101 Series: Entity Selection: Partnerships (A Cautionary Tale) - Daniel Ross & Associates

Pitfalls of Partnership

Let me first say that, perhaps with the exception of limited liability partnerships, the partnership relationship is an outdated, inefficient, and extremely risky type of legal entity. So why write about it at all? Because unlike other, more beneficial legal forms, you can enter into a partnership quite unwittingly. A partnership can be formed by:

  • Accepting someone’s services without paying them
  • Allowing someone to participate in management
  • Allowing someone to raise money on your behalf
  • Representing that someone has authority to act as your agent
  • Accepting a loan
  • Accepting a capital contribution
  • Accepting someone’s idea (think contribution of intellectual property)
  • Co-signing a lease
  • Opening a joint bank account
  • Promising to share profits
  • Failing to memorialize agreements

The last item on this list, failing to memorialize agreements, illustrates the best way to avoid falling into a partnership: memorialize your agreements! Form a contract and sign it – and include a “no partnership” clause. Aside from the language on the page, it’s a great way to “bring it home” and have everyone involved demonstrate that they are serious about their obligation and dedication to the agreement. Otherwise, your “informal” arrangement may stick you with someone invested in your venture who now has the right to manage the capital account, share in partnership profits, have their capital contributions be repaid (with priority), and manage business matters.

Not to mention the fact that you are now responsible (read: personally liable) for the actions, inactions, debts, and obligations of the other partners and the partnership. Personal liability is the number one reason why partnerships have gone by the wayside in favor of limited liability entities.

If you are unsure whether you are or may become involved in a partnership, look to these key factors:

  • the intent of the parties
  • the right to share in profits
  • the obligation to share in losses
  • the language of the written agreement (if any)
  • whether there is a community of power
  • representations toward third parties

Dissolving An Unwanted Partnership

If you find yourself in a relationship that may give rise to a partnership, the good news is that unless it’s by way of an explicit, written partnership agreement, they’re usually easy to dissolve. The most effective and straightforward approach is to give notice to other partners and potential partners of your intent to dissolve the partnership. If you feel the relationship is worthwhile, you can always reengage them with a written contract from there.

If you are a party to a contract that either by its terms or in application creates a partnership agreement, you’ll have to consult the provisions of the contract (which will hopefully provide for dissolution). If you are on good terms with the other partners, I suggest approaching them about amicable ways to disengage or restructure the agreement. Never burn a bridge you don’t have to!

Finally, there are several statutory situations where a partnership might dissolve automatically. They vary by state, but generally include:

  • The purpose of the partnership has become illegal
  • A partner may no longer legally own a business
  • The partnership is dissolved under a court order
  • The term of the partnership agreement (if any) has expired
  • A partner files bankruptcy
  • A partner dies

The Basic Partnership Structure

In the meantime (or if you absolutely must carry on with the partnership), it may be useful to understand a partnership’s structure. A partnership is defined as two or more persons carrying on as co-owners in a business for profit; meaning that a partnership can have any number of partners, and the agreement which is the basis for the partnership must be for the purpose of making money.

Each partner is an agent of the partnership and can bind the partnership by his or her words or actions. As with anyone who represents you or your business, make sure you trust your partners. That said, a partner cannot entangle the partnership with abandon. Each partner as certain fiduciary duties to the group, including:

  • The duty of care: a partner cannot engage in gross negligence, reckless or illegal conduct where the partnership is concerned
  • The duty of loyalty: partners must account for profits collected on behalf of the partnership, cannot enter deals where there is a conflict of interest, and cannot engage in business that competes with the partnership
  • The duty of good faith and fair dealing (also known as the duty of honesty)

The main benefit of a partnership (which, as we will see, has been replicated in other business entities) is single, personal taxation. There are no other forms or required filings – each partner simply declares the income from the partnership as part of his or her personal income. Partners do, however, generally have to pay self-employment tax on their partnership earnings.

Alternative Partnership Structures

I don’t need to tell you this, but the law isn’t a cut-and-dry thing. Far from a lean machine with a smooth evolution, the development of business structures is jolting and there are some less-than-useful evolutionary tails. Limited partnerships, and to a lesser extent limited liability partnerships, are examples of business structure adolescence. Still, you may run across them in your B2B dealings, so it’s useful to understand them as they come up.

Limited Partnerships
Limited partnerships share characteristics with both a partnership and a limited liability company. An LP is simply a partnership with one general partner and one or more limited partners. Just like in a traditional partnership, a general partner in an LP is personally liable for the debts and obligations of the LP. And like a member (i.e. owner) in an LLC, the limited partner(s)’s liability is limited to his or her capital investment in the partnership. The key difference is that general partners exert managerial authority over the business, whereas limited partners are “dumb money.” When a limited partner does exert control, he or she may become a general partner and incur personal liability.

Limited Liability Partnerships
Limited liability partnerships are essentially LLCs for professional groups. LLPs are a big step up from partnerships and LPs, especially in the context of professional groups where malpractice claims are a prevalent concern (think attorneys, accountants, physicians). These groups use LLPs to insulate themselves and the LLP itself from malpractice claims against a partner. The partner whose (in)action prompted a malpractice claim, however, cannot hide behind limited liability.

In the next post we’ll discuss LLCs – the gold standard for small business.

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