MAJOR TYPES OF ORGANIZATIONS
Various forms of business organizations are differentiated by the tax and other liabilities borne by their investors. Three major forms in the mid-2000s were corporations, partnerships, and limited liability companies (LLCs).
In a corporation an investor only risks the value of his or her investments in the company in the case of failure and only owes taxes on dividend income received. The corporation is legally a "person" and pays its own taxes. It is also at liberty to pay or not to pay dividends, although it is technically governed by the will of a majority of stockholders. The stockholder, in effect, is taxed twice: first on the net income of the corporation that he or she owns (in part) and then on the dividends. The investor, of course, never sees the first tax but gets less in dividends because it is paid by the company.
In a partnership each partner is an equal co-owner of the entity, pays an equal share of taxes due, and, in case of failure, equally shares in all of the liabilities of the partnership. Thus, in a partnership, liabilities are shared but not limited. The benefit of partnerships is that general partners are only taxed once. The partnership itself pays no taxes.
In an LLC the structures of a corporation and of a partnership are combined. Participants are "exposed" only to the extent of their investment because the LLC is treated as a corporation for purposes of liability; at the same time, the taxes owed by the LLC are paid by the participants in proportion to their share in the revenues. They are taxed once, not twice, as in corporations. LLCs, described in more detail elsewhere in this volume, are a relatively recent form of organization and growing rapidly because of the advantages that they offer. Because LLCs are limited in various ways, their growth appears above all to impact partnerships—the form of organization described in this article.
WHAT PARTNERSHIPS ARE
In the words of the Uniform Partnership Act, a partnership is "an association of two or more persons to carry on as Co-owners of a business for profit." The essential characteristics of this business form, then, are the collaboration of two or more owners, the conduct of business for profit (a nonprofit cannot be designated as a partnership), and the sharing of profits, losses, and assets by the joint owners. A partnership is not a corporate or separate entity; rather it is viewed as an extension of its owners for legal and tax purposes, although a partnership may own property as a legal entity. While a partnership may be founded on a simple agreement, even a handshake between owners, a well-crafted and carefully worded partnership agreement is the best way to begin the business. In the absence of such an agreement, the Uniform Partnership Act, a set of laws pertaining to partnerships that has been adopted by most states, governs the business.
There are two types of partnerships:
General Partnerships In this standard form of partnership, all of the partners are equally responsible for the business's debts and liabilities. In addition, all partners are allowed to be involved in the management of the company. In fact, in the absence of a statement to the contrary in the partnership agreement, each partner has equal rights to control and manage the business. Therefore, unanimous consent of the partners is required for all major actions undertaken. It is well to note, however, that any obligation made by one partner is legally binding on all partners, whether or not they have been informed.
Limited Partnerships In a limited partnership, one or more partners are general partners, and one or more are limited partners. General partners are personally liable for the business's debts and judgments against the business; they can also be directly involved in the management. Limited partners are essentially investors (silent partners, so to speak) who do not participate in the company's management and who are also not liable beyond their investment in the business. State laws determine how involved limited partners can be in the day-today business of the firm without jeopardizing their limited liability. This business form is especially attractive to real estate investors, who benefit from the tax incentives available to limited partners, such as being able to write off depreciating values.
Collaboration. As compared to a sole proprietorship, which is essentially the same business form but with only one owner, a partnership offers the advantage of allowing the owners to draw on the resources and expertise of the co-partners. Running a business on your own, while simpler, can also be a constant struggle. But with partners to share the responsibilities and lighten the workload, members of a partnership often find that they have more time for the other activities in their lives.
Tax advantages. The profits of a partnership pass through to its owners, who report their share on their individual tax returns. Therefore, the profits are only taxed once (at the personal level of its owners) rather than twice, as is the case with corporations, which are taxed at the corporate level and then again at the personal level when dividends are distributed to the shareholders. The benefits of single taxation can also be secured by forming an S corporation (although some ownership restrictions apply) or by forming a limited liability company (a new hybrid of corporations and partnerships that is still evolving).
Simple operating structure. A partnership, as opposed to a corporation, is fairly simple to establish and run. No forms need to be filed or formal agreements drafted (although it is advisable to write a partnership agreement in the event of future disagreements). The most that is ever required is perhaps filing a partnership certificate with a state office in order to register the business's name and securing a business license. As a result, the annual filing fees for corporations, which can sometimes be very expensive, are avoided when forming a partnership.
Flexibility. Because the owners of a partnership are usually its managers, especially in the case of a small business, the company is fairly easy to manage, and decisions can be made quickly without a lot of bureaucracy. This is not the case with corporations, which must have shareholders, directors, and officers, all of whom have some degree of responsibility for making major decisions.
Uniform laws. One of the drawbacks of owning a corporation or limited liability company is that the laws governing those business entities vary from state to state and are changing all the time. In contrast, the Uniform Partnership Act provides a consistent set of laws about forming and running partnerships that make it easy for small business owners to know the laws that affect them. And because these laws have been adopted in all states but Louisiana, interstate business is much easier for partnerships than it is for other forms of businesses.
Acquisition of capital. Partnerships generally have an easier time acquiring capital than corporations because partners, who apply for loans as individuals, can usually get loans on better terms. This is because partners guarantee loans with their personal assets as well as those of the business. As a result, loans for a partnership are subject to state usury laws, which govern loans for individuals. Banks also perceive partners to be less of a risk than corporations, which are only required to pledge the business's assets. In addition, by forming a limited partnership, the business can attract investors (who will not be actively involved in its management and who will enjoy limited liability) without having to form a corporation and sell stock.
