Are you thinking about starting a business with another person or business entity? This article will discuss the “basics of partnerships”, the various “types” of partnerships, examples of each, the advantages and disadvantages of each, and the advantages and disadvantages of partnerships over other kinds of business entities like limited liability companies (LLCs) and corporations.
A partnership is created when two or more people go into business together for profit. Unlike other legal entities such as a Limited Liability Corporation (“LLC”), an S-Corporation (“S-Corp”) and a C-Corporation (“C-Corp”), partnerships can be quite relaxed. For example, a General Partnership (“GP”) doesn’t require a written agreement—you can simply agree (orally or otherwise) with your partner to enter a business relationship.
Although a partnership agreement is not required, it is certainly advisable, as the partnership will be subject to your state’s variation of the Uniform Partnership Act (the “UPA”) should you decline to enter into a partnership agreement. Every state has implemented some version of the UPA except for Louisiana. The UPA provides strict guidelines on how a partnership is governed and will not provide the flexibility that a partnership agreement will. Accordingly, you would be well-advised to consider a partnership agreement to protect oneself—and potentially your partner—from excessive liability.
One advantage that all partnerships (the General Partnership, the Limited Partnership, and the Limited Liability Partnership) have over other business entities is “pass-through” taxation. Pass-through taxation means that the partners and the partnership are not taxed separately. Rather, the partnership is only taxed once (discussed below). Next, we look at each type of partnership and what each has to offer.
The General Partnership
As explained above, a General Partnership is created when two or more people enter a business relationship to make money. Should the partners decline to enter into a written partnership agreement, your state’s partnership rules will be applicable to the partnership. Note that a partnership lasting longer than one is required to be in writing. As discussed above, every state—except Louisiana—has adopted some version of the UPA. While the relatively causal process in creating a partnership could be seen as advantageous, the UPA’s rules are rather rigid. Accordingly, it is recommended that you enter into a partnership agreement to avoid the negative consequences associated with a GP (explained in detail below). Should you decide not to create a written partnership agreement, here is what you can expect:
With respect to a GP, all partners maintain an equal right to manage the partnership. But, with this broad grant of authority comes a consequence; provided a partnership agreement does not state otherwise, all partners share equally with respect to the partnership’s income and losses incurred. Ostensibly, each partner is responsible regarding all other partners’ negligence and remains personally liable regarding any transaction made by the partnership. And not only is the partnership itself liable, but all the partners will also be held personally liable as well extending beyond their initial capital contribution.
For example, suppose Partner D and Partner E create a partnership to produce and bottle hand sanitizer. Partner D makes an initial capital contribution of $5,000 and Partner E makes an initial capital contribution of $50,000. Partner D has a gambling problem and doesn’t have the business-mind or skill set needed to properly manage a partnership and subsequently lands the partnership in $275,000 in debt. Bankrupt, the partnership is required to dissolve. Here, poor Partner E will not only forfeit their initial capital contribution, but they will also be personally liable with respect to the remaining debt—even though the debt occurred through no fault of Partner E.
Important lesson: give thoughtful consideration as to the kind of person you want to enter a partnership with. Are they trustworthy? Honest? Reliable? Suppose that you’re sure that your proposed partner is one of the “good ones” only to discover later that that isn’t the case—this is where the partnership agreement comes in. By making these considerations ahead of time, you’re able to protect yourself from what could be a potential disaster.
Partnership Agreement Requirements
If you are wanting to enter into a partnership agreement with your partner(s), here are some issues that should be addressed:
Note: Remember, even if you create a document entitled a “Partnership Agreement,” your state’s partnership rules will apply to all terms and conditions not addressed in the agreement. It is recommended that you consult with an attorney when creating a partnership to avoid excessive liability and other issues that could arise.
Keep in mind that a partnership requires two or more people. Accordingly, should one partner decide to leave the partnership, the partnership will not continue. However, it is possible that partners could enter “buy-sell agreements” with one another to avoid dissolution. A buy-sell agreement would allow the remaining partner to purchase the leaving partner’s interest so that the partnership may continue. When a partnership is terminated (through the process of dissolution), the partnership must resolve any outstanding issues concerning the partnership, the partnership’s debt, and the partnership’s creditors. Upon paying the partnership’s debt and creditor’s—should any assets remain—they will be allocated equally amongst the partners (unless your partnership agreement provides otherwise, of course).
