Types of Partnerships
Various partnership types enable partners to determine the ideal distribution of profits and liabilities among business owners.
Differentiate between partnership types, and recognize the key role liabilities play in these partnerships
- Starting an unincorporated organization, complete with one or more partners, is generally referred to as a partnership. Balancing the risks and returns of this relationship is accomplished through types of partnerships.
- Common types of partnerships include general partnerships, limited partnerships, joint liability partnerships, several liability partnerships, and limited liability partnerships.
- The primary points of differentiation between all of these models revolves around liability, and how it is distributed among partners.
- Having limited liability in a given partnership agreement offers protection from legal and financial claims, while simultaneously resulting in some loss of control and potential returns.
- Coming to complete agreement regarding the type of partnership, and the division of liability and profit, is the first step to building an organization from the ownership point of view.
- liabilities: Obligations, responsibilities, or debts owed to somebody.
- stipulate: To require something as a condition for a contract or agreement.
Starting an unincorporated company with one or more partners via an agreement is generally referred to as a partnership, in which each of the owners assume personal liability for the legal actions and debts of the entity (unless otherwise stated by law or within the agreement). Under this model, there are a few different formats that new business owners should consider before finalizing the agreement. Each format has implications, primarily revolving around the concept of liability, and choosing the right format for the needs of the partners is a critical starting point.
Types of Partnerships
For the purpose of this discussion, the most important types of partnerships to consider are general partnerships, limited partnerships, joint liability partnerships, several liability partnerships, and limited liability partnerships.
General Partnerships (GP)
This represents a default version of a partnership, which governs the relationships between the individual partners as well as between the partnership and the outside world. Each partner in the organization is considered an agent of the partnership, which means each partner represents the organization when dealing with external parties. Similarly, each partner has equal right to participate in the management, decision-making, and control (unless otherwise stated). Under most formats, adding a new partner requires the complete support and consent of all existing partners.
In terms of risks and returns (or liabilities and profits), the default assumption is that profits are distributed equally, and that liability is shared jointly and severally. Any debt or liability impacting the organization can be distributed equally (or via allocated responsibility) across the partners’ personal assets.
Limited Partnerships (LP)
In a limited partnership, a general partner may collaborate with a limited partner. A limited partner has no managerial authority, nor in most situations would they earn equal returns. However, the limited partner is protected by limited liability in legal situations regarding debt or other costs that may impact the general partner’s personal assets. Along similar lines, limited partners are not considered agents of the organization from a legal perspective. It is also important to understand that this is not the same as a limited liability partnership (LLP), in which all partners have limited liability.
Joint Liability Partnerships
Exactly as it sounds, a joint liability partnerships holds all partners equally liable for any financial and legal issues. As opposed to a several liability concept, in which liability may be distributed based on certain proportionate responsibility, joint liability partnerships are equal across the board. Picture a married couple purchasing a home. A joint liability on that loan would stipulate that both parties are equally responsible for repayment as well as equally in possession of the asset (i.e. the home).
Several Liability Partnerships
Several liability is the converse to joint liability, in which the involved parties will settle liability disputes based on respective obligations. This is easiest to demonstrate via an example. Assume two partners create a business, let’s say exporting wine. Partner A is in charge of sourcing, getting great wine from around the world. Partner B is responsible for the buyer side, and ensuring legality with the countries they are selling too. While selling to a more conservative country, it turns out Partner B accidentally overlooked some legal steps in the importing process.
As alcohol can be legally complex with costly mistakes, and it was partner B’s responsibility, it could be argued in a several liability case that partner B owes 80% of the cost for that mistake. To say 100% would likely be a little unfair, considering Partner A should be aware of the full channel. But how much liability does each party deserve? These are difficult questions, making this type of partnership slightly more complex.
Limited Liability Partnerships
Finally, there are limited liability partnerships (LLPs). In this situation, some or all partners have limited liability, which grants it some similarity with a corporation. LLPs do not hold each partner responsible for the financial and legal mistakes of the other partners. In some countries, LLPs must have a central GP with unlimited liability to put this risk somewhere (see limited partnerships). This format is quite popular among certain high-end services, such as law and accounting. It allows collaborative work while maintaining independence in regards to liability.
Like most legally complex concepts, in the United States in particular, LLP rulings can vary significantly from area to area. Understanding which liabilities are limited and which are not is important information to have before entering into a partnership.
When considering the appropriate type of partnership, liability is the key word. Prior to any formalized arrangement, each party should put forward their expectations concerning profit sharing and liability in clear terms. Aligning on the risk and return is the first step to moving forward in any professional business relationships at the ownership level.
Partnership agreements govern the relationship between the various individuals who are collaborating on a given venture.
Recall the more common components of partnership agreements, and recognize why these agreements are valuable
- Partnerships are not limited liability models, and as a result incur a great deal of individual risk for each partner.
- Partnership agreements are designed to mitigate such risks, and ensure that each partner is in complete agreement as to the terms of the overall business arrangement.
- Common clauses within a partnership agreement revolve around how decisions are made, how compensation is decided, how to mediate disagreements and disputes, and when it may be appropriate to remove a partner.
- partnership: An agreement between individuals to collaborate towards mutually determined objectives.
- Expulsion: The forced removal of an individual from a group, usually due to poor behavior.
Why Create An Agreement?
Similar to a sole proprietor, a partnership shoulders the majority of the risk when opening a new venture (unlike limited liability models). As a result of this, partners entering an agreement will want to consider creating a partnership agreement, which governs the nature of their relationship relative to the venture they are collaborating on.
