Introduction

If you’re considering going into business with a friend, or several friends, you’re joining in a basic American dream—running your own show, being your own boss, and hopefully gaining some control over your economic destiny.

Before you take the plunge, however, you should take a step back and consider whether forming a partnership makes sense. We mean this in two ways. First, are you ready to start a shared business of any kind? While there are great benefits to shared ownership, it can also create stress—and it will definitely require you to work very closely with your co-owners. Before you get started, it makes good sense to take a very close look at your own willingness to be that intimately involved with your prospective partners.

Second, if you decide that you want to start a shared-ownership business, what legal form should that business take? A partnership is only one of a handful of ways you can structure a shared ownership business. Before you invest the time and energy drafting a partnership agreement, you should carefully consider whether another ownership structure—such as a corporation or a limited liability company—might better suit your business.

This chapter will help you answer both questions. If you decide, after careful consideration, that forming a partnership is the best way to realize your business and personal goals, the rest of this book will help you draft a partnership agreement that will serve your business well for years to come.

Sharing Ownership of a Business

The advantages of having one or more co-owners can be tremendous, but so can the headaches of trying to make group decisions, agree on business goals, run your company together, and distribute the work, profits, and debt fairly. Whether shared ownership is right for you depends both on your own personality and on the partners you’ve chosen.

Advantages and Drawbacks

Shared ownership has many benefits. The chemistry and spirit of two, three, or more minds working together can often produce exciting results. There’s more energy and enthusiasm, and—at least as important—more cash, skills, and resources. And it’s a lot easier to arrange for time off if you have partners than if you’re trying to run a business all by yourself.

But for all of those who dream of doing their own thing—and who hasn’t?—only a relatively small number will be committed (or nutty) enough to invest the love and labor necessary to get a small business off the ground. Those who do will almost inevitably go through periods of stress, and their survival will depend on their ability to quickly and competently master all sorts of unfamiliar skills and tasks. In a partnership business, there are also the stresses and risks that can come with shared ownership. Money can be incendiary stuff. Before you decide to throw in your financial lot with others, you need to make sure you’re willing and able to become involved that intimately with each other.

In a shared business, your co-owners will make decisions that directly affect your life. Of course, there are steps you can take to put some limits on this, such as requiring decisions to be made by the whole group or limiting the authority of one owner to act for others. But ultimately, sharing a business requires you to give up some control. Shared ownership allows you to share the burdens of your business, but it also requires you to share the responsibilities. If that doesn’t sound like you, a shared-ownership business probably isn’t the right call.

Choosing the Right Partners

The most important assets of any shared business are the co-owners’ competence, determination to work hard, and the trust they have in one another. Of course, your business partners must share your dream, but they must also be willing to share the work. Of course, you and your partners should get along well personally, but that’s not enough. You must also have compatible work styles, have similar expectations about how much each of you will do for the business, and have the same goals for your business’s future.

Partnerships are (very) human enterprises. While we can’t tell you exactly who you should pick as a partner, we can tell you that not every friendship— or every romantic relationship—makes a good business partnership. Our experience has taught us that there are a few questions prospective partners should consider before throwing in their lot with one another:

• Do you all understand and agree that you’re going to run a business with the aim of making a decent profit? Any money-making enterprise qualifies as a business. If any would-be partners are nonbusiness types who simply aren’t comfortable with that, you (and they) don’t want to be part of the same partnership.
• How long have you known each other? We’ve seen some new friendships crumble under the stress of running a business together. Don’t enter any partnership casually.
• Are all prospective partners roughly on the same economic footing? If not, how do you feel about the possibility that some partners’ decisions may be based not on the business’s economic realities, but on their own outside financial resources or needs?
• How’s your chemistry? There are no rules at all here. Sometimes, people with different temperaments work out very well as partners. And sometimes, people who are longtime friends with very similar personalities can’t develop a harmonious business relationship. Probably, the best you can do is ask yourself whether you can imagine being in a close business relationship with your prospective partners ten or more years from now. If you can’t, think twice about going forward.

A Personal Note

If you’re feeling a bit overwhelmed about starting a shared business, you’re certainly not alone. But we’re confident that you’ll find—as we have—that along with the hard work and unavoidable stresses of running a shared business, there’s a lot of excitement and freedom as well.

Both of us grew up on the East Coast, went off to college, and emerged, like so many others, unsure about "what we wanted to do." We considered lots of choices; both of us drifted to law school with the vague hope that the law would give us some skills useful in making the world a better place. How we each became disillusioned with that dream is another story; the point here is that through all of our dreaming and planning, neither of us ever imagined that we’d wind up as proprietors of small businesses, full-fledged members of the "free enterprise system." But that’s what happened. We’ve experienced both great satisfaction and some very real pain in running our own shops. We’ve been through our complete beginner stage and have made most of the routine mistakes, as well as pioneering some lulus. Somehow, we’ve survived it all to realize that doing our own thing at Nolo gives us a sense of freedom and self-worth, at the same time that we make a good living—a combination that’s hard to match in this increasingly bureaucratized world.

