Going into business can be a real challenge, especially when there’s more than one owner. In this article I’ll explore partnerships—what they are, how to form one, and their advantages and disadvantages.
A partnership is a business structure owned by two or more persons who agree to carry on business together for a profit but decide not incorporate or form a limited liability company. There are three types of partnerships: general, limited, and limited liability partnerships.
In a general partnership, profits, losses, and managerial responsibilities are shared equally among the partners. Each partner has unlimited personal liability, which means that any or all of each partners’ personal assets can be taken in a lawsuit or to settle a debt.
A limited partnership is not a partnership in the typical sense. Rather, it is better viewed as an investment financing arrangement. In a limited partnership, there are two classes of partners: the general partner who has unlimited liability and the limited partner whose personal liability is limited to their investment in the business. The general partner manages the business while the limited partner remains silent on the sidelines. The general partner has full legal and financial responsibility for the business while the limited partner remains uninvolved in the management of the business. They typically have no personal liability beyond their investment in the business. Limited partnerships are commonly used for short-term projects, such as filmmaking, or for real estate investments.
A limited liability partnership is only available to certain professions, licensed by the state, such as accountants, attorneys, doctors, and engineers. The personal assets of the partners in a limited liability partnership cannot generally be used to satisfy business debts and liabilities. However, the limited liability partnership does not protect the partners for their own negligence or malpractice.
In this article, I want to focus our attention 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 for money, 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 to you as partner.
Each partner contributes to all aspects of the business, including money, property, labor and talent. In return each partner shares in the profits and losses of the business.
As with most things, it is usually a good idea to have things in writing, so 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 will operate. Your partnership agreement should include: how the business will be financed; who will do what work; what happens if a partner dies or becomes disabled; and what happens if a partner wants to leave.
The IRS considers a general partnership a “pass-through” entity, which means that, like a sole proprietorship, profits and losses flow through to the partners’ individual income tax returns. All the partners will share in the profits and losses of the business as well as be jointly and severally liable for all of its debts, liabilities, and obligations.
Each general partner has equal responsibility and authority to run the business and to bind it. What this means is that any one partner can commit the partnership by entering into an agreement on behalf of the partnership. And all the remaining partners will be personally liable, regardless of whether they authorized the agreement or even knew of its existence.
Because each partner has unlimited personal liability, a general partnership is the most dangerous type of entity to form. Not only can you be held liable for any agreement your partner enters into, you can also be held liable for any partner’s negligence.
In addition, each partner is personally liable for all of the partnership’s obligations. For example, if you are one of ten partners, you are not responsible for just ten percent of the partnership’s obligations. You are responsible for 100 percent. If the other partners are unable to pay their respective shares, you’ll be responsible for the entire amount.
The shared ownership attribute that characterizes a partnership has distinct advantages and disadvantages.
Advantages of a partnership
Easy and inexpensive to form—general partnerships are relatively easy to establish and are less strictly regulated than corporations or LLCs. The biggest expense in forming a partnership is drafting a written partnership agreement.
Easier to raise capital—with more than one owner, the ability to raise capital is enhanced because you have more resources to draw upon and the capacity to borrow money is usually greater.
More resources—a partnership benefits from the combined abilities of a group of persons who have complimentary skills. One person may be good at marketing while another is better at operations. There is a wider pool of knowledge, skills, and contacts to draw upon.
Disadvantages of a partnership
Unlimited personal liability—the main disadvantage is the fact that the partners have unlimited personal liability for all business debts, obligations, and liabilities. If the business is sued and judgment is obtained, all the partners could lose their personal assets to satisfy the judgment. And if the business goes bankrupt, all the partners will have to clear the debts, even if it means selling their personal assets. Most important, each partner is individually liable for the acts of the other partners.
Loss of independence—profits must be shared with others. And you’ll have to come to an agreement on how you value each other’s time and skills, which can be a challenge.
Limited life—the partnership usually has a limited life: it can end upon the withdrawal or death of a partner.