BUSINESS LAW: Partnerships

A partnership is an association of two or more persons coming together to carry on, as co-owners, a business for profit, whether or not the persons intend to form a partnership.

Basically, there are three types of partnerships, the "General Partnership" the "Limited Partnership" and the "Limited Liability Partnership". This article will discuss these entities.

GENERAL PARTNERSHIP

WHAT IS A GENERAL PARTNERSHIP? . . .

A general partnership allows for the participation of a number of principals, therefore permitting the distribution of work and sharing of risks among the principals.

Although the Uniform Partnership Act of 1994 provides a statutory framework for operating a partnership, the general partnership agreement, if one exists, is the primary source for determining the rights and obligations of the parties. Most of the statutory rights and duties of partners to one another are expressly made subject to any agreement between them.

NO PROTECTION FROM PERSONAL LIABILITY . . .

General partnerships provide no protection to the principals from losses generated by the business. General partners have the right to bind the partnership to contracts with third parties, although this right may be limited in certain situations. Each partner’s assets are fully exposed to third-party claims that arise from the operations of the partnership. All general partners may also be held liable for the partnership’s payroll taxes, including any penalty for nonpayment, regardless of which partners are responsible among themselves for remitting the taxes. Therefore, one must be confident in and comfortable with the other general partners.

Disparity of net worth, experience, or business acumen among the principals may indicate that general partnership is not appropriate in every case.

IMPORTANCE OF A WELL-DRAFTED
PARTNERSHIP AGREEMENT . . .

A good partnership agreement is necessary to address certain issues common to every partnership, before a dispute arises. The biggest mistake by partnerships is not having a well drafted partnership agreement and costly litigation often occurs after the break-up of a partnership, in order to resolve issues that could have been provided for in the partnership agreement.

Also, among other things, a partnership agreement should address issues regarding a buy-out of the partnership interest of a deceased partner, and a life insurance policy to fund the buy-out, making the transition of ownership of the partnership and estate issues easier.

For partnerships formed before 1997, the Uniform Partnership Act provides that a general partnership may be dissolved for myriad reasons, including the death or bankruptcy of a partner, withdrawal or admission by a partner, or the express will of any partner if no definite term or particular undertaking is specified.

For partnerships formed after 1996, the Uniform Partnership Act of 1994 controls. The newer version does not call for dissolution when a single partner dies, but instead requires the express will of at least half of the partners to dissolve and wind up the partnership business, thereby allowing for longer continuity of existence.

The partnership agreement can provide for a continuity of existence as agreed upon by all partners. Absent an agreement to the contrary, a partner cannot sell a general partnership interest without the consent of all other partners.

A partner is not a co-owner of partnership property, and has no interest in partnership property that can be transferred. A partner may, however, transfer his or her share of the profits and losses of the partnership, as well as the partner’s right to receive distributions. The remaining general partners of a general partnership traditionally are the most likely potential purchasers of a general partner's interest when an unanticipated occurrence forces a liquidation of that partner's interest. If the remaining general partners are unable or unwilling to purchase the interest of a withdrawing partner, the partnership may be forced to liquidate, much in the same manner as a proprietorship.

MANAGEMENT AND CONTROL . . .

A general partnership allows the responsibility for management, as well as the control of the decision making, to be spread among the partners. A general partnership allows the partners an infinite number of choices in dividing up the management responsibilities and allocating the ownership percentages. The choices are limited only by the imagination of the practitioner drafting the partnership agreement. Note, however, that the concept of centralized management may be difficult for a general partnership to accomplish because each general partner has the ability to bind the partnership in dealing with third parties.

A general partnership does not protect the partners from personal liability for company debts, but requires less formality and tax consequences than a corporation, and is less expensive to maintain than either a corporation or a limited liability company.

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FAQ's - About General Partnerships . . .

QUESTION: How do I choose a business format?

ANSWER: Owners of small businesses often choose a business format when they first open their doors, but this is a decision that should be reevaluated at regular intervals throughout the business' existence. What worked when you started may be costing you in taxes, or liability exposure later.

QUESTION: What is a general partnership?

ANSWER: A general partnership is a business owned directly by two or more people. Like a sole proprietorship, it is legally and financially equated to its owners. Financially, all of the profit or loss passes through to its owners, regardless of whether they take that money out of the business or not. And legally, all of the partners are liable for 100% of the business debts.

QUESTION: Why would anyone form a partnership?

ANSWER: A partnership does not have the formality requirements of a corporation of limited liability company. If personal liability is not an issue in the business, a partnership is an easy, natural, flexible business entity, and sometimes has good tax consequences.

QUESTION: Can you agree with your partners that only one of you will be liable for your share of the debts?