We know we are not alone in finding a measure of satisfaction in jointly participating in a small business. In the process of putting this book together, we talked to many people who have successfully created their own small business partnerships. We’ve been told time and again about the satisfaction, and even joy, derived from providing a product or service that genuinely interests the provider and benefits the consumer. We’ve also learned a lot about how people relate to—and may even gain some satisfaction from—the tough competition that’s so much a part of the world of small business, where survival depends on your ability to offer something that people really want and need. And most of all, we’ve been reminded constantly that although money is important, it’s not usually the primary reason people organize their own businesses. It’s gratifying to talk with partners more concerned with the quality of work and a sensible life than the top dollar. Happily, we’ve found that integrity and creativity— even altruism—are alive and well in small business America.

Business Structure Options

There are five common legal forms of business ownership:

• partnership
• sole proprietorship
• corporation
• limited liability company, and
• limited partnership.

(Some states have distinct subcategories of these five, especially partnerships. For example, there’s a creature called a "mining partnership" used for mining and oil ventures in some states. In this chapter, we’ll just concern ourselves with the basic forms.)

To help you choose the business structure that best suits your needs, this chapter explains the legal and practical consequences of each option. Of course, our emphasis is on the partnership form, but don’t assume that it must be the right one for you without exploring your alternatives. We’ve received letters from readers of earlier editions telling us that after reading these materials, they decided to form a small corporation or a sole proprietorship. That’s great; the time to consider your options is here at the start. Once you’ve created your legal form, it takes some time and trouble to change it.

Partnerships

In this section, we give you a quick look at the nature of partnerships, so that you can compare them to corporations, limited liability companies, and sole proprietorships. Later in this chapter, we’ll explore the partnership legal form in more depth.

Here are five key points about partnerships:

1. A partnership is a business owned by two or more people.
2. Each partner can perform all acts that are necessary to operate the business, including hiring employees and spending or borrowing money. (However, you can put some limits on a partner’s authority, as explained in "A Closer Look at Partnerships," below.) Each partner is personally liable for all debts incurred by the business. This is a vital reason why your partners must be trustworthy. If a creditor has a claim against your partnership and the partnership doesn’t have enough assets to satisfy that claim, the personal assets of any partner can be taken to pay the business debts.
3. Partners share in profits or losses, in whatever proportion they’ve agreed on. Partnerships themselves don’t pay taxes (although they do file an annual tax form). The partners report their share of profits or losses on their individual tax returns, as part of their regular income.
4. Partnerships begin when two or more people form a business. Although technically a partnership ends if one partner leaves, you can agree at the beginning that the partnership business will continue to be run by the remaining partners, if there are any. If you want the business to continue after a partner leaves—and almost all partnerships work this way—you’ll need to work out what will happen to the interest of the departing partner. Who can, or must, buy that interest? How will you determine a fair price for that interest? (See Chapter 5.)
5. The owners normally have a written partnership agreement specifying their respective rights and responsibilities. The purpose of this agreement is to cover all major issues that may affect the partnership, from the manner of dividing profits and losses to management of the business to buyout provisions in case a partner leaves or dies. This agreement does not have to be filed with any government agency, and no official approval is required to start the partnership. (There are different rules for limited partnerships; see Chapter 9.)

The Sole Proprietorship

A sole proprietor means, as the words say, that there’s one owner of the business. The owner may hire (and fire) employees. The owner may even arrange for employees to receive a percentage of the business profits as part of their wages, but he or she remains the sole owner. The owner—and the owner alone—is personally liable for all the debts, taxes, and liabilities of the business, including claims made against employees acting in the course and scope of their employment. The business does not pay taxes as an entity; instead, the owner reports and pays taxes on the profits of the business on his or her own individual income tax returns.

Resource: Want more information on setting up and running a sole proprietorship? Take a look at The Small Business Start-Up Kit, by Peri Pakroo, and Legal Guide for Starting & Running a Small Business, by Fred S. Steingold, both by Nolo.

Personality Traits and the Sole Proprietorship

Quite simply, the main advantage of a sole proprietorship is that there is only one boss (you), so potential managerial conflicts are eliminated, except for your inner ones. The disadvantages stem from the source—there is only you as owner and boss. If you get sick, want time off, or simply want to share the responsibility of decision making with someone else, you won’t have a lot of flexibility.

Whether you should be the only boss is often a question of temperament. Some people like, and need, to run the whole show and always chafe in a shared ownership situation, while others want, need, or at least appreciate the resources and strengths, from cash to camaraderie, that co-owners can bring. The best advice we can give you here is that old axiom—know thyself.

Sole Proprietorship Compared With Shared Ownership

In deciding whether to operate a business as a sole proprietorship or adopt a form of shared ownership such as a partnership, a business organizer may be inclined to choose shared ownership to involve key employees in the future of the business. While it may make great sense to allow important employees to become co-owners, either as partners or stockholders, this is not the only way to reward dedicated and talented employees. A profit-sharing agreement within the framework of the sole proprietorship may be a good alternative approach, at least until you see if you and the key employees are compatible over the long term.

Example 1:
Eric is a self-employed architect. He gets a big job and advertises for help, soon hiring Frank and Samantha to assist with the drafting. Halfway through the new job, things are working so well that Eric decides to bid on an even larger job. He knows that to complete this new job successfully, he’ll have to depend a great deal on his two assistants. Eric first considers making Frank and Samantha junior partners. However, because he has only known them for a few months, and because Samantha is pondering moving to the other side of the country, Eric decides that it makes more sense to put off the partnership decision and offer each 15% of his profit on the deal, over and above their regular salary.

