What is a partnership?

Going into business can be a real challenge, especially when there's more than one owner. In this post, I'll explore what a partnership is, how to form one, and its pros and cons.

Partnership defined

A partnership is a business structure owned by two or more persons who agree to do business together for a profit but decide not to incorporate or form a limited liability company.

There are three types of partnerships: general, limited, and limited liability.

Partners share profits, losses, and managerial responsibilities in a general partnership. Each partner has unlimited personal liability if the company loses a lawsuit or must settle a debt.

A limited partnership is not a partnership in the typical sense. Instead, it is an investment financing arrangement. Short-term projects, such as filmmaking or real estate investments, commonly operate as limited partnerships.

In a limited partnership, there are two classes of partners: the general partner, who has unlimited liability, and the limited partner, whose liability is typically limited to their investment in the business.

The general partner manages the business while the limited partner stands silent on the sidelines. The general partner has full legal and financial responsibility for the company, while the limited partner remains uninvolved in business management.

A limited liability partnership (LLP) is only available to state-licensed professionals, such as accountants, attorneys, doctors, and engineers. With an LLP, a partner is not liable for another partner's mistakes.

In this post, I want to focus on the most common type of partnership, the general partnership.

How to form a general partnership

Like a sole proprietorship, a general partnership is relatively easy to set up and maintain, as no paperwork is usually required to create it. Once you and at least one other person get together and sell a product or service with the intent to make a profit, a general partnership has begun.

Partnership status confers solely and automatically from the business activities of you and your partner. And partnership law automatically applies to your business and you as a partner.

How a partnership operates

Each partner contributes to all aspects of the business, including money, property, labor, and talent. Each partner has equal responsibility and authority to run the business and to encumber it. In return, each partner shares company profits and losses.

The importance of a written partnership agreement

You should invest the time needed to draft a written partnership agreement. If you don't, the partnership laws of your state will govern how your partnership operates.

Your partnership agreement should include how you will finance the business, define each partner's rights and responsibilities, specify what happens if a partner dies or becomes disabled, and explain what happens when a partner wants to leave.

How a partnership is taxed

The IRS considers a general partnership a "pass-through" entity, which means that profits and losses flow through to the partners' individual income tax returns. The partnership files IRS Form 1065.

The liability risk of a general partnership

Remember: each partner can encumber the partnership. Unfortunately, each partner is jointly and severally liable for the other's actions, even if they were not a party to the agreement or were unaware of its existence. 

Even more disturbing is that you are liable for your partner's negligence.

And to add insult to injury, each partner is personally liable for all partnership obligations.

For example, imagine you're one of four partners. You're not responsible for just 25% of partnership debt; you're responsible for 100% if the other partners cannot pay their share. While the shared ownership attribute of a general partnership offers some advantages, it comes in at too high a cost.

So let's take a further look at the pros and cons of a general partnership.

Advantages of a partnership

Easy and inexpensive to form. General partnerships are relatively easy to establish and less strictly regulated than corporations or LLCs. Drafting a written partnership agreement is the most significant expense in creating a partnership.

Easier to raise capital. With more than one owner, raising capital is easier because you have more resources to draw upon, and the capacity to borrow money is usually greater.

More available resources. A partnership benefits from the combined abilities of a group of persons with complementary skills. One person may be good at marketing, while another is better at operations. There is a broader pool of knowledge, skills, and contacts.

Disadvantages of a partnership

Unlimited personal liability. The main disadvantage is the partners' total personal liability for company debts and obligations. All the partners could lose their assets to satisfy a judgment. And if the business goes bankrupt, all the partners will have to meet the debts, even if it means selling their assets. Most importantly, each partner is individually liable for the acts of the other partners.

Loss of independence. Profits are shared. And you must agree on how you value each other's time and skills, which can be challenging.

Limited life. The partnership usually has a limited life: unless the partnership agreement makes provisions, the association ends when a partner withdraws or dies.