If two or more people are doing business without first forming some sort of registered entity first, they become a partnership. There are several types of partnerships: general partnerships, limited partnerships and limited liability partnerships. Each of these have different formation requirements, provide different liability protections, and may be good options in the different circumstances.
Similar to the sole proprietorship, you may be operating as a general partnership and not even realize it! A general partnership simply requires two or more persons to carry on as co-owners of a business. There is no formal creation required. To meet the requirements for forming a general partnership, “carrying on” can refer to sharing profits, sharing authority, or any of a wide range of activities for a business that is intended to make a profit for the partners. Even if you did not specifically refer to your relationship as partners, if you are acting as such then that is probably enough to have created a partnership. For example, let’s say two people have a great idea to start a dance company. They find a studio, book lessons, and split profits. Although there was no discussion about being a partnership, this is the entity they have created through their actions. Therefore, (similar to the sole proprietorship) you need to file with the state as a different entity type to avoid being considered a general partnership.
When running your business as a general partnership, it is wise to have a partnership agreement to be able to alter the harsh default rules that state law imposes. For example, the default rule for dividing profits between partners in Virginia is that each partner is entitled to an equal share of the partnership profits. Unless changed in a partnership agreement, a court would follow this default rule without other compelling evidence to suggest that profits should not be divided equally.
In a general partnership all of the partners have complete authority to do business on behalf of the partnership. Unless the partners agree to do things differently, one partner could decide to sell off all the equipment the other partner purchased just the day before, so it becomes very important to make sure that the partners have the same intentions. The partnership interests are able to be transferred but partnership rights are not; this means that partners may sell their share but cannot transfer the rights they have as a partner to anyone without unanimous consent of all other partners due to the fact that there is no separation of control in a partnership.
Another very important reason to have a partnership agreement is to avoid dissolution of the partnership if a partner leaves. According to the default rules, if a partner leaves, the partnership is dissolved. If the reason for a partner leaving is death, incapacity, or filing for bankruptcy, the partners are allowed to wind up and terminate or buy out the disassociating partner, but the decision must be unanimous.
A major reason to prefer a different entity type over the general partnership is because of each partner’s exposure to personal liability. In a general partnership, a partner is personally liable for ANY other partner’s conduct on behalf of the business! General partnerships have what is known as “joint and several liability” among the partners. This is very important to keep in mind, because if a judgment is entered against the partnership the creditors can come after you and only you for the entire amount regardless if it was your mishap or not! There are ways to still be a partnership and limit liability though, by filing as a Limited Liability or Limited Partnership
Partners have both a duty of care, and a duty of loyalty. A partner’s duty of care to the partnership and the other partners is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of the law. This is not an extremely high standard because as a partner there is already an incentive to make smart decisions. Care, however, does not mean perfection: the law does not want to discourage partners from taking reasonable risks to advance the interests of the business by making them afraid of a duty of care violation.
A partner’s duty of loyalty limits partners in three ways: 1) they cannot steal opportunities from the partnership, 2) stand on the other side of the deal, 3) nor can they directly compete with the partnership. These limitations are read very narrowly and are very specific, but they do provide the partnership with valuable protections against unscrupulous behavior.
Partners can waive fiduciary duties in some ways. Partners cannot waive the duty of loyalty but they can specify certain transactions that will not be considered violations of this duty. To accomplish this, there must be an amendment to the partnership agreement, which requires a unanimous vote.
Yes, if you file as a Limited Liability Partnership! This entity allows you to operate essentially the same as a general partnership but it LIMITS the personal liability of partners. In this type of partnership, partners are generally NOT liable for the debts of the partnership. To be able to obtain this protection, filing with the State Corporation Commission is required! Once registered as a limited liability partnership, personal assets of the partners will be protected when it comes to debts of the partnership. However, partners still may be liable for their own debts and obligations as a partner, so there are limits to the limited liability but at least they are not liable for the debts of other partners.
Partnerships of all varieties can be customized, to some degree, through the implementation of a partnership agreement. A partnership agreement is essentially a contract between the partners that defines how the business will be run. You can alter the distribution of profits and/or losses. You can limit the authority of individual partners in order to divide the responsibilities. And you can specify how you want decisions to be made if there are multiple partners. It is important to remember that a partnership agreement, while it may be binding on the partners, does not have any effect on third parties. Even if you decide that your general partnership will be responsible for any and all debts of the business a third party can still sue the partners individually and the partnership agreement will only impact how the result of that lawsuit gets passed along to the business.
Partnerships can be simple to form, have very few requirements to run, and may be a good option for your business. If you are looking for something with a bit more structure, and more personal liability protection, you may want to learn more about LLCs
© 2016 John V. Robinson, P.C.