Example 2:
Susan decides to open a sandwich shop near a busy college campus. She wants her friend Ellen to work with real enthusiasm but, because money is short, can only pay her a modest salary to start. To ensure Ellen’s continued dedication, Susan offers her a bonus of a profit-sharing agreement under which Ellen gets 25% of all net profits.

Terminating a Sole Proprietorship

When the owner dies, a sole proprietorship ends. By contrast, in theory at least, a partnership, a small corporation, or a limited liability company can continue under the direction of the surviving owners. Practically, however, a sole proprietor who wants his or her business to continue after its owner dies can leave the remaining assets (after paying off its debts, of course) to someone who will continue its operations.

Caution: Sole proprietors need to plan for probate. If the owner of a sole proprietorship leaves business assets through the owner’s will, the probate process can take up to a year and make it difficult for the inheritors to either operate or sell the business (or any of its assets). To avoid this, small business owners should consider transferring the business into a living trust, a legal device which avoids probate and allows the assets to be transferred to the inheritors promptly. (For more information on creating a living trust for a business, see Plan Your Estate, by Denis Clifford (Nolo).)

Corporations

A corporation is a legal entity separate from its owners, who are its shareholders. Traditionally, the chief attraction of running a small business as a corporation is that the shareholder owners enjoy limited personal liability for business debts or obligations. Ordinarily, each shareholder stands to lose only what he or she has invested in the corporation. Other assets, such as the owners’ houses and investments, can’t be grabbed to pay business debts.

Because of the development of the limited liability company (LLC), discussed below, the corporate form of ownership has lost much of its appeal for shared owners of a small business. Limited liability companies also offer owners limited personal liability but avoid some of the drawbacks of organizing either as a partnership or a corporation. We examine those drawbacks below. Here, we’ll take a brief closer look at how the corporate form works.

In theory, a corporation involves three groups: those who direct the business (directors), those who run the business (officers), and those who invest in it (shareholders). In the case of a small business corporation, these three groups are often one and the same person. Indeed, one-person corporations are legal and common in many states.

A corporation is created by filing articles of incorporation with the appropriate state agency, usually the secretary or department of state. Once this is done, the corporation comes into legal existence. The directors are responsible for the overall supervision of the business. The officers (president or chief executive officer (CEO), vice president, treasurer, and secretary) are in charge of the day-to-day operation of the business. The shareholders are the owners, who have invested in the business by buying stock.

The directors normally adopt corporate bylaws, which cover the basic rules of how the business will actually operate. Practically speaking, for a small business, bylaws can serve the same purpose as a partnership agreement. However, many shareholders of small corporations also enter into a shareholders’ agreement, which usually spells out the circumstances under which a shareholder may sell his or her stock and describes what happens to a shareholder’s shares if he or she dies, becomes disabled, gets divorced, or retires.

Unlike partnerships, sole proprietorships, and LLCs, corporations must also hold formal director and shareholder meetings and document major corporate decisions in corporate minutes. If corporations don’t hold these meetings or prepare records of these corporate decisions, the owners risk losing their limited liability.

Corporations are taxed first at the business entity level and, then again, when corporate owners pay personal income tax on corporate profits distributed to them. But this double taxation can be minimized or avoided if the owners pay out profits to themselves as tax-deductible salaries and benefits.

Corporations have emerged in the last 150 years as the major organizational form through which large-scale international capitalism does business. Because corporations seem to be such a grownup, big-time way of doing business, some people starting a small business are convinced that they, too, need a corporation—or at least that there must be great advantages to doing business in corporate form.

As we discuss below, however, for many new owners of small businesses, immediately forming a corporation isn’t necessary. Usually, the corporate form of doing business provides no real advantage over a partnership or limited liability company and sometimes can be disadvantageous. And remember, whichever legal ownership form you decide upon, you’ll have to resolve the same basic issues regarding power between the owners.

The Limited Liability Company

There’s a relatively new legal animal in the business world, called a limited liability company (LLC). This business entity is now available in every state. An LLC needs only one member, so even sole proprietors now have the option of structuring their businesses as LLCs.

The LLC attempts to blend many of the benefits of a partnership and a corporation. The business can choose to be treated as a partnership, tax-wise, which means all profits are taxed at the individual level rather than the business level. But LLCs also permit owners to obtain a key attraction of a corporation—limited liability. An LLC owner’s personal assets cannot be taken to pay business debts. And, LLCs are generally not required to observe the same formalities as a corporation— they don’t have to elect directors, hold annual shareholders meetings, or even prepare formal minutes of meetings or business decisions, unless they agree to do so in writing.

To form an LLC, the owners prepare articles of organization, a document quite similar in form and content to corporate articles of incorporation. Articles of organization include basic facts, such as the LLC name, principal office address, agent and office for receiving legal papers, and the names of the initial owners.

An LLC’s articles of organization must be filed with the appropriate state agency, usually the department or secretary of state’s office. In some states, you must also pay a fee, which can range from about $200 to as much as $900, depending on the state. (In California, for example, a new LL C pays a filing fee of $70, but must also pay a minimum of $800 annually.) Most states require an LL C to file an annual form or report. (This is in addition to state-required LL C income tax returns, discussed below.) Further, a number of states impose annual fees on LL Cs and a few impose annual franchise taxes.

