The Small Business Partnership: General and Limited Partnerships
Knowing about the different forms of small business partnership can help you decide whether forming a partnership is right for you.
General partnerships are the easiest type of business relationship to form. Unlike corporations or limited liability companies (LLC), partnerships have no formal requirements or paperwork that needs to be filed. All you need to form a partnership is a business and a sharing of profits (there's no such thing as a non-profit partnership). Partnerships are a unique business relationship because they are so easy to form, and, as you'll see below, potentially difficult to manage and dissolve.
Types of Partnerships
There are three types of partnerships that businesses can choose—general, limited or joint venture. In a general partnership, the partners equally divide management responsibilities, as well as profits.
Joint ventures operate as general partnerships, but are specifically formed for a limited purpose or a single project. If, however, the joint venture is repeated, it may be labeled a general partnership, at which point it must follow the rules for dissolution of a general partnership.
In a limited partnership, there are managing partners and limited liability partners (who are essentially passive partners who just invest money). The managing partner(s) manage the business and assume all liability from the success or failure of the business, while the limited partners can only lose the money they invested. Limited partnerships are more complex and generally require paperwork that formally recognizes the structure.
For this article, we'll focus on general partnerships, as they are the most common, with a few references to limited and joint venture partnerships, where relevant.
Because partnerships are so easily created, you'll want to choose your partners carefully and, wherever possible, enter into a partnership with a written document that guides the behavior of all parties. Without a written agreement, partners are required to follow certain rules for partnerships. For example, in the absence of a written agreement, partners can't draw a salary and instead share profits equally. Even if you're doing 80% of the work and your partner only 20%, without a written document to the contrary, you must split profits evenly.
Yet another reason to choose partners wisely is that all partners share equal authority to bind the partnership to business deals and debt obligations. This means that if your partner enters into a contract with an overpriced supplier, the partnership is responsible for the contract, and as you'll see below, you are personally liable for the debt if the partnership can't pay it.
Liabilities to Creditors
Probably the most important thing to know about partnerships is that owners are personally liable for all of the partnership's obligations. This means that if the business goes bankrupt or can't pay some of its debt obligations, the creditors can go after the partners' personal assets, including bank accounts, cars, and homes.
It is a frightening proposition and is the main drawback to partnerships. Many people choose to create limited liability companies (LLC) instead of partnerships because LLCs protect personal assets from business creditors. New partners aren't responsible for old debts incurred by existing partners, but outgoing partners can still be liable for new debts if they don't give notice that they are leaving the partnership.
There is an exception to personal liability in the case of limited partners, who have only invested money into the partnership. Limited partners must file a limited partnership certificate that includes the names of all general partners. Without such a document filed, even if the intent by all parties is to have general partners who run the business and limited partners who only invest money, the limited partners may still be personally sued by creditors.
Any debt that is owed to creditors can be collected from a single partner. The legal term is joint and several liability, and it means that each partner is individually responsible for the entire debt. It's a legal method that prevents passing the buck between defendants (or, here, partners). Of course, if one partner does end up paying for the entire debt, he can sue the other partners to collect his fair share.
Responsibilities to Other Partners
As in any marriage, you owe certain duties and bear responsibilities to your partner(s). These responsibilities include:
- a duty of loyalty and fiduciary duty
- equal profit sharing (unless there's an agreement that says otherwise)
- equal control and no salary (unless there's an agreement)
The fiduciary duty and duty of loyalty that all partners owe each other simply mean that a partner must act in the best interest of the partnership and can't act primarily to enrich himself. Partners must provide a proper financial accounting of their actions, and the partnership can sue individual partners for any financial wrongdoing.
The equal profit sharing, equal control, and no salary requirements again highlight the need for written agreements. Note that in any profit sharing agreement, you should confirm how the profits and losses are to be split. If you have an agreement that losses will be split 60/40 but don't mention profits, the profits will be split evenly, despite the fact that you are doing a majority of the work or have provided the startup capital.
Because the partnership isn't a special corporate entity (like an LLC), taxes on profits are paid through partners' personal income tax. The partnership reports its profits to the IRS (though it doesn't pay taxes on them), and this way the IRS can be sure it collects the proper amount.
Terminating a Partnership
In the absence of a written agreement, a partnership ends when a partner gives notice of his express will to leave (dissociate). When there's a written agreement, the partnership ends when an event outlined by the agreement occurs or when a majority of the partners decide to end the partnership after a single partner dissociates. Written agreements can be very useful in the termination of a partnership, because they can outline a process to be followed. For example, the partnership can allow remaining partners to continue the business if they agree to do so.
Whether there is a written agreement or not, it's fairly easy to leave a partnership, though you'll still be responsible for obligations that the partnership incurred while you were there. Terminating a partnership is more of a process than a single moment in time because there generally remains business that needs to be wound down (i.e., debts to be paid, obligations to be fulfilled).
Partnerships have the advantage of easily flowing profits into personal income and very easy formation, but also have the disadvantage of personal liability for business obligations. As a business owner, you'll have to weigh these factors and determine whether forming a partnership is right for you.