Partnerships can be an effective way to structure a small business. However, before forming one, you should carefully consider whether it's the best legal structure for you. This article explains "what is a partnership in business," discusses the risks and benefits of forming one, and highlights some of the many legal issues that a partnership can face, including the negotiation of a partnership agreement, resolution of partnership disputes, and dissolution of partnership.
Advantages and Disadvantages of Partnerships
A partnership is a relationship between two or more people to do trade or business. Each person contributes money, property, labor, or skill, and shares in the profits and losses of the business. While a partnership must file an annual tax return to report the income, deductions, gains, losses, etc., from its operations, it does not pay income tax. Instead, it "passes through" profits or losses to its partners. Each partner reports their share of the partnership's income or loss on their personal tax return.
The partnership is one of the simplest business entities to form (short of a solo enterprise). There are no corporate formalities to observe, and partners are not required to file separate tax returns for the business. However, partnerships can also have significant disadvantages.
The major disadvantage is that general partners have unlimited liability, meaning that each partner is personally liable for all of the business debts and claims, not just their share. Therefore, partners should make sure additional legal protections are in place to protect their personal assets.
For instance, a general partner doesn't have to be a person but can be another entity such as a corporation or a limited liability company. Since these business structures provide liability protection for the owners, the risk to a general partner's assets can be minimized or often eliminated. Of course, this does take away from the simplicity of operating as a partnership.
Additionally, a partnership is not as stable as a corporation or limited liability corporation. Without an agreement to the contrary, a partnership will dissolve when one general partner dies, files for bankruptcy, retires, resigns, or otherwise leaves the partnership.
Types of Partnerships
There are several different types of partnerships, each of which has its own risks and benefits. Below is a brief summary:
- General Partnership: In a general partnership, general partners have equal legal and financial liability and are jointly liable for the partnership's debts. They also share profits equally, with the details outlined in a written partnership agreement.
- Limited Partnership: Limited partnerships consist of both general and limited liability partnerships. In this type of partnership, at least one of the partners must be a general partner and bear full personal liability for the business. The general partner manages the company and is responsible for making decisions, while the limited partner has no responsibilities because they do not engage in the business's activities.
- Limited Liability Partnership: All partners actively run the business under a limited liability partnership (LLP), but they have limited liability for one another's activities. While partners are entirely accountable for the company's financial obligations and legal liabilities, they are not liable for the negligent conduct of their fellow partners. LLPs are commonly used by professionals such as architects, accountants, and lawyers.
Formation of a Partnership
You can form a partnership using a simple handshake. However, partners should always execute a partnership agreement, even though not required by law. The partnership agreement should minimally address crucial issues such as the financial contributions of the partners, the allocation of management duties, the distribution of profits and losses, and the procedures for resolving disputes and rights upon termination. Having an agreement in place not only allows the business to run more smoothly but also helps avoid partnership disputes and other commercial litigation.
Resolving Partnership Disputes
Nearly every small business experienced bumps along the way, and partnerships are no different. Partnership disputes can arise when partners fail to communicate effectively. Other sources of conflict include differing visions for the business and inequitable distribution of the workload. Financial disagreements are also common, with partners failing to see eye-eye on partner salaries, distribution of profits, and how funds will be reinvested into the business.
Thankfully, there are a number of ways to resolve a partnership dispute. In mediation, a neutral third partner can help you and your partners informally reach an agreement. Assuming everyone is willing to commit to the process, mediation can be a quicker and less costly way to resolve a conflict. Arbitration, another form of alternative distribute resolution (ADR), may be required under your partnership agreement or agreed to be the partners. In arbitration, the dispute is submitted to arbitrators who make a binding decision on the dispute. While court proceedings generally take longer and are more expensive than ADR, in some cases, litigation is unavoidable.
Dissolution of a Partnership
Partners may dissolve their partnership for a variety of reasons. In some cases, the business has simply run its course, and the partners are ready to retire or pursue new opportunities. The dissolution of partnership may also be necessary if the partners can't resolve an internal dispute or a partner dies or becomes incapacitated.
To help ensure the partnership dissolution process proceeds smoothly, your partnership agreement should establish the procedures for dissolving the partnership. This will give you a roadmap for the dissolution process and can dramatically reduce the likelihood of disputes. As discussed in greater detail here, issues that must be addressed when dissolving a partnership include paying outstanding liabilities, distributing assets, notifying customers and business partners, and filing any necessary paperwork. Given the legal complexities involved, when attempting to end or dissolve a partnership, always seek the legal advice of a business dispute attorney who can protect your legal interests.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.