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General Partnership Explained

15. What are the major characteristics of a “general partnership”?

A general partnership is the most basic form of business entity. The primary characteristics of the general partnership are as follows:

•    Creation & Maintenance – A general partnership is an agreement between two or more persons to share a common interest in a commercial endeavor and to share its profits and losses. There is no government-filing requirement to form a general partnership. The partnership can arise by default from the actions or activities of the partners. This general partnership definition contains similar elements to the sole proprietorship, but it requires more than one person. The agreement between the individuals does not have to written or expressed. It can be implied from the actions of the partners. It is important to understand that a general partnership is a default entity. That is, the partners do not have to intend to create a general partnership, nor do they have to realize that a general partnership has been formed. Under the doctrine of “partnership by estoppel”, a court may deem a relationship to be a partnership when the requisite elements are not present. This situation arises when third parties rely upon an individual representing himself as a partner or consents to another representing himself as a partner.

⁃    Note: In some situations a court may determine that principles of fairness and equity require that the activities of individuals constitute a partnership. This is known as a “partnership by estoppel”.

⁃    Example: I learn about an opportunity to make money by raking leaves for a local business. I approach Elsa and ask her to help me rake leaves to make money. We agree to split all proceeds from raking leaves. We have formed a general partnership.

Individuals may enter into a written agreement, known as a “partnership agreement”, establishing a general partnership. A partnership agreement is the governing document for any type of partnership. Partnership agreements are not mandatory, but it is advisable for any partnership to have an agreement governing the partnership relationship.

⁃    Note: Documenting the relationship between individuals in a business activity can serve to characterize the relationship as either a general partnership or employer-employee relationship. In the absence of a formal agreement, states have default rules governing the operations of the partnership and the relationship between the partners. While the default rules are comprehensive, they often do not always align with the specific intent of the parties.

⁃    Example: If you wish to hire an individual (not bring her on as a partner) and compensate her with a share of the profits, you will need to document the employment relationship. This may require special structuring of any profit sharing as a bonus paid to the employee, rather than as an ownership percentage in any profits.

A general partnership has no formal maintenance requirements. There are, however, default rules that provide for the rights of partners with regard to the partnership. This may include the right to vote for certain partnership decisions and a right to profits of the partnership. These rules are a form of governance requirement that may be considered maintenance of the business entity.

•    Continuity – The duration of a partnership is determined by the intent of the parties. An “at-will” partnership has no stated date. The partnership will continue until the partners dissolve the business. The partners can designate a time period for the general partnership, after which the partnership dissolves. This is known as a “term partnership”. This means that the parties may have some duty to the partnership to remain partners for the pendency of the state time period. If the parties do not designate a specific purpose or time for the partnership’s existence, it is considered an at-will partnership. This means that partners can dissociate from the partnership at any time.

⁃    Note: If there is a dispute between parties over assets or income at the time of dissolution, each partner is entitled to an “accounting” of partnership assets. This is an equity action used to determine the partner’s rights to partnership assets. This right is important, as partners are generally not allowed to sue each other in court over dollar damages as a result of dissolution.

⁃    Example: I form a partnership with Maria. We specifically state that the partnership will last until the current work project is complete. We have a term partnership and we have a duty to the partnership to remain partners until the completion of the project. If we do specifically state that the partnership ends at the conclusion of our project, our general partnership is an at-will partnership. We can both leave the partnership at any time without violating any duties to the partnership.

Any partner in a partnership may dissociate at any time. This, and certain other actions by partners, may give rise to dissolution. Absent an agreement otherwise, the following activities generally give rise to dissolution of the partnership: change in partners; winding up process; expulsion of partner that is breach of partnership agreement; it becomes impossible to continue business; or the partnership activity becomes illegal; death or bankruptcy of a partner; or pursuant to a court order for gross misconduct or willful breach of partnership agreement.

⁃    Note: If partnership wrongfully dissolved, remaining partner may continue. Must settle up with withdrawing partner.

Continuity of the partnership is determined by the partnership agreement. If the partners do not have a partnership agreement stating otherwise, the partnership does not have continuity. That is, the default rule in many states is that a general partnership dissolves when a member dissociates. As such, a partnership interest cannot be transferred or passed along to one’s heirs. Most states, however, allow the remaining partners to take steps to reform the general partnership and continue in business after cashing out the dissociating party’s interest.

⁃    Note: The transfer of a general partner’s interest, death or incapacity, may give rise to a right of dissociation by other partners. An exception to the default dissolution rule is when a partner passes away or dissociates by reason of incapacity. In such a case the general partner does not automatically dissolve.

⁃    Example: I form a partnership with Cliff. We state in the partnership agreement that either party may leave at any time. We include provisions for the continuation of the business and the obligation of the partnership to purchase the leaving partner’s business interest. Without this agreement, the partnership would dissolve upon Cliff or me leaving.

As stated above, partners can change the default rules governing the general partnership by entering into a partnership agreement. The agreement may also designate the procedures for winding down the business or allowing the remaining partners to continue the business. It can further allocate responsibility for debts of the general partnership or allocate the proceeds upon continuation or dissolution. These types of agreements are known as “buy-sell agreements”.