Conflict with partners. While collaborating with partners can be a great advantage to a small business owner, having to actually run a business from day to day with one or more partners can be a nightmare. First of all, you have to give up absolute control of the business and learn to compromise. And when big decisions have to be made, such as whether and how to expand the business, partners often disagree on the best course and are left with a potentially explosive situation. The best way to deal with such predicaments is to anticipate them by drawing up a partnership agreement that details how such disagreements will be dealt with.
Authority of partners. When one partner signs a contract, each of the other partners is legally bound to fulfill it. For example, if Anthony orders $10,000 of computer equipment, it is as if his partners, Susan and Jacob, had also placed the order. And if their business cannot afford to pay the bill, then the personal assets of Susan and Jacob are on the line as well as those of Anthony. And this is true whether the other partners are aware of the contract or not. Even if a clause in the partnership agreement dictates that each partner must inform the other partners before any such deals are made, all of the partners are still responsible if the other party in the contract (the computer company) was not aware of such a stipulation in the partnership agreement. The only recourse the other partners have is to sue.
The Uniform Partnership Act does specify some instances in which full consent of all partners is required:
- Selling the business's good will
- Decisions that would compromise the business's ability to function normally
- Assigning partnership property in trust for a creditor or to someone in exchange for the payment of the partnership's debts
- Admission of liability in a lawsuit
- Submission of a partnership claim or liability to arbitration
Unlimited liability. As the previous example illustrated, the personal assets of the partnership's members are vulnerable because there is no separation between the owners and the business. The primary reason many businesses choose to incorporate or form limited liability companies is to protect the owners from the unlimited liability that is the main drawback of partnerships or sole proprietorships. If an employee or customer is injured and decides to sue, or if the business runs up excessive debts, then the partners are personally responsible and in danger of losing all that they own. Therefore, if considering a partnership, determine which of your assets will be put at risk. If you possess substantial personal assets that you will not invest in the company and do not want to put in jeopardy, a corporation or limited liability company may be a better choice. But if you are investing most of what you own in the business, then you don't stand to lose any more than if you incorporated. Then if your business is successful, and you find at a later date that you now possess extensive personal assets that you would like to protect, you can consider changing the legal status of your business to secure limited liability.
Vulnerability to death or departure. Unlike corporations, which exist perpetually, regardless of ownership, general partnerships dissolve if one of the partners dies, retires, or withdraws. (In limited partnerships, the death or withdrawal of the limited partner does not affect the stability of the business.) Even though this is the law governing partnerships, the partnership agreement can contain provisions to continue the business. For example, a provision can be made allowing a buy-out of a partner's share if he or she wants to withdraw or if the partner dies.
Limitations on transfer of ownership. Unlike corporations, which exist independently of their owners, the existence of partnerships is dependent upon the owners. Therefore, the Uniform Partnership Act stipulates that ownership may not be transferred without the consent of all the other partners. (Once again, a limited partner is an exception: his or her interest in the company may be sold at will.)
FORMING A PARTNERSHIP
Reserving a Name
The first step in creating a partnership is reserving a name, which must be done with the secretary of state's office or its equivalent. Most states require that the words "Company" or "Associates" be included in the name to show that more than one partner is involved in the business. In all states, though, the name of the partnership must not resemble the name of any other corporation, limited liability company, partnership, or sole proprietorship that is registered with the state.
The Partnership Agreement
A partnership can be formed in essentially two ways: by verbal or written agreement. A partnership that is formed at will, or verbally, can also be dissolved at will. In the absence of a formal agreement, state laws (the Uniform Partnership Act, except in Louisiana) will govern the business. These laws specify that without an agreement, all partners share equally in the profits and losses of the partnership and that partners are not entitled to compensation for services. If you would like to structure your partnership differently, you will need to write a partnership agreement. The subject is covered more fully in this volume under Partnership Agreement.
RIGHTS AND RESPONSIBILITIES OF PARTNERS
The Uniform Partnership Act defines the basic rights and responsibilities of partners. Some of these can be changed by the partnership agreement, except, as a general rule, those laws that govern the partners' relationships with third parties. In the absence of a written agreement, then, the following rights and responsibilities apply:
- All partners have an equal share in the profits of the partnership and are equally responsible for its losses.
- Any partner who makes a payment for the partnership beyond its capital, or makes a loan to the partnership, is entitled to receive interest on that money.
- All partners have equal property rights for property held in the partnership's name. This means that the use of the property is equally available to all partners for the purpose of the partnership's business.
- All partners have an equal interest in the partnership, or share of its profits and assets.
- All partners have an equal right in the management and conduct of the business.
- All partners have a right to access the books and records of the partnership's accounts and activities at all times. (This does not apply to limited partners.)
- No partner may be added without the consent of all other partners.
- Partners must report and turn over to the partnership any income they have derived from use of the partnership's property.
- Partners are not allowed to conduct business that competes with the partnership.
- Each partner is responsible for contributing his or her full time and energy to the success of the partnership.
- Any property that a partner acquires with the intention of it being the partnership's property must be turned over to the partnership.
- Any disputes shall be decided by a majority vote.
Clifford, Denis, and Ralph E. Warner. The Partnership Book: How to Write A Partnership Agreement. Nolo, 2001.
Gage, David. The Partnership Charter: How to Start Out Right With Your New Business Partnership. Basic Books, 2004.
Mancuso, Anthony. Form Your Own Limited Liability Company. Nolo, 2005.
Thompson, Margaret Gallagher. "Where We Were and Where We Are in Family Limited Partnerships." The Legal Intelligencer. 1 August 2005.