Like a partnership, an LL C also should have a written agreement (called an "operating agreement"), which defines the basic rights and responsibilities of the LL C owners. To prepare a sound operating agreement, LL C owners must deal with the same issues as partners preparing a partnership agreement, including how much capital each member will contribute to get the business going, how much each person will work for the business, to whom departing members can sell their share of the business, and how that share is to be valued.

Resource: If you want to create a limited liability company. All the forms and information you need to create an LLC are contained in Form Your Own Limited Liability Company, by Anthony Mancuso (Nolo). Nolo also publishes LLC Maker, by Anthony Mancuso, a computer program that automates the process of creating a limited liability company in all 50 states.

Like shareholders of a corporation, the owners of an LLC generally are not liable for company debts beyond the amount each has invested in the company. However, unlike a corporation, an LLC is not subject to income tax as a business entity unless its owners choose to be taxed this way. Usually, owners choose to be treated like a partnership for tax purposes with LLC profits "flowing through" to the owners, meaning that any profits the business earns are subject to federal income tax only on the owner’s personal tax return.

For most small businesses organized as LLCs, the owners are also the managers of the business. However, an LLC can also be used as a type of investment device, in which many or even most owners do not take an active role in business management but instead are passive investors. The business is run by a small group of the owners, called a "management group" or "board of managers." This use of the LLC form is similar to a limited partnership, discussed in Chapter 11. In this type of LLC, the manager-owners must comply with federal and state securities laws when selling interests in the LLC to passive investors. To be sure you know how to comply with the securities laws, you must do careful legal research yourself or see a securities lawyer.

Limited Partnerships

A limited partnership is a special kind of legal animal that, in some circumstances, combines the best attributes of a partnership and a corporation. Its advantage as a business structure is that it provides a way for business owners to raise money without having to give up managerial control or go to the trouble of creating a corporation and issuing stock. (You’ll find more detailed information on limited partnerships in Chapter 9.)

A limited partnership must have at least one "general partner," the person or entity that really runs things. The general partner can be another partnership, an LLC, a corporation, or a human being. There can also be more than one general partner. However many there are, each general partner has the rights and potential liabilities normally involved in any partnership—such as management powers for the business and personal liability for business losses or debts.

Limited partners, on the other hand, have no management powers, but neither are they personally liable for the debts of the partnership. Limited partners are basically investors. The return they receive for their investment is defined in the partnership agreement. If the business fails, the most that the limited partners can lose is what they invested in the business.

Example:
Anthony and Janice plan to purchase rundown houses, renovate them, then (hopefully) sell them at a good profit. All they lack is the cash to make the initial purchases. To solve this minor difficulty, they first create a general partnership between themselves. Then they establish a limited partnership (with their own partnership as the general partner) and seek others who are willing to put up money for a defined interest in the venture. Janice and Anthony decide that they need $100,000 to get started, and they manage to sell ten limited partnership interests for $10,000 each.

Sometimes, limited partners receive a fixed return on their investment. For instance, they might receive "10% interest annually, with principal, to be repaid in three installments over seven years." Investing in a limited partnership like this is similar to making a loan, except it doesn’t remain an obligation if the partnership business fails. Limited partners aren’t liable for the business’s debts, but they risk losing their entire investment if the partnership goes belly up.

More commonly, instead of a fixed return, limited partners receive a percentage of the profits (assuming the venture makes money) for a specific period of months or years, or even forever. Limited partnerships can also be a useful means for expanding an existing business to raise money, especially at times when other sources of cash are tight and interest rates are high.

Example:
Judith and Aretha have a small picture frame shop that has just begun to prosper after a couple of years on short rations. Believing that the time is now right to expand, the two women spot a much larger store in a much better location, which will allow them to stock a large selection of fine art prints as well as frames. Unfortunately, they don’t have the money they need to finance the move and the larger inventory that it will entail. To solve this problem, they create a limited partnership, offering a $20,000 investor an 8% interest in the total net profits of the store for the next three years as well as the return of the invested capital at the end of that period. They sell four of their limited partnerships, raising $80,000. (As Judith and Aretha’s original partnership agreement didn’t provide for limited partners, they must rewrite it and create a separate limited partnership agreement.)

Caution: Limited partnership interests are securities. Offering and selling limited partnership interests involves the sale of what’s called a "security." The most common example of a security is a corporate stock or bond. You must comply with all federal and state securities laws when you offer any limited partnership interest for sale. See Chapter 9 for more information.

Legal Formalities of Limited Partnerships

Limited partnerships involve many more legal formalities than general partnerships. In addition to securities laws, limited partnerships are generally subject to other state controls. Setting up and operating a limited partnership is similar in many ways to the process of organizing and operating a small corporation. State law usually requires that a registration certificate be filed with a government agency. The information required on this document varies, depending on state law. Often, partnership and limited partnership agreements must be disclosed, and the names and addresses of all partners and limited partners listed. Failure to comply with state registration requirements can subject the partnership to serious penalties and cause would-be limited partners to lose their limited liability status.

Fortunately, it’s not that difficult to comply with the registration requirements; thousands and thousands of limited partnerships are formed each year. Also, every state except Louisiana has adopted the Uniform Limited Partnership Act, which standardizes both the law and the registration procedures. Many states have adopted the revised Uniform Partnership Act of 1997, which further streamlines the law in this area.