ANSWER: Yes, you can, but that agreement isn't binding on the creditors. They can look to you for 100% of the debt, and you have to find, and collect from your deadbeat partners. After all, you picked them.

QUESTION: What are the rest of the partnership choices?

ANSWER: There is a variation on the general partnership, and that is a limited partnership. In a limited partnership there is at least one general partner, who has full liability, and one or more limited partners who are only liable up to the extent of their investment. In other words, if the company becomes insolvent, the limited partners will lose their investment, but no one can come after them for any more money. The general partners, on the other hand, are fully liable for all debts. Often, a corporation will be the general partner, thereby insulating the shareholders from personal liability.

QUESTION: A limited partnership sounds a lot better than a general partnership. Why wouldn't you always use that?

ANSWER: First you would have to decide who was going to be the general partner, with all the exposure. More significantly, the limited partners can only have a limited role in the operation and management of the business. If they overstep the legal limitations, they become general partners and have full liability. Also, there are special costs and filing requirements for limited partnerships.

For information on Limited Liability Companies, click here: LLC

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LIMITED PARTNERSHIPS

A limited partnership is a partnership formed by two or more persons that has one or more general partners and one or more limited partners (or their equivalents under another name).

Often used for real estate transactions, the limited partnership provides a vehicle through which certain principals (the limited partners) may avoid subjecting their assets outside the limited partnership to the claims of the limited partnership's creditors. Only those assets contributed to the partnership by a limited partner, or as to which the limited partner has an obligation to make subsequent contributions, are subject to claims of third-party creditors of the partnership. This makes the limited partnership a superior vehicle for the attraction of equity capital.

A limited partnership must have at least one general partner and one limited partner. There may be different classes of general partners and limited partners. If there are, the Partnership Agreement must define the rights, powers, and duties of those classes relative to other classes of general and limited partners, respectively. The different classes may be given the right to vote separately or with all or any class or the general partners or any class of general partners on any matter.

If a limited partnership is not formed in accordance with applicable statutes, or if a limited partner is named as a general partner in the certificate or participates in the control of the business, the limited partner may lose the limitations on liability afforded by the limited partnership.

General partners in a limited partnership generally have unlimited liability for obligations incurred by the partnership. It is not uncommon to require that limited partners execute guarantees in certain business transactions. These guarantees subject the limited partner to liabilities in excess of those imposed by the obligation to make capital contributions.

In addition, if a limited partner participates in the control of the business without being named as a general partner, that partner is liable as a general partner only to persons who transact business with the partnership with (1) actual knowledge of that partner's participation in control and (2) a reasonable belief, based on that partner's conduct, that the partner is a general partner at the time of the transaction.

A limited partner is not deemed to be participating in control merely because the limited partner acts on matters related to the partnership business that are specified in a written partnership agreement to be subject to the approval or disapproval of the limited partners, or because the limited partner exercises any right or power under the California Revised Limited Partnership Act.

Continuity of existence is not a characteristic generally associated with limited partnerships. Although limited partnership interests are generally transferable, a limited partnership will be dissolved and its affairs wound up upon the earlier of the following:

1. The occurrence of an event specified in the partnership agreement;

2. The written consent of the general partners and a majority in interest
of the limited partners (unless the agreement otherwise provides);

3. The general partner ceases to be a general partner (for example, because of withdrawal, incompetence, or termination of corporate status), unless:

(a) the partnership agreement allows the partnership to be continued by other remaining general partners and there are other remaining general partners who agree to continue the partnership; or

(b) a majority in interest of the limited partners or the greater interest provided in the partnership agreement agree in writing to continue the business of the limited partnership and, within six months after the last remaining general partner has ceased to be a general partner, to admit one or more general partners.

4. The entry of a decree of judicial dissolution.

The transferability of interests of partners in a limited partnership has distinctively different characteristics depending on whether a general or limited partnership interest is being transferred.

A partnership agreement may provide that a general partner may not assign or encumber a partnership interest in a limited partnership. In addition, the transferability of general partnership interests is subject to significant restriction through (1) the requirement that all general partners consent in writing to the admission of a new general partner, and (2) the statutory right of limited partners to vote on the admission of a general partner.

In addition, a general partner who assigns all of his or her interest in a partnership to a third party may be removed by a majority in interest of the limited partners.

The transfer of a limited partner's interest does not dissolve a limited partnership, and the interests of limited partners tend to be freely transferable.

A limited partnership interest is assignable in whole or in part.

A transfer by way of merger is also possible when two or more limited partnerships merge into one limited partnership, subject to dissenting limited partners' rights.

