By Hanna Hasl-Kelchner, The No Nonsense Lawyer™
Whenever two or more people go into business together, the law presumes it’s a general partnership unless the individuals successfully incorporate their business. That legal presumption holds true even if no partnership agreement was entered into and no other steps were taken to formalize the arrangement.
In terms of the five factors to examine when determining the right business structure for your new venture (ease of formation and formality, tax reporting, legal liability, management and ownership flexibility, and future needs—see comparison chart), partnerships are very easy to create and have little required formality associated with them. They can be created by verbal agreement or written agreement.
Written partnership, or operating, agreements are preferable, and it’s best to negotiate them during the inception, or the honeymoon stage, of the business when compromise and consensus is most likely to occur and the financial stakes relatively low. A good partnership agreement addresses issues such as management and control, the sharing of profit and loss, contributions to the business (money, labor, and other assets such as equipment, patents, land, etc.), general rights and responsibilities, asset distributions, and the process for admitting new partners. Absent an agreement, a partnership automatically terminates upon the death or withdrawal of a partner.
Partnerships are not taxed as separate entities. Instead, profits and losses flow through to the partners’ individual tax returns. Profits and losses are also shared equally, unless there is a written agreement that states otherwise.
Multiple owners provide the advantage of sharing day-to-day management responsibilities, and from a management perspective, offers more flexibility than a sole proprietorship. The disadvantage of having multiple owners, however, is that from the legal liability perspective, each partner is jointly and severally liable for the legal obligations of the entire partnership.
Joint and several liability is a legal phrase that in this context means any one partner is responsible for the legal obligations of the entire partnership, not just the partner’s individual share. At first glance, the concept of joint and several liability sounds unfair. But the legal theory behind the concept is that it’s easier for a single partner to hold their other partners accountable, than to expect a third party to go after each and every partner individually. Basically, the purpose of joint and several liability is to protect third parties from getting the run around.
Since any general partner can bind the entire partnership, the practical consequence of joint and several liability is that you could wind up paying for your partner’s mistakes out of your own pocket; personal assets are not shielded by this form of business. The personal liability exposure will make you want to pick your partners carefully as well as craft appropriate contract protections.
One way to limit your personal liability somewhat is to enter into what is called a limited partnership. Rules for setting these up vary from state to state. Generally, such agreements must be in writing and differ from general partnerships by providing for two classes of partners: general or operating partners. These are the partners who handle the daily operations and continue to have unlimited personal liability, and limited partners whose personal liability is capped by the amount of their investment. Limited partners are the investors, who are sometimes referred to as “silent partners.”
Limited Liability Partnerships
If you want to limit your personal liability, but don’t want to limit your management role, you might consider a limited liability partnership. This third form of partnership is similar to a limited liability company and combines the flow-through tax features of a partnership, with the liability protection of a corporation. Requirements vary from state to state, and in some states, limited liability partnerships are only available for professional practices, such as doctors and lawyers.
While creating a partnership is a major decision, it is not an irreversible one. You can always change your form of business organization if the circumstances merit it. If you do find yourself wanting to make such a change after you’ve been in business for a while, it is highly recommended that you consult with an accountant and an attorney who is experienced in such matters so that you can avoid unnecessary tax consequences and complications. You’ll want to be sure that all of the appropriate legal steps are taken for a smooth and seamless transition.