The Joint Venture
A “joint venture” is a type of GP that is created in contemplation of a certain event or for a certain period. Accordingly, a joint venture will continue until the named event has occurred or a specified amount of time has elapsed. For example, suppose you and your best friend are avid knife-makers. While you love making knives together—and hope to enter a partnership someday—your current full-time positions do not provide adequate resources to take on knife-making full-time. However, in the meantime, you and your best friend both decide to take some time away from your full-time positions to try your luck at making and selling knives at the Texas State Fair (which only takes place during the month of October). Because the partnership is limited to knife-making for a specified period (the month of October), this constitutes a joint venture.
The Limited Partnership
A “Limited Partnership” (“LP”) is like a GP; however, a LP contains two classes of partners: “general partners” and “limited partners.” Accordingly, to qualify as an LP, there must always be a general partner and limited partner. The LP is based on the premise that some individuals maintain a specific skill set (a chef, for example), but do not retain the means to raise the capital (the money) needed to start a business, while other individuals are skilled in investing, but don’t maintain the required skills to manage a business.
A limited partner, unlike a general partner, can only be held legally liable with respect to their contribution to the partnership. For example, suppose Partner A and Partner B create Taco Stand, LP. Partner A, a talented chef, is a general partner who manages Taco Stand’s day-to-day operations and prepares Taco Stand’s special tacos. Partner B, an investor, is a limited partner who merely made a capital contribution of $10,000 so that Partner A could start the business. Now suppose that Taco Stand, LP went under and still has $25,000 in outstanding debt. Here, Partner A is legally liable with respect to the entire $25,000, whereas Partner B is only legally liable with respect to their initial contribution—the $10,000.
To be clear, a limited partner is not permitted to participate in the management of the partnership (even if the general partner(s) are running the partnership poorly). Indeed, once the limited partner engages in the management of the partnership, they are automatically deemed a general partner and lose their limited partner status along with their limited liability. So, while the LP is advantageous in that it can limit liability, the advantage can easily be lost.
Also like a GP, an LP enjoys pass-through taxation and is only taxed once rather than each partner being taxed individually, and then the partnership entity being taxed again. However, unlike a GP, a partnership agreement is typically required, and your state could also require you to register your LP with the state (at a cost, although minimal).
The Limited Liability Partnership
A Limited Liability Partnership (LLP) shares many of the characteristics of a GP and LP. However, unlike a GP and LP there are no general partners, and all partners are limited partners. An LLP is considered a legal “person” and can engage in any activity or transaction that an actual person would: purchase property, retain employees, and execute contracts. Like an LP, an LLP will require some kind of written agreement between partners. An LLP is one of the more beneficial business plans, as it spreads the level of risk amongst partners (all partners have limited liability and are not personally responsible for the negligence or malpractice of other partners), exploits individual skills and expertise, and establishes a clear division of labor. Typically, you will see doctors, attorneys, architects, accountants, veterinarians, etc. That set up LLPs. This is because most states require at least one partner (if not more) in an LLP to maintain a professional license.
An LLP can also be explained as a cross between a partnership and a corporation. While an LLP maintains some of the benefits associated with partnerships—pass-through taxation, for example (discussed above)—it also can come with the legal reporting requirements associated with corporations. Keep in mind that not all states permit LLPs—and understandably so. With all partners maintaining limited liability, a patient or client harmed by a partner’s negligence could receive limited damages. Currently, about 40 states permit LLPs. Make sure to research your state’s partnership rules prior to making the decision to create an LLP.
Which Type of Partnership Should You Choose?
While this article was intended to provide you with the “basics” of partnerships—as the title suggests—there are many more aspects with respect to each type of partnership to consider before deciding which one is right for your business. The type of partnership you choose will be highly dependent on the kind of business you want to run and your preferred responsibilities. If you want to invest in a business without having the responsibility of managing a business, then a general partnership probably isn’t for you. Likewise, if you have concerns about starting a new business that could be a total flop, you might not consider a general partnership (without a partnership agreement) as it could leave you legally liable with respect to the partnership’s debts. As always, it is recommended to consult with an experienced attorney to help you assess which business type is right for you and can assist you in creating your business entity pursuant to your state’s requirements.