Restrictions on Limited Partnerships

State law normally imposes restrictions on the availability and use of limited partnership names. ("Limited" or "Ltd." at the end of a business or partnership name does not automatically mean the entity is a limited partnership—these terms are simply the British equivalent of "Incorporated" and "Inc." Some U.S. companies include these British terms in their name because they believe it sounds aristocratic.) In addition, these laws govern the manner of calling and holding meetings and may impose many other legal requirements, which apply to the operation of the limited partnership unless alternative rules are clearly spelled out in the partnership agreement.

Comparing Partnerships to LLCs and Corporations

No matter which legal form you and your co-owners choose, you must confront and resolve the same day-to-day problems, such as allocating shares of ownership, operating the business, paying salaries and profits, and resolving disputes, among others. Because there are fewer legal formalities to comply with, business owners who form partnerships have more time to focus on questions of their relationship with each other. By contrast, when creating an LL C or a corporation, the owners must file formal documents with the state and observe more technical requirements in their operations, which can sometimes distract the owners from confronting important issues about the way they work together.

One obvious advantage of forming a partnership is that you don’t have to pay costly filing and other fees, as you would to form a corporation. But, overall, most business owners conclude (as we have) that the advantages and disadvantages of these three ways to organize your business are not as significant as many advocates of one or the other approach would have you believe.

For example, suppose you and two friends are co-owners of a computer repair business. It’s clearly prudent to decide what will happen if one person unexpectedly quits or dies. A common method of handling this is to create a "buyout" clause, enabling the remaining owners to purchase (usually over time) the interest of the departing owner. If the business is owned as a partnership, the buyout clause you devise will normally be included in the partnership agreement. If the business is an LL C, the clause will be in the owners’ operating agreement. In a corporation, this clause is normally put in the bylaws or in a shareholders’ agreement. But the practical reality will be the same.

Below we look in depth at key issues concerning the form of ownership of a shared business. We’ll start here by summarizing the most important points:

• The partnership form is the simplest and least expensive of the three forms to create and maintain.
• For small, shared ownership businesses that face risks of major money lawsuits, the LL C is usually the best initial choice.
• For most other types of small shared ownership businesses, the partnership form is normally the best choice. If business growth makes a different structure more desirable, the partners can easily convert to an LLC or a corporation.
• Occasionally, the corporate form makes sense for a new business. For instance, a corporation may be desirable if the owners want to raise large sums of money from a number of investors.

Resource: Want more information on other business structures? In this book about partnerships, the discussion of other ways to organize your business is necessarily limited. For a more in-depth discussion of the pros and cons of sole proprietorships, LLCs, and corporations, see Legal Guide for Starting & Running a Small Business, by Fred S. Steingold (Nolo), and LLC or Corporation?, by Anthony Mancuso (Nolo).

Limited Liability

Shareholders of an LLC or corporation are not normally personally liable for corporate debts or liability stemming from lawsuits, as long as the LLC or corporation is adequately capitalized (that is, it has sufficient cash or other assets invested). This is called "limited liability." In partnerships, all partners have open-ended personal liability for all partnership debts. But before you rush to form an LLC or incorporate, you should know that the difference between limited and unlimited liability is often less significant than many people believe.

There are two important forms of liability almost any business must deal with: lawsuits and business debts. To deal with the first possibility, most small business people with common sense, whether incorporated or not, purchase insurance to protect them from the most obvious sorts of liability claims (such as insurance protecting restaurant owners from claims filed by customers who become ill or fall down in the premises). An LLC or a corporation’s limited liability is obviously no substitute for business liability insurance, since limited liability doesn’t protect the assets of the LLC or corporation itself from being wiped out by a successful claim. However, limited liability can be a valuable protection if a small business is engaged in a high-risk activity and insurance coverage is unavailable or too expensive.

Many—perhaps millions—of American businesses, including many retailers and small service providers, do not normally face serious risk of liability stemming from their business (aside from things like vehicle accidents, which obviously can and should be covered by insurance). For instance, businesses as varied as a shoe store, a graphic design outfit, a small religious publishing company, or an ice-cream parlor are very unlikely to face a lawsuit for large sums of money. By contrast, other types of business—for instance, manufacturers or businesses that handle toxic materials—have a much higher risk of liability claims. And because they do, it’s often prohibitively expensive for the owners of these types of businesses to purchase insurance to cover potential lawsuit judgments. Some other types of high-risk businesses include:

• Accountants. There have been some huge, successful claims against accounting firms for negligence. In some of these situations, accountants were found to be liable when they helped businesses conceal large losses or other damaging financial facts, thus costing investors and suppliers millions.
• Lawyers. Law firms can also face immense financial exposure for negligent, or worse, conduct. This conduct can range from actively participating in, or at least negligently abetting, fraudulent behavior by a client to causing financial injury to the law firm’s own client.
• Architects and Construction Companies. In the day of multimillion-dollar judgments for injured persons and frequent problems with cost overruns, everyone in the construction field is vulnerable to suit for all sorts of reasons.
• Real Estate. Increasingly, buyers of property who later discover undisclosed defects—everything from termites, water in the basement, land shifting, or a nasty next-door neighbor—sue both the seller and the real estate people who represent the seller.

