As described in the web article on limited liability entities, there are essentially three ways to engage in business in the United States: as a sole proprietor in which one person engages in business; as a partnership in which two or more people or entities engage in business; or as a limited liability entity in which a legally separate structure engages in business and that entity is owned by either individuals or other entities.
It is noteworthy that while the advantage of the limited liability entities are clear both in terms of limited risk and tax planning, most businesses in the United States are either sole proprietorships or partnerships. The reasons for this are usually based on the way most businesses get started. Quite often family members simply combine in a business thus forming a defacto oral partnership and especially at the commencement of business, taxes are not critical (since little money is made) and limited liability not a major concern since there often are few assets owned by the original owners to protect. Likewise, when an individual decides to begin a business, he or she does not want to "waste time" worrying about legalities and usually just buys inventory and opens the doors attempting to maximize income as soon as possible.
Further, many individuals are confused about the nature of corporations or limited liability companies, think that they cost a great deal to create or that a single person can not be the owner of such a limited liability entity.
As such, it is common for business people to have to confront the unique attributes and requirements of partnerships and while such entities can be altered to limited liability structures if the partners agree, quite often such agreement is not forthcoming and the business must remain a partnership.
Which is not all bad. Partnerships do not have the advantages of limited liability or separate tax status, but they would not have survived for hundreds of years as a type of business structure had they not had significant benefits as well.
This article shall discuss the basic modes of partnerships, their advantages and disadvantages, and shall make recommendations as to how to avoid certain recurring problems that exist in partnership relationships. This article will not discuss "Limited Partnerships" which are a unique structure usually used in real estate ownership and the subject of a separate article.
THE BASICS: WHAT IS A PARTNERSHIP?
A partnership is simply two or more persons engaged in business together pursuant to an agreement between themselves to do so. The maximum number of partners is unlimited and the minimum is two. The persons may be limited liability entities or even other partnerships. The agreement may be verbal or written. It may even be implied by the acts of the partners.
A partnership that is created to perform a specific task which has a discernable end is often called a "joint venture," and is expected to end when the particular task is completed or other events agreed by the partners occur. Typical joint ventures are partnerships created to construct a building or buildings; to exploit a particular market that will exist for a finite time; or to sell a product or products whose useful life is limited.
A more modern variation on a partnership is often called a "strategic alliance" in which separate entities combine to engage in a particular business in a particular market while often remaining competitors in other markets or with other products. Thus, rather than developing a product of its own, a particular manufacturer may enter into what amounts to a partnership with another manufacturer in which the marketing apparatus of one in a particular country is used with the product of the other with the profits divided.
Most partnerships are verbal ones and often people engage in business together without formally entering into any particular agreement other than, "let’s be partners." The danger of that approach is discussed in detail below but it is vital to note that partnership agreements do not have to be in writing to be binding.
Partners, unless there is agreement to the contrary, each have full and complete authority to bind the partnership to third parties. Each partner is thus the authorized agent of the other and since partnerships are NOT limited liability entities, each partner is jointly and severally liable for the debts and taxes of the entire partnership.
That last point must be stressed since it forms the most dangerous single aspect of partnerships. Each partner is one hundred percent liable to third parties for the entire obligations of the partnership and that is a personal obligation. While the partners have the right of contribution from each other, (e.g. if I pay 100% of a partnership obligation, I have the right to seek contribution of the fair share from my other partners) each partner is fully liable to third parties for the entire amount. This means that if I am a creditor and I know you are one of three partners, I need only sue you and it is no defense for you that you have other partners...it is up to you to seek your own contribution; I have the right to obtain my full recovery from you.
The typical danger, of course, is that the partner with the most money ends up paying the entire debt since creditors flock to him or her and he or she may not have any other partners with money to contribute. More on this below.
Partnerships exist for the period of time in the partnership agreement and if there is no limit therein, until the partners voluntarily end it or the number of partners is less than two due to death or withdrawal. Unlike joint ventures, there is no particular time for them to end. (It is again important to notice the difference between limited liability entities, which can exist even after all the original shareholders are dead or have left, and partnerships, which are coextensive with the life and participation of the actual partners.) Of course, corporations can be partners themselves and often are.
In terms of income, each partner is normally entitled to receive an pro rata percentage of the income of the partnership-and is equally liable pro rata to each other partner for the actual debts that are to be paid. (Thus, if I own 30% of the partnership, I am entitled to 30% of the profits and am liable to the other partners for 30% of the losses and expenses.) Taxes are treated precisely the same way with the notable exception that the taxing authorities, like other third party creditors, are free to seek all the taxes from one of several partners and let the individual partners fight it out between them for appropriate contribution.