A limited partnership may merge with a general partnership into a limited partnership or general partnership, provided that the merger is specifically permitted in the general partnership agreement.

Mergers with other business entities are authorized. Limited partnership interests do not represent an attractive commodity to third-party purchasers, and limited partners may be faced with a sale of their interests at a substantial discount if forced to liquidate an investment in a limited partnership.

In a limited partnership, management and control rests primarily in the general partners; as with general partnerships, management responsibilities among general partners in a limited partnership may be divided in a variety of ways in the limited partnership agreement.

Limited partners are allowed to vote on a limited number of issues and engage in various activities with the limited partnership without jeopardizing their status as limited partners.

A limited partnership is required to file appropriate certificates of limited partnership in a timely manner in order to provide the protection of limited liability to the limited partnership, and the protections from liability available to a limited partner are not fully available until the certificate of limited partnership has been properly filed.

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LIMITED LIABILITY PARTNERSHIPS (LLP)
(Only available to accountants and lawyers)

A limited liability partnership is a partnership formed by two or more persons that has one or more general partners and one or more limited partners (or their equivalents under another name). However, only partnerships engaged in the practice of public accountancy or the practice of law may be structured as a Limited Liability Partnership (“LLP”). No other businesses may consider the LLP option.

Legal and accounting businesses must weigh the advantages and disadvantages of an LLP compared to other entities. Among the advantages of an LLP are the following:

Limited liability of partners for tort, contract, or other damages that are incurred by the partnership while it is an LLP, and that arise by reason of being a partner or acting in the conduct of the business or activities of the partnership. An LLP partner cannot, however, escape liability to third parties for his or her own tortuous conduct:

Flexibility in form and structure that is available to all partnerships disporportionately allocate items of income, gain, loss, deduction, and distributions pursuant to the partnership agreement, within the restrictions of Internal Revenue Code Section 704(b). This flexibility is not available to corporations. Treatment as a partnership pass-through entity for federal tax purposes under the elective entity classification rules.

Characterization as a partnership avoids the double taxation imposed on subchapter "C" corporations, first on their earnings at the entity level and again at the shareholder level on dividends and distributions of property to shareholders, and LLPs, as partnerships, are not subject to the accumulated earnings tax or the tax on personal holding companies.

DIFFERENCES BETWEEN LLPs AND GENERAL PARTNERSHIPS . . .

The major difference between LLPs and general partnerships is that LLP partners can limit their liability by registering as an LLP and satisfying the security requirements. With certain exceptions, such as for personal tortious conduct, LLP partners are not personally liable for the LLP's obligations unless they agree to be liable, guarantee its obligations, or are held liable for obligations due to the LLP's failure to satisfy the statutory security or net worth requirements.

In contrast, all the assets of general partners are exposed to claims arising from obligations of the general partnership. A partnership is liable for loss or injury caused to a person, or for a penalty incurred, as a result of a wrongful act or omission, or other actionable conduct, of a partner acting in the ordinary course of the partnership or with the authority of the partnership. A partnership is also liable for the misapplication of funds or property by a partner.

A partner may become jointly and severally liable from the resulting partnership liability following from the above acts. Further, partners are jointly liable for any other obligations of the partnership. This extensive liability of general partners and the recourse to each partner's personal assets constitutes a fundamental disadvantage of a general partnership compared to an LLP, and is the primary motivating factor behind a partnership's determination to convert to a registered LLP.

DISADVANTAGES OF AN LLP . . .

Probably the most critical disadvantage of an LLP is that at the present timeCalifornia has no case law on which to rely for guidance in interpreting the limited liability that is intended to be afforded by the LLP legislation. In contrast, well-developed and instructive bodies of law exist concerning both corporations and limited partnerships.

TAXES AND LLP'S . . .

An LLP is considered a general partnership for state law purposes. An LLP may elect to be treated as a partnership under federal tax law. Except for special registrations and security requirements that must be complied with by LLPs, there is little to distinguish the day-to-day functioning of the two entities. Any existing partnership agreement of a general partnership converting to LLP status, however, would need to be modified to take into account various matters relating to the conversion.

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CONCLUSION . . .

Chosing a business entity must be made through a careful weighing and balancing of all the interrelated tax and non-tax factors involved in the formation and conduct of a business venture. It cannot be overemphasized that this choice must be made on a case-by-case basis and must be tailored to the specific tax, legal, and financial objectives and expectations of the principals involved in the venture. Both short-term and long-term objectives must be determined. The choice of the proper business entity need not be made at the inception of a venture. It is an ongoing decision that requires review and reconsideration at least yearly in the light of changing tax laws and the changing circumstances of the business and its principals. Changes can always be made when the circumstances require.


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