Here in Part 2 I will cover the general partnership (as distinct from the limited partnership, which I will cover in a future article).
General partnerships are created whenever two or more people become co-owners in a business for profit. Generally however, partnerships are formally created by filing a certificate of organization with the state Secretary of State’s office or a DBA (“doing business as”) certificate with the City Clerk’s office, depending on the jurisdiction. After a partnership is formed, it is not generally required to draft a partnership/operating agreement like a corporation is required to draft bylaws — in the absence of a written partnership agreement the state partnership act and the course of performance between/among the partners serve as the default agreement.
Unlike corporations, where ownership and management are nominally distinct, in partnerships partners are usually responsible for strategic and day-to-day management of the partnership. By default, each partner is an agent of the partnership — they usually have the apparent authority to bind the partnership to transactions that are normally completed in the usual course of business. This can be an issue if partners are geographically disperse (and therefore partners are unable to check in on one another), but the situation can be improved by a well-crafted partnership agreement.
Partnership interests are relatively illiquid; under the default “pick-your-partner” rule, new partners can only be admitted by vote of the existing partners. Generally however, the economic rights of a partnership interest — that is, the right to receive tax credits and distributions of profits — can be freely bought and sold, but they do not carry any management rights. Moreover, a partnership lacks “continuity of life” — by default, the resignation, retirement, or death of a partner terminates the partnership; however, a partnership agreement can provide the partnership or the partners individually the right to purchase the interest of a resigned, retired, or deceased partner and keep the partnership going (in practice this is almost always done).
The agency, “pick-your-partner”, and lack of continuity life features that are by default a part of partnerships can make obtaining seed funding in exchange for equity (from family and friends, angel investors, or venture capitalists) by start-ups difficult. Not only would granting a partnership interest to seed investors by default grant management rights, which entrepreneurs may not want, but selling a partnership interest is difficult, which can discourage investment by angel investors or venture capitalists who normally invest with a view to selling their equity for a profit. Such issues can be mitigated, but not eliminated, by a partnership agreement.
Partners are jointly and severally liable for the obligations of the partnership, even if they arise as a result of the actions of only one of the partners. However, partnerships can file registration statements with their state’s Secretary of State office to obtain a limited liability shield. However, the shield usually only protects the partners from liability that arises after limited liability was obtained; furthermore, of course, partners are not protected from personal liability they incur in the course of partnership business, such as tort liability, for example.
Partnerships are considered pass-through entities for taxation purposes, so partnerships profits and losses are reported on the partners’ tax returns (though partnerships must also file informational returns). It is possible for profits, losses, and tax credits to be specially allocated among partners. The upside to pass-through taxation is that profits are only taxed once as opposed to the double-taxation of C corporations; the downside is that the tax liability is the partners’ responsibility, not the partnership’s responsibility. However, many partnership agreements include clauses that in the event that profits are retained in the partnership, distributions will be made to the extent to cover the partners’ tax liabilities.
As always, if you have any questions, or suggestions for future articles, head over to the Contact page and send us an email! Thanks for reading!