Primer on Business Partnerships

Primer on Business Partnerships

Advantages of a Partnership Structure

• Profits go straight into the 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

• Raising funds may be easier with more owners

• Easy to establish

Disadvantages of a Partnership Structure

• Partners are subject to the actions of other partners

• Limited life of a partnership -- if one partner leaves the partnership can end

• Partners are individually liable for business debts

• Shared decision making means you do not have full control, which could lead to disagreements or paralysis of the partnership

Three 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.

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.

Partnership Formation

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 operating 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.

Although not a legal requirement, it is a very good idea to have a written partnership agreement to prevent misunderstanding, internal squabbling, and to give the partnership solid direction. Limited liability partnerships do have to be in writing. 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.

Rules on the Operation of Business Partnerships

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 must be included in a written partnership agreement to be binding. 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.

Partnership Agreements Should Be in Writing

Partnerships are unique business relationships that don't require a written agreement to be legal. However, it's always a good idea to get it spelled out in writing. Partners share profits equally and, in the absence of a written agreement, you could run into situations where some partners feel they are not getting a fair deal. It's always smart to cover all major issues related to your business in writing.

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 cannot afford to pay creditors or if the business fails, the partners are individually responsible to pay for all the debts of the partnerships and creditors can go after personal assets such as bank accounts, cars, and even homes.

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.

Differences between a Partnership and a Corporation or an LLC

In a partnership, creditors can sue the partners personally to repay all business debts whereas a corporate entity, such as a limited liability company (LLC) or an S-corporation, the owners of the entity are on liable for the capital invested in the enterprise. If you form an LLC instead of a partnership, your personal assets would be safe from creditors of the business.

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. They also have a harder time raising capital because the creditors cannot go after owners to recover outstanding obligations.

Tax Treatment of Partnerships

Partnerships are pass-through entities, meaning that 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 the owners pay tax on their individual portion.

Terminating a Business Partnership

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.

The written agreement can specify that the partnership can dissolve if a certain event happens or it can provide a mechanism for the partnership to continue if the remaining partners agree to do so.