In terms of power, each partner is entitled to vote his or her opinion, usually based on the percentage of the ownership owned, and assuming an unequal number of partners, majority vote prevails. Equal partner interest voting can result in deadlock quite easily and such a deadlock will normally destroy the partnership business if not quickly resolved.
The above basic attributes can be radically altered if the partners so agree in the partnership agreement. Obviously, a written agreement is vital to avoid confusion and dispute as to the alterations from basic partnership structure since the parties seldom agree as to what the terms were in a verbal partnership agreement once a fight begins.
ADVANTAGES AND DISADVANTAGES OF THE PARTNERSHIP STRUCTURE
The greatest single advantage of the partnership is also its greatest weakness: it is easy and fast to set up and the most informal way for two or more people to engage in business together. If you begin to do business in conjunction with another person, you are automatically partners and there is no need to file any documents with any governmental agency or have an attorney write up a partnership contract. Since the partnership has no separate tax identity, even your taxes do not require additional complex filings since the partnership income (or loss) is simply added to your own taxes based on a separate attachments to your income tax forms. While business licenses have to be obtained along with all the other paraphernalia of starting a business, that is true of a sole proprietorship as well and it seems to many business people that they therefore can become partners with almost no "fuss" at all.
Which is true. And, so long as things go well, the weaknesses of a partnership do not surface. Even personal liability for business obligations can be minimized by appropriate liability insurance and anyone who starts a new corporation or limited liability company is aware that many creditors and banks require personal guaranties from the owners of such limited liability entities in any event.
The weakness of the partnership is quite simple: the structure works well so long as things go well but if anything goes wrong, it is usually the worst possible structure to have and the way to solve most of the structural problems-a good and long partnership written agreement-is just as complicated and expensive to create as setting up the corporation or limited liability entities that are even better than a partnership for business operations.
A few examples of typical partnership weaknesses should suffice to demonstrate the types of problems the partnership structure creates.
First, if a corporation or limited liability company goes bankrupt or closes its doors, the owners may lose what they invested in the company but, absent personal guaranties, their personal assets are safe. When a partnership goes bankrupt, the personal assets of each and every partner are liable for each and every debt of the partnership and if your various partners do not have sufficient sums to pay their share, then YOU pay their share.
Second, each partner has "apparent authority" to commit the partnership (thus each and every other partner) to contracts and obligations to any third party. That is true whether or not the other partners actually approved the obligation. While the partners may have the right to sue each other for abusing such authority, in reality the usual situation is that the partner who made the commitment is without funds thus the solvent partner is left having to pay the debt he/she never agreed to...without any real relief.
Third, if there is a dispute among partners, the result is usually total domination of a minority partner by the others or deadlock of the partnership which stymies all operations. The former results in the minority partner trying to force dissolution of the partnership in court. The latter results in the court appointing a receiver to run the partnership. Both events are usually disastrous to the business and result in its demise.
Fourth, the death, disability or divorce of one of the partners almost always results in the destruction of the partnership thus the continued existence of the partnership is dependent on the continued ability of each partner to continue his or her involvement. Death of the partner means his or her heirs own his or her interest: usually this is an untutored spouse or child who seems a burden to the other partners and who is unable to protect his or her interest. Disability results in a key member of the partnership not being able to contribute-but still being entitled to a share of the profits. The remaining partners are usually desperate to have help, guilty at wishing the disabled partner was not there...and therefore caught in a bind which normally destroys the partnership.
Perhaps divorce is the most dangerous event to occur in a partnership since most divorce attorneys use the partnership interest as a bargaining chip for the spouse facing divorce and the partnership either finds itself with two very hostile spouses as partners, each owning half of the former joint interest, or finds itself with a partner completely distracted as he or she tries to raise funds to pay off the spouse and save the partnership.
Fifth, tax planning is not only difficult, but the tax goals of the different partners may result in friction within the partnership. For instance, a partner with outside income may wish the partnership to avoid making too much income, thus to reinvest into various business expenses to achieve a loss for the year and a deduction for his or her income; other partners may be desperate to squeeze every last dollar out and not have other income to try to shelter. The differing goals may lead to bitter fights within the partnership and there is little that can be done to assuage the different needs in a structure that is "tax transparent."
