There is no more important decision you will make in starting your new business than the form under which your business will operate. For new business owners who are considering whether to establish a partnership, here are five important things to take into account in making your decision.
A PARTNERSHIP IS NOT JUST A PARTNERSHIP
So you want to form a business partnership? Well, all you have to do is find a partner, share the work, and divvy up the profits, right? Sounds simple. However, while a partnership can be the simplest form of business for many people, it is also more complicated than it sounds. Accordingly, the first step is to make sure that you select the form of business that is most appropriate for your particular situation.
There are many things you need to consider, including most importantly the protection of your personal assets against liability and the tax consequences of each particular form of business. An attorney will be able to tell you whether a partnership will provide you and your assets with adequate protection from liability in the event of a lawsuit. Consult with your accountant to determine what the tax consequences to the business and to each individual partner will be if you operate as a partnership.
Once you decide that a partnership is the best business form for you, your work is not over. A partnership can take many forms. It can be organized as a general partnership, a limited partnership or a limited liability partnership. Each form offers different protections, advantages and disadvantages. Investigate each partnership form and decide which is the best form for you and your partner(s).
You may choose to set up your business as a general partnership. If you do not choose a business form, under most state laws, a general partnership is the default partnership form. In other words, if you do not make a selection as to which type of partnership yours will be, the government will choose for you, and basically, a general partnership is a form the government will choose. Essentially, there are no formalities that are required to be followed to form a general partnership. No written partnership agreement is specifically required. Oral partnership agreements may be enforceable, although, as discussed below, it is highly recommended that a written partnership agreement be prepared.
With a general partnership, absent a formal agreement, all partners are considered to be equal partners. This means that each partner owns an equal interest in the partnership, is equally entitled to participate in operating and managing the business, and is entitled to an equal share in the profits of the business. This also means that each partner will share equally in paying taxes on those profits. Unless there is an agreement that specifies otherwise, disputes are settled by a majority vote of the partners and changes to the partnership agreement must be by a unanimous vote of the partners. If this is not the agreement you want to have with your partners, it is especially important to spell out in writing the agreement you and your partners will have with respect to managing the business and sharing in its profits.
While a general partnership can be the most simple partnership form, it does have some disadvantages. For example, under a general partnership, each of the partners is exposed to unlimited personal liability. This means that each partner is liable for the debts, obligations and losses of the partnership. Each partner is also liable for the actions of the other partners. By law, if a general partner makes a decision associated with the partnership’s business, the other general partners are bound by that decision.
The remaining partners may also be held liable for the tortious conduct of one of the partners committed in connection with the partnership’s business, e.g., fraud or misappropriation of funds. Such liability is joint and several, which means, for example, that if there are five general partners, liability will not necessarily be apportioned five ways. For instance, if a judgment is entered against a general partnership made up of five partners, the judgment creditor can go after the personal assets of all five partners in an attempt to satisfy the judgment. If only one of the general partners has personal assets, then one hundred percent of the judgment may be satisfied with that partner’s assets. He or she will not be able to argue that only one-fifth of the judgment should be satisfied with his or her assets.
As you can see, it is extremely important to actively select the appropriate business form for your partnership. If you do decide on a general partnership, it is crucial that you spell out the rights and responsibilities of the partners in order to avoid being subjected to the default general partnership rules. If you and your partners do not want to be saddled with the obligations and liabilities imposed by a general partnership, then you should consider the other partnership options available to you.
A limited partnership is a statutory form of partnership. In other words, each state has specific statutes regulating the conduct of limited partnerships. A limited partnership has one or more general partners and one or more limited partners. Basically, the general partner or partners take on all of the responsibility for running the business. They also take on the partnership’s liabilities, as well as the responsibility for any debts and obligations of the partnership. The limited partners are essentially financial backers. Their interest in the partnership is financial only. They put up the capital to operate the business of the partnership and share in the profits of the partnership. Their liability is limited to the amount of their contribution of capital to the partnership.