This list is intended to be instructive, not exhaustive. We can’t give you definitive advice about the liability/lawsuit risks of the type of business you plan to engage in. Only you can decide how serious these risks are and what kinds of steps you can sensibly take to eliminate or at least minimize them. The higher the risk, the more desirable an LLC or corporation. And, obviously, the lower the risks, the more a partnership agreement, combined with basic liability insurance (such as for "slip and fall" accidents on the business premises) and vehicle insurance, should safely protect you.

But what about debts? If the business loses money, as lots of new ventures do, doesn’t limited liability protect individual owners from having personal assets taken as part of an LLC or corporate bankruptcy or liquidation? Again, while the answer is "yes" in theory, in reality limited liability protection is likely to be immaterial. Why? Because lenders and major creditors are well aware of the rules of limited owner liability. Banks, landlords, and other savvy businesspeople routinely require the owners of a new small business (whether a partnership, an LLC, or a corporation) to personally guarantee any loan or significant extension of credit made to the business. By doing this, LLC or corporate owners put themselves on much the same legal footing with their creditors as if they ran their business as a partnership. However, we should note that because many providers of routine business supplies and services do not require a personal guarantee from LLC or corporation owners, these owners can escape personal liability for these types of debts if the business becomes insolvent.

Here’s another important restriction on the limited liability of corporate and LLC owners: A corporation or LLC must start with a minimally reasonable amount of cash ("capital") to function in the business world. If the entity is only a shell, without the cash necessary to function, a court may "pierce the corporate veil" and hold individual corporate or LLC owners personally responsible for all the entity’s debts, whether they personally guaranteed them or not. While it is fairly rare for a court to determine that a corporation or LLC was undercapitalized, it can happen, particularly if fraud is involved.

Business Continuity

Corporations have "eternal life." This means that if one (or even all) of the principal owners of a small corporation dies, the corporate entity continues to exist. Partnerships, on the other hand, can dissolve when any partner withdraws or dies. However, this difference is also immaterial in real life. It’s easy, and fully legal, to insert a standard clause in your partnership agreement that provides that the partnership entity continues after one owner leaves or dies.

LLCs are often functionally similar to partnerships regarding business continuity. As noted, a partnership can technically dissolve when one partner retires, dies, or withdraws. Similarly, some state statutes require members of an LLC to vote to continue the LLC within a specified period of time after a member withdraws or dies; if they do not, the LLC is technically dissolved. Many LLC operating agreements provide that an owner’s departure triggers a vote by the remaining owners on whether to continue the LLC. The effect is that, if the owners wish it, the LLC will continue in business without legal interruption.

Additionally, a few states require LLCs to establish termination dates in their articles of organization. Even in those states, however, the owners can easily keep the business going by filing an amendment to the LLC’s articles of organization extending the date on which the LLC is scheduled to dissolve. Partnership owners do not have to face this hassle, because no state has laws requiring a termination date for a partnership.

If one of the two co-owners of an LLC or small corporation quits or dies, the survivor of the business will face the same issues that would face a surviving partner. No matter what business structure you choose, you’ll want to compensate a departing owner (or his or her heirs) fairly, but you’ll also want to preserve the business for the remaining owners. How is the value of that departing interest to be calculated? How can the remaining owners be assured they’ll have adequate cash to buy out a departing owner? We discuss methods of resolving these problems in Chapter 5. Our point now is simply that you don’t avoid any of them by choosing to form an LLC or a corporation rather than a partnership.

Caution: A general partnership isn’t the right choice if you want to raise money from people who won’t participate in the business. For larger businesses that need to raise money from outside investors and will comply with complicated federal and state securities registration and sales laws to do so, it can sometimes be psychologically easier to raise capital by selling stock to passive investors than by trying to sell participation in a partnership (which will constitute a limited partnership—see Chapter 9).

Transfer of Ownership

Corporate ownership comes in the form of shares that can theoretically be transferred to new owners. By contrast, a partner’s interest cannot be transferred without the consent of all partners unless, as is rarely the case, the partnership agreement expressly allows for free transferability. Similarly, an owner of an LLC is usually restricted by state law or the members’ operating agreement (or both) from transferring an ownership interest in the business without the consent of all other owners. But does this legal difference really add up to a practical difference?

The answer is clearly no, for two reasons. First, when it comes to small, closely held corporations, state law often restricts the right of a shareholder to freely transfer shares no matter what the shareholders want. Second, and more importantly, the stock of most small corporations is extremely difficult or even impossible to sell. There is no regular, public market for small business interests. Shares of small corporations are not listed on stock exchanges, and outsiders are rarely interested in working closely with total strangers, particularly if they can’t purchase a majority, controlling interest. Even if the business is doing well, a potential buyer will probably be more interested in purchasing the entire business or profitable business assets (for example, a building, patent invention, inventory, and so on) than one owner’s shares.

Finally, even if the shares or one person’s LLC interest or partnership interest in a small business could be sold to an outside buyer, there are likely to be drawbacks. The success of almost any small business depends on the efforts and skills of a few people. If one of a corporation’s owners can summarily transfer her interest to an outsider, the business and other owners are obviously vulnerable if the new owner has no ability to help the corporation or is unacceptable for any other reason. To protect against this happening, the bylaws or shareholders’ agreement of many small corporations—just like the partnership agreements of most partnerships and operating agreements of LLCs—restrict the right of any owner to sell to a third person and provide that the remaining owners have the option to buy out the interest of any departing owner. So again, the realities of running a small business dictate that the owners take certain similar steps to limit or prevent sales to outside buyers, no matter what the legal form of the business.