•    Ownership – General partners are the sole owners of the general partnership. The parties may agree on each partner’s percentage of ownership. In the absence of a partnership agreement, default partnership rules govern the relationship. By default, partners are entitled to equal ownership rights. This means that the partners share equally in profits or losses, unless the parties specifically agree to some other allocation of profits and losses. Further, the default rule is that ownership interests cannot be transferred to third parties without the consent of the existing partners. Attempting an unapproved transfer of an ownership interest is grounds for dissolution of the partnership.

⁃    Example: Katie and I form a partnership. We do not have a partnership agreement. As such, by default, Katie and I are equal owners of the partnership. We later enter into a partnership agreement that establishes me as 70% owner and Katie as 30% owner. This will replace the default rule that we are equal owners.

•    Control – The general partners have complete control over the partnership. This means that partners have decision-making authority with regard to the governance and strategy of the partnership, as well as authority to act on behalf of the partnership as a general agent. The partners may establish a partnership agreement that changes or limits any partner’s right of control or voice in the management of the partnership. This does not, however, limit the authority of a partner to obligate the partnership by entering into transactions or relationships with third parties, such as loan or sales agreements. The partnership can limit the authority of a partner to act on behalf of the partnership by specifically giving any third party notice that the partner’s authority is limited.

⁃    Note: Some partnership decisions require consent of both partners.

⁃    Example: Terry and I form a partnership. Terry and I have equal ability to make decision for the partnership. If Terry wants to enter into a purchase contract, she has the authority to do so. If we decide to limit Terry’s authority in a partnership agreement, this does not limit her authority with respect to third parties. I will need to provide notice of that agreement to any third parties who may interact with the partnership through Terry.

•    Personal Liability – A general partnership is similar to a sole proprietorship in that it does not offer the business owners any form of personal liability protection. Each partner is personally liable for any debts, obligations, or tortious conduct of the business. This means that, if the business stops operating or goes bankrupt, the owners are liable for the debts and obligations of the business. In fact, each partner can be held totally liable for the entire debt of the business. This is known as “joint and several liability”. Per the law of agency, the partnership is liable for the obligations established by its agents or their tortious conduct committed within the scope of employment. As such, each partner is potentially personally liable for the actions of partners and employees of the partnership. This may be true even if a partner or employee exceeds her authority under a partnership agreement or employment agreement. These facts alone make a general partnership a potentially risky entity form under which to carry on business.

⁃    Example: Eric and I from a partnership. We hire an employee, Jane. Jane is careless and injures a third party when driving the company truck. The injured party sues Jane and the business. If Jan receives a judgment against the business, Eric and I will be personally liable for the business debt. If the business does not have funds or assets to satisfy the debt, our personal assets will be at risk.

•    Compensation – General partners are compensated by receiving a draw of partnership funds (generally profits). This is known as the partner’s distributive share. By default, this draw is often representative of the percentage of ownership of each partner. The partners may, however, enter into an agreement allocating the distribution of profits or losses differently from the ownership structure. That is, a partner may receive a percentage of partnership profits or losses that is greater than or less than her ownership percentage. This must be justified based upon an economic reality of the partnership, such as one partner spending more time working for the partnership.

⁃    Note: Partners are not entitled to receive a salary based upon their ownership percentage or for services rendered to the general partnership. Only employees of the partnership who are not also partners may receive a salary as compensation.

⁃    Example: Tanya and I form a partnership with equal ownership. We have one employee, Josh. At the end of the year, the partnership has $10,000 in earnings. The only expense is Josh’s salary of $2,000. Tanya and I will receive a distribution of $4,000 each. Josh, who is not an owner, received a salary. It does not matter whether Tanya and I work in the partnership. As owners we do not receive a salary.

•    Taxation – General partnerships are not taxable entities; rather, they are pass-through tax entities. The partnership will subtract expenses and other deductions from revenue to determine the annual profits or losses. Like a sole proprietorship, partners report their share of general partnership profits or losses on their personal income tax returns. The general partnership does, however, have to prepare a tax return. This return is known as an “informational return” and is filed on IRS Form 1065. The return outlines the revenues and expenses attributable to operations. It will also outline the percentage or amount of the profit or losses to which each party is entitled. The partnership is obligated to provide individual partners with a Form K-1 outlining that partner’s share of profits or losses. These amounts are then recorded on the owner’s individual tax return.

⁃    Note: A partner is required to pay taxes on her allocated percentage of partnership profits, whether she withdraws the profits from the partnership or leaves those profits in the business entity.

⁃    Example: Barry and I form a partnership. At the end of the year, the partnership has profits of $10,000. Barry and I are equal partners, so we are each entitled to 50% of the profits. The partnership will prepare and information return and provide K-1s to Barry and me. The K-1 will indicate that we received $5,000 in profits, which we must report when filing our individual income tax returns.

•    Discussion: Is there ever a situation when carrying on business as a general partnership is a good idea? Hint: Think about situations where other business entities are the general partners.

•    Practice Question: In a short paragraph, can you describe the primary attributes of a general partnership?

 

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