Partnerships

There are two types of partnerships, general and limited, each of which are discussed below. Like all other business entities, partnerships are a creation of state law. The majority of small business enterprises where there is more than one entity are general partnerships. Given the liability such business people face as a result of this, this fact is somewhat disturbing.

General Partnerships

General partnerships consist of two or more partners, and each one of those partners carries unlimited personal liability for the obligations of the partnership. Each partner has complete and equal managerial control over partnership affairs unless there is a partnership agreement stating otherwise.

Crib Notes–General Partnerships
Selling the Business: Selling an interest in a general partnership is very troublesome. All other partners typically have to agree.
Existence: The partnership can and usually does end at certain specified events (e.g., a partner dies) or when one or more partners decide it’s time to end the partnership.
Liability: All partners have UNLIMITED liability for all business debts and legal troubles! Each partner’s personal assets (i.e., home, savings, etc.) can be seized to pay partnership debts.
Taxes: Income earned by the partnership is attributed pro rata to the partners, who then pay income tax on their respective portion of the income.
Profits: These can be divided among the partners as they deem appropriate. (Note that this affects the partner’s tax liability accordingly.)

The law governing general partnerships can be found in the Uniform Partnership Act. The U.P.A. is a model law that states around the country have adopted with greater or lesser fidelity; states often modify it or fail to update their laws as the U.P.A. is revised, so there is some variance among the states. The laws contained in the U.P.A. are general guidelines for partnerships and are usually open to modification by the partners. In the parlance of attorneys, the U.P.A. rules are “default rules” that apply if the partners have not expressly contracted otherwise. Because the U.P.A. serves as only a fallback or “default regime”, businesspeople are left a great deal of flexibility to craft agreements governing the innumerable issues that could be important to their business.

Although a partnership can be formed very informally and without legal aid, it is preferable to have your lawyer draw up an agreement reflecting your particular needs, if only to prevent future disagreements over present intentions of the parties.

A partnership has some characteristics of a separate legal entity. Often, a partnership can sue other parties in courts and convey or buy property. But partnerships retain one very large disadvantage of the sole proprietorship: partners are held personally liable for the obligations of the partnership.Unpaid debts and tax bills of the partnership can result in the partners’ personal assets being subject to seizure.

Formation

Formation of a partnership can be easy. Two people who say to each other, “We’re partners!” may be partners under the law, even of they do not write anything down or say another word on the topic. Clearly this is not the best way to form a relationship where any more than nominal amounts of money are going to be involved.

Assuming you have a lawyer form a partnership for you, it will probably be more expensive than either a sole proprietorship or a corporation. (See the respective sections on formation for each of them to determine why this is.) The additional expense comes from the attorney-time necessary to craft a partnership agreement. Partnership agreements tend to be less standardized than other business entity agreements and thus need more attention. In any event, the expense should not be over $2000 and it is worth the expense to have the clarity that a well-drafted partnership agreement can bring to your partnership (Lenders and investors like clarity.)

Similarly, it is possible that the law will treat you as partners in certain circumstances (e.g., sharing profits in some instances, failure to legally create a limited partnership or a corporation, representing oneself as a partner) even without any agreement between the supposed partners. Even though formalities are unnecessary when forming a partnership, each state’s law should be consulted to insure that there are no particular requirements (for example, New York requires a filing in every county where the partnership will be doing business).

Forming partnerhsips haphazardly is very risky financially since, as noted above, each partner is liable for the partnership liabilities and a partner’s personal assets can be seized to pay such liabilities (see below for more). When coupled with the fact that each partner has complete and total power to act on behalf of the partnership, you have a potentially ruinous situation. Imagine, for example, your partner taking out a loan from a bank in the partnership’s name, which he could legally do, and then he loses it all in a risky derivatives deal that was a “sure thing”. Who is liable? The partnership, and that means you are liable. Such occurrences can be avoided.

Maintenance Costs

Partnerships are often cheaper to maintain than corporations. Partnerships do not have to make minutes detailing their actions like corporations, nor do partnerships pay taxes (the partners pay taxes individually on the income they receive from the partnership). There are no directors, officers, etc., just the partners.