For example, let’s assume that a startup company decides to formulate their business as a partnership between four people. They estimate that $100,000 will be required to get the business off the ground over the next two years. They agree to invest equally, and write in the contract that each individual will contribute $25,000. However, after the first two years, one member fails to contribute. This voids the contract with that partner, and the overall ownership of the business now rests with the individuals who fulfilled the contract.
Common Partnership Agreement Components
The above example is fairly simple. However, businesses encounter a wide variety of challenges in which contractual agreements can be useful. Here are a few common components of partnership agreements:
- Majority Management – This indicates that business decisions will be made through the authorization of the majority of partners, protecting partners from one individual partner controlling the entire organization.
- Annual Account – This obligates each partner to collaboratively settle organizational accounts and debts each year.
- Consistent Interest – As partnerships are often side projects, this obligates each partner to a certain amount of interest and/or time commitment in the venture.
- Resolution of Dispute – It is often a good idea to anticipate which types of disputes may arise, and denote standard practices for how these disagreements will be handled.
- Causes Income Losses – If the company is not achieving the expected profitability, this will scale down the compensation received by each partner relative to the business’s overall success.
- Misconduct Expulsion – At times, it may be necessary to remove one partner due to poor behavior. An example of this may be one partner spending far too much on business expenses, such as flying first class and abusing shared resources.
While there may be many more aspects of a partnership agreement depending on the specific type of business, and the needs of each partner, this list is a good tool in understanding the general logic behind such agreements. When entering a collaboration, it is important to consider what could go wrong before it goes wrong, and plan for how to handle that contractually.
Advantages and Disadvantages of Partnerships
Partnerships are easy to establish and carry many advantages, however there are risks due to the concentrated ownership structure.
Discuss the characteristics and advantages of partnerships
- The profits from the business flow directly through to the partners’ personal tax returns.
- The most obvious advantages to a partnership are the ease in which they may be established, the combination of a wider pool of skills and knowledge, and the increased ability to raise more funds with more partners.
- The business usually will benefit from partners who have complementary skills.
- tortious: Of, pertaining to, or characteristic of torts.
A partnership is formed between two or more professionals where the partners work together to achieve and share profits and losses.
Partnerships have certain default characteristics relating to both the relationship between the individual partners and the relationship between the partnership and the outside world. The former can generally be overridden by agreement between the partners, whereas the latter generally cannot be done. The assets of the business are owned on behalf of the other partners, and they are each personally liable, jointly and severally, for business debts, taxes or tortious liability. For example, if a partnership defaults on a payment to a creditor, the partners’ personal assets are subject to attachment and liquidation to pay the creditor.
By default, profits are shared equally among the partners. However, a partnership agreement will almost invariably expressly provide for the manner in which profits and losses are to be shared. Each general partner is deemed the agent of the partnership. Therefore, if that partner is apparently carrying on partnership business, all general partners can be held liable for his dealings with third persons. By default, a partnership will terminate upon the death, disability, or even withdrawal of any one partner. However, most partnership agreements provide for these types of events, with the share of the departed partner usually being purchased by the remaining partners. By default, each general partner has an equal right to participate in the management and control of the business. Disagreements in the ordinary course of partnership business are decided by a majority of the partners, and disagreements of extraordinary matters and amendments to the partnership agreement require the consent of all partners. However, in a partnership of any size, the partnership agreement will provide for certain electees to manage the partnership along the lines of a company board. Unless otherwise provided in the partnership agreement, no one can become a member of the partnership without the consent of all partners, though a partner may assign his share of the profits and losses and right to receive distributions. A partner’s judgment creditor may obtain an order charging the partner’s “transferable interest” to satisfy a judgment.
Advantages of Partnerships
- Partnerships are relatively easy to establish; however time should be invested in developing the partnership agreement
- With more than one owner, the ability to raise funds may be increased
- The profits from the business flow directly through to the partners’ personal tax returns
- Prospective employees may be attracted to the business if given the incentive to become a partner
- Usually the business will benefit from partners who have complementary skills
Partnerships and Taxes
Various partnerships need to file different tax forms; it is important to understand the IRS codes before embarking on a partnership.
Discuss the general tax requirements for subchapter S corporations and limited liability companies
- An S corporation, for United States federal income tax purposes, is a corporation that makes a valid election to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code.
- In general, S corporations do not pay any federal income taxes. Instead, the corporation’s income or losses are divided among, and passed through, to its shareholders.
- The shareholders must report the income or loss from the S-corp on their own individual income tax returns.
- limited liability: The liability of an owner or a partner of a company for no more capital than they have invested.
Partnerships and Taxes
Different types of partnerships have different tax requirements, and partners will need to fill out different forms depending on the type. Below, we discuss Subchapter S Corporations, and LLCs.
Subchapter S Corporations
Subchapter S Corporations have a tax election only; this election enables the shareholder to treat the earnings and profits as distributions and have them pass through directly to their personal tax return. The catch here is that the shareholder, if working for the company (and if there is a profit), must pay him/herself wages, and must meet standards of “reasonable compensation”. This can vary by geographical region as well as occupation, but the basic rule is to pay yourself what you would have to pay someone else to do your job, as long as there is enough profit. If you do not do this, the IRS can reclassify all of the earnings and profit as wages, and you will be liable for all of the payroll taxes on the total amount.
Limited Liability Company (LLC)
The LLC is a relatively new type of hybrid business structure that is now permissible in most states. It is designed to provide the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. Formation is more complex and formal than that of a general partnership. The owners are members, and the duration of the LLC is usually determined when the organization papers are filed. The time limit can be continued, if desired, by a vote of the members at the time of expiration. LLCs must not have more than two of the four characteristics that define corporations: Limited liability to the extent of assets, continuity of life, centralization of management, and free transferability of ownership interests.