The next topic in our continuing discussion about selecting an appropriate form of entity for your business is “partnerships.” When the first two people in history came together in some hopefully lucrative enterprise, they had a “partnership” whether they knew that or not. Today of course, there is a little more to it.
Generally, a “partner” may be an individual or another legal entity (i.e. another business) such as a corporation, a limited liability company, or even another partnership. Depending on what you’re trying to do, there can be some restrictions from a tax or security perspective.
General and Limited Partnerships
Partnerships may be legally regarded as “general” or “limited” partnerships. A general partnership may be created in fact by simply doing business together, even without any formal agreement between the partners; however, some filings are indeed necessary to operate that business in compliance with laws and government regulations. The general partnership is recognized by law as a legal entity separate from its owners. Therefore, separate business licenses may be required, as well as obtaining separate tax identification numbers and filings of various types of tax returns and forms on behalf of the partnership.
In a general partnership, profits and losses may be shared in any percentage the partners desire. However, it is important to understand that the partners are jointly and severally liable for all of the obligations of the partnership. If the business should become insolvent and insufficient, partnership funds remain to pay all debts. Each partner is liable for 100% of each debt. Thus, one partner with funds may be required to pay all of the partnership debts because the other partner or partners do not have sufficient funds. While the solvent partner may have the right to collect a fair share from the others, the creditor is generally not restricted to collecting only each partner’s share from each partner.
On the other hand, a partnership may be created as a “limited partnership.” In a limited partnership there are “general partners” and “limited partners.” There must be at least one general partner. The general partner is responsible for management of the day-to-day operations of the business. Once again, the general partners are also jointly and severally liable for all of the debts and obligations of the limited partnership.
The limited partners, however, are liable for debts and obligations only to the extent of their investments in the business– their liability is “limited.” This limited liability is conditioned upon one important requirement. A limited partner cannot participate in the day-to-day management of the business. While a limited partner may vote on some matters generally related to the relationships between the parties, such as termination of the partnership, it is important that the ownership interest of the limited partner be “passive.” A limited partner who actively participates in the business operations runs a substantial risk of losing limited liability status.
While not required to operate as a general partnership, we strongly recommend that a written partnership agreement be prepared. In any business environment what was once amicable can swiftly turn adversarial. Without a signed written agreement to govern such important matters as sharing profits and losses, receiving an accounting for business finances, how to withdraw or wind up the business, transfer of partnership interests, and many other crucial issues may be left up to a court of law. To say that this may be disastrous to the business is an understatement.
A written agreement should be executed in order to form a limited partnership. This agreement is what defines the status of limited partners and limits their involvement and liability. Moreover, a Certificate of Limited Partnership summarizing the major points of the agreement must be filed with the appropriate filing authority in each state. Absent such filing, limited partners may be held to be general partners and thus lose the limitation on their liability.
No separate income tax is paid however. Partnerships are pass-through or “disregarded” entities whereby the profits and losses of the business are passed through to the partners in proportion to their interests in the business for income tax purposes.
One of the main advantages of creating a limited partnership is the enhanced ability to attract capital investment to the business. The unlimited liability of a general partner often acts as a great deterrent to potential investors, especially those who want to be passive owners and not be involved in the details of the operation. Formation of a limited partnership allows such investors to put a defined financial stake into the business in anticipation of a share of the profits without having to risk their entire net worth in doing so.
As with most types of entities, ownership interests in both general and limited partnerships are freely transferable or may pass as part of an estate absent written agreement to the contrary. Such agreements restricting transfer are very common in small business. A business founder also needs to be aware that public offerings for the sale of interests in a partnership, especially limited partnerships, may be subject to federal and/or state securities regulation depending upon the number of investors sought or the method of solicitation.
To repeat our previous admonishments, this is a lot for an untrained individual to understand and consider. We have really done nothing in this blog other than to point out the choices and the issues that may come up. How they are resolved is the subject of much more discussion. Obtaining the advice of a trained professional when setting up your business is money very well spent.
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