Personal Liability for Partnership Debts

Each general partner in a general partnership has personal liability for all of the partnership debts. Under the Uniform Partnership act, general partners are jointly liable for partnership obligations. This means that each general partner must, in the event of the partnership being unable to pay its bills, pay the proportionate amount of the partnership debts equal to his ownership interest in the partnership. For example, if the partnership in which you have a 66% ownership interest cannot pay its bank loan of $100,000, then you will be personally liable to the bank for $66,666.67 of that amount (perhaps more depending on the state law and loan terms). The other $33,333.33 would be owed by the owner(s) of the remaining 33% interest.

Moreover, general partners are jointly and severally liable for the tortious acts of co-partners who are acting within the scope of the partnership business. Suppose, that there is a civil court case against your business which results in a $100,000 judgment against your business, you would be personally liable for all of the money owed, regardless of the percentage of your ownership interest. Assuming that your partnership was broke and you paid the whole $100,000, your 66% would allow you to seek reimbursement for the 33% of the $100,000 from your co-partner(s), but if they had no money you still have to make up the difference.

If that is too much like math word-problems, just remember this: Any judgment rendered against a bankrupt or cash-poor general partnership can result in the personal assets of the partners being seized to satisfy the judgment. That means your car, house, bank accounts, etc. are subject to seizure to pay the debt. Think about this when you are choosing your partners and making your choice of entity.

Management and Control

The law is fairly quiet about management of a partnership, saying only that in the absence of an agreement to the contrary, all co-owners of the partnership have an equal right to manage the affairs of the partnership regardless of the actual ownership percentage. This means that a partner owning 90% of a partnership cannot overrule his two partners who own 5% each. This dispersal of management authority can be avoided by the partnership agreement. Not surprisingly, this is often done when partnerships are formed, and management authority is commonly given to the partner who will be most active in partnership affairs.

Due to the law’s lack of guidance on management, there is a great deal of flexibility in structuring a partnership’s management. This structuring almost certainly has to be put into written form and will require an attorney’s attention. One of the traditional reasons people preferred partnerships is that there was this flexibility of management structure, as compared with the rigidity of the corporation. The development of a hybrid entity, the Limited Liability Company, has changed this, however. Limited Liability Companies are discussed elsewhere in the Choice of Entity chapter.

Fiduciary Relationship (the ties that bind!)

Partners in a partnership are bound together in a peculiar legal relationship: fiduciaries. While the law may forgive a person’s transgressions against other legal relationships like marriage, brotherhood, and parent/child, the law actually cares about fiduciary duties, and will not look kindly on those partners who do not honor the fiduciary relationship. (Maybe this is because money is at the heart of a fiduciary relationship rather than love. The law understands money, not love.) As a fiduciary of your partners, you will owe them your complete loyalty, honesty and fairness in all business dealings with one another. Once you enter the partnership, you cannot open a competing business, deprive the partnership of your time or skill, misappropriate partnership property (including intellectual property like computer programs), or take money out of the partnership without proper procedures being followed.

There is a positive side to this fiduciary relationship. The law recognizes that people want to choose people with whom they will share this type of relationship, so there are rules concerning the inclusion of new partners. No person can become a member of the partnership without the consent of all the partners. To illustrate, if one of your partners sells his partnership interest to another person who is not a partner, that new person is NOT a partner with all the rights and obligations that the law grants and imposes, at least not until you agree to have the new person as your partner. Note, however, that the new person would have a right to get the profits or losses that their ownership interest entitles them to (e.g., a 50% interest entitles them to 50% of the profits).

Dissolution

Partnerships, unlike corporations, do not have perpetual existence. Partnerships generally end upon the occurrence of the following events: the death, retirement, withdrawal, expulsion, incapacity, or bankruptcy of a partner; court ordered dissolution of the partnership; or the expiration of any date set as the termination date in the partnership agreement. A well-crafted partnership agreement can avoid the operation of the law in this area, but it should be kept in mind that the partnership entity is generally more delicate than a corporation or LLC.

Tax Aspects of a Partnership:

Taxation Basics The good news is that partnerships are not subject to federal income tax on the income they earn. The bad news is that the partners are considered to have earned the income attributable to the partnership (you don’t expect Uncle Sam to let you keep all of that money do you?). What happens is that at the end of the partnership’s tax year, the books for the year are closed out, and all money left over after bills, expenses, etc. are taken care of is (as far as the IRS is concerned) divided up among the partners according to their ownership percentages. And regardless of whether the money actually gets paid out in this, the IRS treats it as though all profits of the partnership have been distributed to the partners according to their ownership interests.

