We've come pretty far in our exploration of the different types of business formation structures. We covered Sole Proprietorships and Limited Liability Companies already and today we're going to explore a new one: Partnerships!
This biz structure has a pretty obvious first rule and that is the business must be carried on by at least two persons. Or "partners" if you will. See? Obvious. But let's take a closer look. Like an LLC, the Partnership is usually treated as a distinct legal entity separate from its partners. For example, a partnership can hold property in its name and it can also be sued. But unlike an LLC, general partners are not shielded from liability for the debts of the company.
Types of Partnerships
There are three types of partnerships: a general partnership, a limited partnership and a limited liability partnership.
1. General Partnerships
In a general partnership, each partner has the power to make management decisions for the business and can make binding agreements on behalf of it. Each partner also has unlimited liability for the debts of the partnership.
2. Limited Partnerships
A limited partnership has one or more general partners (who have the full liability and decision making authority as those in a general partnership) and one or more limited partners. So what is a limited partner? These partners have limited liability for business losses and other problems but they also don't have decision making power.
3. Limited Liability Partnerships
These partnerships are a sort of hybrid form that is used by certain professional partnerships such as law and accounting firms. These are used when state laws restrict these types of partnerships from organizing as limited partnerships. Basically this form just limits the personal liability of the partners so they can't be wholly responsible for the company's debts.
So how exactly do partnerships work?
Most states have laws regarding partnerships, however, partners can create their own business arrangements by entering into a written partnership agreement.
For instance, if there's no agreement that states otherwise, a partnerships profits and losses are split equally among the partners. However, the partners can specify a different way of allocating their profits and losses in a partnership agreement.
Similarly, if there is no written agreement to the contrary, a partnership will cease to exist if a partner dies (remember that pesky two-or-more-persons rule?). However, the partners can choose an alternative such as the buyout of a deceased partner in their partnership agreement.
So do you NEED a written partnership agreement to create a partnership?
Nope! The only requirement is that both parties have a mutual understanding that they're creating a partnership. This means both parties must intend to establish a business relationship with the other. Keep in mind that this only applies to general partnerships. A limited partnership requires a written partnership agreement signed by all the partners and a certificate filed with the secretary of state.
As with anything else in business though, it is always recommended that you put any agreement in writing, especially when it comes to the formation of your company. Think of all the possible scenarios that could arise and everything that could go wrong. From a partner wanting to bring on a new partner that no one else wants to a partner who wants to sell the company when the others don't.
Each partner is personally liable for the debts of the partnership. Furthermore, each partner is also responsible for the actions of the other partners. This means each partner is personally liable for the entire amount of any obligation that is related to the business aka the creditor can come after your personal items (i.e., your house) to pay the partnerships debts. The exception to this is for limited partners because they have limited liability.
Partnerships are taxed in the same way as sole proprietorships in that the partnership is not considered separate from the partners for tax purposes. This means the partnership does not pay any income taxes but income "passes through" to the individual partners to report their own share of the profits and losses on their individual tax returns.