Business Formalities

No state or federal law or agency requires a partnership to file its original agreement or maintain any ongoing paperwork. By contrast, government paperwork and costs are required to start up an LLC or a corporation. An LLC must prepare articles of organization and file them with the secretary or department of state. The costs for the initial filing range from close to $900 in California to less than $100 in some other states. In addition, some states impose yearly fees or franchise taxes. Some states also require new LLCs to publish a notice in a local newspaper.

Once it’s operational, an LLC generally does not have to observe the same formalities as a corporation (such as holding annual meetings) but can mostly function with the informality of a partnership. Like a partnership, an LLC can function with exactly the amount of formality— formal meetings, quorum requirements, keeping minutes of meetings, and so on—that the owners want. Most states do, however, require LL Cs to file a brief annual report, in addition to any fees or taxes imposed. This annual form usually requires basic business information, such as the name and addresses of the current owner, and the business agent for service of process (legal papers).

Creating and maintaining a corporation is usually more expensive than creating an LL C. Filing incorporation papers costs $300–$1,000 and up in some states. (For example, in California, the cost is a $100 filing fee and, after the corporation’s first year, a minimum franchise tax of $800.) If you hire a lawyer to set up your corporation, the total costs can easily approach $3,000–$5,000, or more. Running a corporation also requires more continuing paperwork, such as organizing and calling annual shareholders and directors meetings, preparing minutes of major decisions, and issuing share certificates. In many states, it is possible to adopt provisions in a corporation’s bylaws that allow the corporation to skip many of these rules and operate relatively informally. (Banks and other financial institutions, however, often demand a properly prepared corporation resolution before approving a loan or other transaction.) However, it remains accurate to say that partnerships normally can be created and operated with much less formality.

Resource: Resources to incorporate your business. How to Form Your Own California Corporation, by Anthony Mancuso (Nolo), contains excellent information and forms on computer disk for creating a corporation in California. And for all states, you can use Incorporate Your Business: A Legal Guide to Forming a Corporation in Your State, by Anthony Mancuso (Nolo). Further, The Corporate Records Handbook: Meetings, Minutes & Resolutions, by Anthony Mancuso (Nolo), provides all the forms and information corporations in any state need to properly document ongoing business matters. Using these books can significantly reduce the cost of creating and maintaining a corporation.

The perceived formality of corporate existence is sometimes said to encourage some people to maintain better records and to engage in more organized management practices. There may be some truth in this, especially when a sole proprietorship is incorporated. But there is no logical reason why a partnership can’t install excellent business controls and practices; in our experience, most successful ones do.

Taxation

A partnership is not taxed. Partnership net income (profits) is taxed only on the individual partners’ income tax returns. An LLC can choose to be taxed as a partnership or as a small corporation. Most LLCs choose to be taxed in the same way as partnerships.

You might think that partnerships and LL Cs enjoy a real advantage over corporations because corporate profits are taxed twice (first at the corporate level and then at the shareholder level), while partnership or LLC income is only taxed once. For small businesses, this distinction usually is immaterial. Small corporations can often avoid double taxation. They can pay out to owners most of what would otherwise be corporate profits in the form of salaries, bonuses, and other fringe benefits (rather than in dividends). As long as the owners actually work in the business and the salaries aren’t outrageously unreasonable, paying the owners salaries as employees is acceptable to the IRS. Because monies paid in salaries, bonuses, Social Security, health plans, and other fringe benefits are deductible business expenses for the corporation, these expenses are not subject to corporate tax. In this way, many small corporations reduce their corporate income to zero, and corporate income is taxed only at the individual level.

In some situations, corporate taxation allows small business people to pay less overall tax on their income by retaining a portion of corporate or LLC profits in the corporation from one year to the next. The individual shareholder owner is taxed only on income received, whether in the form of corporate salary or as profits. The profits retained by the corporation or LLC are also taxed, but at a generally lower rate (15% for the first $50,000 and 25% on the next $25,000) than individual income. In a partnership or an LLC that has chosen to be taxed like a partnership, these retained profits would be taxed as income to the partners at their marginal rate, which will probably be much higher, whether or not they actually received any cash. For businesses that will pay all profits to owner-employees in the form of salaries and benefits, these initial low rates of corporate taxation offer no advantage. However, if your business will need to retain substantial earnings for future operations, incorporating is likely to make economic sense. Corporations can retain profits of up to $250,000 for future needs without question by the IRS. LLCs do not have this right. (The $250,000 corporate retained earnings rule does not apply to certain personal service corporations owned by professionals, such as doctors and lawyers, which are limited to $150,000.) And, if the corporation has a valid business reason, it can easily retain much more than $250,000.

Small corporate businesses can also avoid double taxation by electing something called federal "S corporation" status. An S corporation functions like a partnership for income tax purposes. Thus, an S corporation doesn’t pay income taxes on profits; only the shareholders do. You may ask, "Why form an S corporation if you can attain the same tax results with a partnership or LLC?" Good question. The S corporation is rapidly being superseded by the LLC, which offers both principal attractions of an S corporation—limited liability and pass-through taxation. Further, LLCs are far more flexible than S corporations, which have to comply with complicated IRS rules.