Pass Through Taxation Process The partners then pay income tax on the money they received from the partnership as though that money was personal income. Alternatively, if the partnership lost money that year, the partners get a deduction equal to the losses equal to their ownership percentages (limited by the basis of what the partner invested and/or the passive activity rules). (Like any other business entity a partnership must obtain a federal employer identification number using Form SS-4 and file its annual returns even though it is not acutally paying taxes.) The partnership annual tax report is made on IRS Form 1065. Remember, the partnership does not actually pay any taxes when it sends in Form 1065, this is filed only for informational purposes. States almost always have a form which is equivalent to Form 1065 and this must be filed annually as well.

The partnership (i.e., one of the partners) must prepare and provide each partner a Schedule K-1, which shows each partner’s share of the partnership’s profits and losses. The K-1 forms are then filed with each individual partner’s personal tax return. THOSE INDIVIDUAL PARTNERS THEN PAY INCOME TAX (or claim losses) IN AN AMOUNT EQUAL TO THEIR PROPORTIONATE SHARE OF THE PARTNERSHIP’S INCOME (or losses).

Distributive Share Sounds easy, right? Imagine you own a 50% ownership interest in Tanned Feet Partnerhip (a fine investment on your part, congratulations). At the end of 1998, Tanned Feet has income in the amount of $200,000. You will have to pay income taxes on $100,000 of that amount. This $100,000 is considered your “distributive share” as a 50% partner.

Unless there is an agreement to the contrary, the law and the IRS considers all partners in a partnership as owners of equal shares of the partnerhip. This means that if you have three people in the partnerhip, you each own 33.33% unless you agree otherwise. (Any such agreement should absolutely, positively, with no exceptions be put into writing and signed by each partner!) If you agree to split the partnership income in an unequal way, maybe to reflect the fact that some people bring more valuable skills or work longer hours to advance the business, the tax code and the law recognize this and will tax you accordingly. So if you report that a person holds a 65% interest in the partnership’s income, that partner will owe income taxes on 65% of the partnership’s income.

The Bad News There is a downside to the partnership taxation laws. If a partnerhip retains money at the end of the year instead of paying it out, the partners must still pay income tax on their respective shares of the partnership income. For example, if Tanned Feet Partnership earned $200,000 in income during 1998, and rather than being paid out to the partners, this money was kept in the partnership to buy additional computer hardware, the Tanned Feet partners would still have to pay taxes on the $200,000 income. If you think that you are going to run a business which will require a lot of retained capital, you may want to consider a C-corporation. (Remember that an S-Corporation is taxed much like a partnership, so it would not help you in this situation.)

Contributions and Capital Accounts The money and property “given” or contributed to the partnership by the partners are called “contributions”. The value of contributions given by each partner forms each partner’s “capital account”. A capital account is more a financial record of your investment in the partnership than an actual “account” in the way a bank savings acount is an account. The capital account helps determine the tax you owe on distributions paid to you by the partnership.

A partner’s capital account is increased by the value of the property she contributes to the partnership. A partner’s capital account is decreased by her share of the partnership’s distributions. The amount of the capital account forms the partner’s tax “basis”, and until the capital account reaches zero, the partner will not owe any taxes on the distributions she receives.

For example, suppose that in return for a 50% interest in Tanned Feet Partnership you give Tanned Feet Partnership $10,000 cash and $10,000 worth of computer equipment. This gives you a $20,000 capital account. At the end of 1998, Tanned Feet has made income of $200,000. You receive $100,000 from Tanned Feet as a distribution. You do not owe taxes on the first $20,000 of this $100,000 since you were only recouping your initial $20,000 investment. You do owe taxes on the remaining $80,000, however. Your capital account is also now reduced to zero so any future distributions will be fully taxable unless you increase your capital account with additional contributions to the partnership.

Contributions of property rather than money bring other tax rules into effect. Generally, the value of the property you contribute to the partnership will determine your capital account. But if you have already depreciated the property or if the value of the property has increased, you are caught up in a more complex taxation problem than we care to discuss here, and if you are contributing mortaged real estate to a partnership make sure you talk to your accountant!

