Partnership Rules: FAQs
While starting a partnership is much easier than incorporating there are rules and best practices that should be adhered to. For example, you want to make sure the responsibilities and profit split written into the partnership agreement properly reflects the reality of the partnership. Below are answers to some of the most frequently asked questions with regard to partnership rules.
What is a partnership?
A partnership is an association of two or more persons who carry on as co-owners and share profits. There can be a contribution of money (a capital investment in the business project) or services in return for a share of the profits.
What are the different types of partnerships?
There are three types of partnerships -- general partnerships, joint ventures, and limited partnerships. In a general partnership, the partners equally divide management responsibilities, as well as profits. Joint ventures are the same as general partnerships except that the partnership only exists for a specified period of time or for a specific project.
Limited partnerships consist of partners who maintain an active role in the management of the business, and those who just invest money and have a very limited role in management. These limited partners are essentially passive investors whose liability is limited to their initial investment. Limited partnerships have more formal requirements than the other two types of partnerships.
How is a partnership created?
There are no formalities for a business relationship to become a general partnership. This means you don't have to have anything in writing for a partnership to form. The key factors are two or more people who are carrying on as co-owners and sharing profits. Even if you don't intend to be a partnership, if that's how you hold yourself out to the public, then your relationship will be deemed a partnership and all partners will be liable for the obligations of the partnership (see liability issues below). Although there's no requirement for a written partnership agreement, often it's a very good idea to have such a document to prevent internal squabbling (about profits, direction of the company, etc.) and give the partnership solid direction.
Limited liability partnerships do have a writing requirement. It's a document that states that a limited partner has invested money into the partnership and retains little or no control over the partnership's operations. In this way, limited partners will not be held liable for the partnership's debt obligations and the partnership won't be influenced too greatly by the limited partner.
Are there rules on how partnerships are run?
The only requirement is that in the absence of a written agreement, partners don't draw a salary and share profits and losses equally. Partners have a duty of loyalty to the other partners and must not enrich themselves at the expense of the partnership. Partners also have a duty to provide financial accounting to the other partners.
For example, if you're in a partnership, you cannot make a deal to buy from a supplier at an inflated price with the understanding that you will receive a kickback from the supplier. It's a violation of your duty to the partnership, and your partners can demand an accounting from you regarding the deal. If you're found to have violated your duties, the partners can sue you for damages and strip you of your profits from the deal.
On the other hand, if you simply make a bad deal by signing a contract to pay a supplier an inflated price, the partnership will be forced to accept the deal. One of the potential drawbacks of a partnership is that the other partners are bound to contracts signed by each other on behalf of the partnership. Choosing partners you can trust, and who are savvy, is critical.
The only other rules would be found in a written partnership agreement. Such an agreement could outline procedures for making major business decisions, how profits and losses will be split, and how much control each partner maintains.
Do partnership agreements need to be in writing?
Partnerships are unique business relationships that don't require a written agreement. However, it's always a good idea to have such a document. Because partners share profits equally in the absence of a written agreement, you could run into situations where you feel that you're doing all of the work, but your partner is still getting half of the profits. It's always smart to cover major issues related to your business in writing.
What's my personal liability for the business obligations of the partnership?
Partners are personally liable for the business obligations of the partnership. This means that if the partnership can't afford to pay creditors or the business fails, the partners are individually responsible to pay for the debts and creditors can go after personal assets such as bank accounts, cars, and even homes.
For example, if the partnership dissolves and there are still outstanding debts to suppliers or lenders, those creditors can sue you personally to pay for the debts. Debts of the partnership will expose your personal assets to liability unless you're a limited partner, in which case your liability is limited to the money you've invested.
What's the difference between a partnership and forming a corporation?
The major difference is that in a partnership, creditors can sue you personally to repay business debts, whereas if you form a corporate entity, such as a limited liability company (LLC) or an S-corporation, the debt trail ends with the business.
In the example above, if you had formed an LLC instead of a partnership, your personal assets would be safe from creditors of the business. In legal parlance, creditors cannot "pierce the corporate veil", meaning the formation of the corporate entity forms a protective shield around your personal assets. It's a major advantage of forming an LLC, but LLCs also require more paperwork and money to register, start up, and maintain.
How are taxes paid by partnerships?
Taxes are paid through the personal income tax filings of individual partners. As a partner, you have income through your share of the profits (or a loss if the partnership is losing money), and you report this income on your personal taxes. The partnership itself reports profits and losses to the IRS on a special form (so that the IRS knows how much you receive), and you pay the taxes on your portion.
How do partnerships terminate?
In the absence of a written agreement, partnerships end when one partner gives notice of his express will to leave the partnership. If you don't want your partnership to end so easily, you can have a written agreement that outlines the process through which the partnership will dissolve. For example, the partnership can dissolve if a certain event happens or it can provide a mechanism whereby the partnership can continue if the remaining partners agree to do so.
What are the advantages of forming a partnership?
- easy to establish
- raising funds may be easier with more owners
- profits go right into partners' pockets, providing for easier tax reporting
- partners can combine their individual talents to complement each other and strengthen the partnership
- employees may be attracted to work for the partnership if they have an opportunity to become a partner
What are the disadvantages of forming a partnership?
- partners are individually liable for business debts
- partners are subject to the actions of other partners
- limited life of a partnership -- if one partner leaves the partnership can end
- shared decision making means you do not have full control, which could lead to disagreements or paralysis of the partnership
Get a Free Legal Evaluation of Your Partnership Needs
The type of business organization you form is a decision you must make on your own. However, an attorney will be able to guide you and your partners through the process and find any potential trouble spots before they become actual problems. You can get started today with a free evaluation from a small business attorney near you.