Limited partners do have the right, as investors, to access and review the records of the partnership. However, in order for the limited partnership form of business to be legally effective, it is crucial that the limited partners stay out of the day-to-day operations of the business and the decision-making process. If a limited partner becomes involved in those aspects of the business, he or she may expose himself or herself to the same liabilities as a general partner. He or she may also lose the tax advantages afforded to a limited partner.
To further reduce exposure to personal liability, a limited partnership may be formed with a corporation or corporation as the general partner(s). Under this scenario, the corporation(s) would bear the responsibilities and liabilities of the general partner and the individual shareholders would under most circumstances be afforded protection from personal liability.
LIMITED LIABILITY PARTNERSHIP
A very popular form of business today is the relatively new limited liability company form of business. This business form is considered a hybrid business form because it offers many of the protections from liability that forming as a corporation provides while retaining much of the favorable tax treatment that a partnership offers. However, statutory law in many states prohibits certain entities from forming as a limited liability company. For example, in the state of California, attorneys, accountants, and architects are prohibited by law from forming limited liability companies. These entities can, however, form a limited liability partnership.
The limited liability partnership form of business developed only recently. It resembles a general partnership, but with the added liability protection of a corporation or limited liability company. In general, this business form is available only to those professions that are precluded by statute from forming as a limited liability company, e.g., attorneys, accountants, or architects. By following certain steps, members of these professions can obtain protection from liability. For example, in the state of California, a law firm organizing as a limited liability partnership must register with the Secretary of State and with the State Bar. It must also provide evidence of liability insurance or sufficient net worth to satisfy judgments against the partnership in order to qualify for limited liability status.
GET IT IN WRITING
Whatever form your partnership takes, it is crucial that you have a written partnership agreement. This is true even if your partner has been your best friend since day one of kindergarten. In fact, this is ESPECIALLY true if your partner is a close friend. The best way to protect your friendship is to make sure that each partner understands exactly what is expected of him or her from the very beginning.
Believe me, this will save you disagreements and misunderstandings down the road. While you do not want to go overboard, generally speaking, the more detailed your partnership agreement is now, the better off you will be in the long run. Try to plan in advance for any and every contingency. There is any number of good books available at your local bookstore that set out sample partnership agreements. Look at these and see which provisions pertain to your particular partnership.
At a very minimum, your partnership agreement should spell out exactly what is expected of each partner in terms of both financial contributions and contributions to the work of the business. For example, will one partner be putting up the financial capital while the other partner’s contribution to the equity of the business takes the form of work, labor, and other efforts?
If so, I guarantee there will be times when the financial partner will think that the working partner is not working hard enough and earning his or her share of the business. And vice versa there will be times when the working partner will feel that his or her labor and efforts are worth far more than the financial value placed on them. For this reason, it is extremely important that the partners have an understanding from the beginning as to how much and what type of work is expected of the working partner(s).
The agreement should also specify whether additional compensation would be paid to partners who perform work in excess of the required number of hours or outside the scope of the agreement. For example, if one partner is an accountant and performs accounting services for the partnership, will he or she receive additional compensation? If so, how much will he or she receive and when will he or she be paid? Or will such services be considered a part of that partner’s capital contribution? If so, how will the value of those services be calculated and credited to the partner?
Finally, the agreement should spell out in great detail when and how the profits of the partnership will be split. Also, make sure your agreement conforms to and meets the requirements of your state. Be aware that, in most states, any agreement is construed AGAINST the party who drafted the agreement. What this means is that, if you take it upon yourself to put together a partnership agreement for the formation and operation of your partnership, and a dispute arises at some point in the future, many courts will take the position that you had an unfair advantage because you wrote the agreement.
For this reason, the most important step of all is to make sure that each partner has his or her own, separate attorney participate in the drafting and review of the agreement. Rather than get into arguments with your partner(s) over the details, let your attorneys hammer it out. They will make sure that each of you is protected and that the agreement is fair to everyone involved.