Lastly, the basic case and statutory law as to how to resolve disputes within a verbal partnership are simply clumsy and expensive to utilize. A suit to dissolve the partnership or to appoint a receiver will often cost tens of thousands of dollars and last months or years. Litigation against copartners who exceeded authority last even longer and cost even more. In the fast moving world of American business, the courts are simply too slow and clumsy to solve the issues facing the average business dispute.
Virtually every one of the disadvantages described above can be minimized by a good written partnership agreement as descried below: but one wonders if the creation of a partnership agreement, which is as long and complex a document as a limited liability company agreement or corporate bylaws, is worth it: to go to the expense and trouble of creating such an agreement probably means one should have incorporated in any event.
(Joint ventures are unique temporary partnerships, usually involving sophisticated business people already engaged in business, thus are appropriate business structure to use for limited business ventures though creating a limited liability entity owned jointly by the cooperating companies is also often done.)
THE WRITTEN PARTNERSHIP AGREEMENT
With well over a hundred years of history, the usual weaknesses of partnerships are well known as are their solutions. A written partnership agreement, executed by all the partners and, if appropriate, their spouses, will solve most if not all of the problems associated with this method of running a business. The key issue is getting all the partners (and their spouses) to execute the document since unless all partners sign, there is little or not value in having any of the partners execute it. Thus, it is at the formation of the partnership or, at least, when all partners are still relatively friendly, that such drafting and execution must occur. Unfortunately, as stated above, most partnerships are verbal and one or more partners only realize the need for a well thought out partnership agreement after a fight has begun, at which time execution is unlikely.
What clauses are good ones in the standard partnership agreement?
First, a clause should be inserted protecting minority rights and providing what occurs if there is a deadlock in voting. For example, a clause can be created that certain acts cannot be taken by the partnership, such as selling certain assets or paying over a certain sum to any partner, thus protecting a minority partner. For deadlocks, the parties can agree on the name or procedure for having a selected person break the deadlock for a particular decision (such as a friend to the partners or a procedure such that each partner picks a person, those persons then select the tie breaker who, alone, breaks the tie.) The costly court procedure is avoided, the matter is kept private, and the tension is normally dispelled. Indeed, a clause can be inserted that if more than a certain amount of deadlocks are encountered in a year, that the partnership will be sold to the partner offering the highest amount and if not so sold, dissolved. Again, court costs are minimized and a fair method created to resolve those disputes.
Another clause should be to insert a Buy and Sell arrangement as described in the Retainer Article on those types of arrangements. See the article on this web site. This clause, if done correctly, will eliminate much of the problems of death, divorce or disability to one of the partners.
Clauses can be inserted providing for arbitration of any disputes and awarding attorneys fees to the prevailing party. That method is relatively cheap and quick and the fact that one must pay to the winning party the attorneys fees incurred means that only truly held beliefs will result in actual arbitration.
Agreements can be inserted in clauses as to how to handle income and taxation, what sort of capital improvements will be allowed and what type of budget will be created.
What clauses cannot do, however, is eliminate the personal liability to third party creditors, including tax, that is inherent in the partnership structure, or the ability of partners to bind one another even in the absent of direct agreement as to what debt to incur. Certainly clauses can be inserted into the agreement limiting what the partners can do between themselves, but as to third party creditors, the clauses are not binding since the creditors do not execute the partnership agreement. It is true that the worried partner can contact a creditor and insist that all the partners must execute any order or purchase but few creditors will extend credit if complex arrangements are required and the old problem of "apparent" authority can arise in which the guilty partner simply lies to the creditor about the powers he or she has. And the issue of personal liability can never be avoided-it is in the very nature of the partnership arrangement. Liability insurance can avoid some of the danger but not the contractual or tax obligations.
As one of our clients once put it, the creation of a limited liability entity is the logical choice, the most inexpensive type of insurance available to a business person in the United States. If for some reason that is not possible, a well written fully executed partnership agreement is the appropriate solution. If none of that has been achieved, an intelligent partner should attempt to have the verbal partners execute one since it can be signed even after the partnership has been in business for years-IF all the partners will sign. Indeed, partners can switch their entity to a corporation or limited liability company but in such case the creditors will have to be informed and must consent to the limited liability status, usually requiring a new credit application or even personal guaranties.
And if they will not, the partner must resign him or herself to the knowledge that the courts do have solutions to many of the problems of a partnership; the solutions are simply slow and expensive. There are better ways to engage in business, true, but it may be some consolation to know that partnerships were the very first form of joint business venture, existed in the Middle Ages, and their continued viability is testimony to their workability in many instances.