Capital accounts are adjusted upward during the life of the partnership as well whenever a partner contributes additional money or property and decreases whenever there is a distribution of money (or recognition of losses).

Contributions of Services If you or another partner is a “skills” person who contributes no money or other property but is instead receiving a partnership interest for bringing a unique (or not so unique) set of skills to the partnership, you should be aware that the IRS does not recognize this as a contribution. As far as the IRS is concerned, a person who receives a partnership interest without making a capital contribution of money or property is getting a valuable asset for nothing. This is a taxable event and the person receiving the partnership interest will have to pay income taxes on the value of the ownership interest received. Keep this in mind if one person is putting in $100,000 for a 50% interest and another is putting in nothing for her 50% interest. The person who put in nothing just received a $100,000 taxable asset.

We know that this brief description of partnership taxation is going to make tax attorneys cringe, but it’s all you probably need for right now unless you intend to be a passive investor in a partnership in which case you probably have enough money to hire an accountant. (Passive investors are people who are just putting money into a business without performing any additional work on behalf of the business. People visiting this website almost certainly will not fall into this category.)

Limited Partnerships

A special type of partnership is the limited partnership. This type of partnership is found in almost all of the fifty states. Although it is based on the structure of the general partnership, the limited partnership has some very significant differences. Each of the following subsections will try to point out these differences.

Formation

To form a limited partnership, there are strict and inflexible statutory rules which must be followed, otherwise the attempt to form the limited partnership fails and a general partnership usually results instead.

Crib Notes–Limited Partnerships
Selling the Business: Selling an interest in a limited partnership typically requires the approval of the general partners.
Existence: The partnership can and usually does end at certain specified events, as enumerated in the limited partnership agreement.
Liability: General partners have UNLIMITED liability for all business debts and legal troubles! Limited partners have no such liability.
Taxes: Income earned by the partnership is attributed to the partners according to their ownership interests (e.g., 10% owners get 10% of the tax bill on income, same as in a general partnership).
Profits: Again, just like a general partnership, the profits can be divided among the partners as the parties desire.

A certificate must usually be filed with the state Secretary of State office or the office of the County Clerk in the county where the limited partnership will operate to provide a public record of the existence of the limited partnership. The filing certificate must contain whatever information is required by that state’s limited partnership act and signed by the partners.

Formation and maintenance costs are still higher than those of corporation for the same reasons that the general partnership costs are higher.

Limited Liability

Limited partnerships have one very large advantage over the general partnership: limited partners do not take on personal liability for the obligations of the partnerships, they are only liable to the extent of the money contributed to the partnerships. The general partner in the limited partnership, however, retains all of the personal liability for partnership debts that one finds in the general partnership entity.

It is important to know that the limited partner’s protection against personal liability can be lost in cases where a limited partner is found to participate in the control of the business beyond the limited role allowed to limited partners. What is the boundary of the limited role allowed to limited partners? How much participation is too much? Good question. This is an open question, so get help from your lawyer to help prevent the unintended loss of limited partnership status.

Limited Partnership’s General Partner

As mentioned earlier, the limited partnership must have at least one general partner who is personally liable for the debts of the partnership debt. But since this general partner can be a corporation, this requirement does not mean that one of the members of the limited partnership needs to accept potentially ruinous liability.

The general partner controls the limited partnership with the same scope of powers as a general partner would have in a standard general partnership.

The general partner also owes the limited partnership at least the same level of fiduciary loyalty that a general partner in a general partnership owes, perhaps more. Limited partners in a limited patnership, however, generally do not owe fiduciary duties to one another.

Continuity of Existence

The death, retirement, withdrawal, or bankruptcy of a limited partner does not end the existence of the limited partnership, but instead only requires an amendment to the limited partnership’s certificate. The limited partnership interest may be transferred to another person without the consent of the other limited or general partners. But the limted partner will still lack some rights unless there is approval by the other partners. The death, retirement, withdrawal, or bankruptcy of the general partner will dissolve the partnership.

Why use it?

The limited liability partnership is often attractive to entrepreneurs because they can retain control of the business by acting as the general partner, while still being able to offer limited partner investors the tax benefits of a tax flow-through entity. But with Limited Liability Companies now offering the same benefits without requiring a general partner, limited partnerships are becoming old news.