thorough, covering all aspects of business operations, from the distribution of profits and losses to the processes in case of a partnership dissolution.

Increased Costs

The formation of a separate business entity to provide liability protection to the role of General Partner in a California Limited Partnership does come with increased initial setup costs and ongoing maintenance costs.

While using a business entity such as a California corporation, California S-Corp, or California LLC as the General Partner is the only sane way to operate a California Limited Partnership, this approach requires two entities to be established, each with its own associated formation and maintenance fees. Both entities will also be subject to at least an $800 annual franchise tax from the California Franchise Tax Board as well.

In the case of a California LLC, whether membership interests are considered securities or not can be a complex issue and is fundamentally about how the LLC is managed and what the members’ involvement is in the management. If the members actively participate in the management and control of the LLC, their interests may not be deemed securities. However, if the members are essentially passive investors, their interests could potentially be treated as securities under applicable law.

Interests of Limited Partners in a California Limited Partnership are always considered securities under applicable law. This is because Limited Partners, by definition, do not participate in the management and control of the partnership because they are passive investors.

While a sole member California LLC or a California LLC managed by all members may not require California and federal securities registrations, qualifications, or exemption filings, securities filings will always be required when issuing interests to Limited Partners, which can also increase the cost of a California Limited Partnership compared to a California LLC.

However, despite these higher upfront and continuing costs, it is important to consider the potential long-term benefits, such as greater liability protection for the General Partner and potential tax savings in the form of self-employment taxes and not subjecting the business to the California LLC Fee.

Only One Person is Investing in Real Estate

Many solo real estate investors opt to form a California LLC over a California Limited Partnership by default because they are the sole party involved in their investment ventures and the structure of a California Limited Partnership requires at least one General Partner and One Limited Partner versus a California LLC, which may be owned, managed, and operated by only one person.

However, even a California Limited Partnership may be owned, managed, and operated by only one person when using a limited liability entity owned and operated by that one person as the General Partner.

Identity of the Limited Partner When Only One Person is Involved

A real estate investor who opts for the structure of a California Limited Partnership can take on the role of a Limited Partner in several ways.

First, they can become a Limited Partner on a personal level, using their own identity.

Second, they can assume the role of a Limited Partner through a trust they already have for estate planning purposes. This methodology aligns the investment with long-term wealth management strategies and ensures a clear transition plan for the assets of the investor.

Finally, the investor can leverage another entity they have already established for other investment purposes, provided they are not concerned about mixing the risks of two investments into one business entity.

Each of these options provides varying levels of liability protection, tax implications, and control over the investment, all of which should be thoroughly considered when deciding on the structure of the Limited Partnership.

Identity of the General Partner When Only One Person is Involved

When one investor intends to operate income property as a California Limited Partnership, as discussed in detail above, it is advisable to form a limited liability entity to act as the General Partner. Entities such as a California corporation, California S-Corp, or a California LLC are suitable options.

This approach not only limits the liability of the General Partner and provides the ability to do strategic self-employment tax planning but as long as the limited liability used as the General Partner is not also named as the Limited Partner, just one person can act as both the limited partner and operate the limited liability business entity that acts as the General Partner.

Is a Limited Partnership Right for Your California Property Investment?

If you are navigating the complexities of real estate investment in California and contemplating whether to opt for a California LLC or a California Limited Partnership, let the experienced corporate attorneys at San Diego Corporate Law be your guide. Our team is well-versed in the nuances of each business entity and can help you make an informed decision tailored to your specific needs. Do not leave your investment to chance; contact us today for assistance in deciding on the best business entity for your real estate investments.