Finally, a corporation or an LLC can establish a tax-deductible pension and/or profit-sharing plan for all its workers, including working shareholders and/or managing owners, while a partnership pension plan is only tax deductible for employees, not for partners themselves. However, this difference, too, is often more apparent than real, since partners are eligible for individual profit-sharing retirement plans, which tend to equalize tax treatment.

Termination

When a corporation is dissolved and distributes appreciated property to shareholders, the gain (increase) in value is taxed both to the corporation and to the shareholders. This means that it can potentially be more expensive to close down a profitable corporation than a partnership or an LLC that has elected to be taxed like a partnership.

Summing Up

We come back to where we started: For many, perhaps most, people who are planning a shared-ownership business, there are few real-world advantages to forming an LLC or a corporation rather than a partnership. (One exception is for owners of small businesses in fields where there’s a plausible risk of lawsuits against the business for large amounts of money.)

A partnership agreement focuses on the basic issues that must be resolved to establish a shared-ownership business with a minimum of red tape and cost. Therefore, we generally recommend the partnership form for shared-ownership small businesses that are unlikely to face large debts or the threat of scary lawsuits. We recognize the possible advantages of becoming an LLC or a corporation later on, for limited liability reasons and possibly for tax purposes as well, if the business becomes successful. Fortunately, as we’ve discussed, you can legally transform your partnership into an LLC or a corporation whenever the partners wish.

We suspect that the real reason why some people starting a business choose the corporate or LLC form has more to do with style than substance. Somehow they feel their business is more likely to prosper with that weighty INC. or trendy LLC decorating the stationery. This seems a bit silly but is harmless enough as long as the business owners remember that the form they’ve chosen will have little effect on how they operate the business day-to- day.

Example:

Polly, Maura, and Linda, all librarians, want to open an electronic information search business with emphasis on information of special interest to women. At a meeting about what computer equipment they should buy, Polly announces that she wants the business run as professionally as possible, which to her means creating a corporation or an LLC. After a lengthy, confusing, and frustrating discussion, they try to return to computer equipment, but their focus is gone.

Linda suggests that they all consider what really matters right now before they meet again. Polly consults a friend who’s a business adviser. The friend suggests that they put their efforts into getting the business started and keep the legal structure as simple as possible—form a partnership.

At their next meeting, to the relief of Maura and Linda, Polly proposes that they run the business as a partnership and prepare a partnership agreement. If the business prospers and expands, they will then consider incorporating or forming an LLC. But for the present, they all agree that what their business needs is income, not energy consumed in creating sophisticated legal structures.

A Closer Look at Partnerships

If you’re still reading, you’ve no doubt decided that you’re ready to start a shared business, that you’ve chosen the right co-owners, and that forming a partnership makes more sense than incorporating or forming an LLC, at least for now. Great! Now, it’s time to learn more about how partnerships work.

Most people have a commonsense understanding of what partnership is: The partners are in it together, all-for-one and one-for-all. In a rough way, this is true. A partnership is an intimate relationship. "It’s the business equivalent of a marriage," one friend aptly stated. Certainly, you’ll be deeply enmeshed with your partners, learn much about them, and develop close relationships after years of shared experience. But partners will also inevitably encounter periods of conflict and problems demanding resolution. As with any intimate relationship, you’ll need to be able to speak openly and candidly with each other (and as members of partnerships ourselves, we can confirm that this is far easier said than done).

Partnership Basics

The legal definition of a partnership is "an association of two or more persons to carry on as co-owners of a business for profit." (Uniform Partnership Act (UPA ) § 6(1).) You don’t have to use the words "partners" or "partnership" to become a legal partnership. If you simply join with other persons and run a shared business, you’ve created a partnership. Using those words will, however, ensure that your business is treated as a partnership. For example, if there is a question whether a person is an employee of a sole proprietorship, or a partner, calling him or her a partner will resolve the matter.

Some other partnership basics:

The Uniform Partnership Act. The UPA was adopted (often with some slight modifications) in all states except Louisiana. The Act provides rules governing partnerships. Certain rules cannot be varied, such as: "Each partner is responsible for all debts of the partnership." Most UPA rules apply only as a default, if a partnership hasn’t provided its own rules for handling the situation in its partnership agreement. You’re not stuck with the UPA rules; you can vary them—and you should, whenever necessary. That way, you can make sure that your partnership operates in the way that best suits you and your partners, rather than having to follow general rules created by distant legislators.

The Uniform Partnership Act of 1997. This Act is a revised, updated version of the original UPA . Over half the states have adopted the 1997 Act. The main provisions of the original Act and the 1997 Act are very similar. In Appendix A, we list the legal citation to each state’s UPA law. States that have adopted the 1997 Act are indicated with an asterisk.

As with the original UPA , you are not required to follow provisions of the 1997 Act, with the exceptions discussed below. If you live in a state that has adopted the 1997 Act, these rules are part of your agreement as a matter of law. Fortunately, these mandatory rules won’t be a problem when preparing your partnership agreement because they are simple, commonsense provisions. You can safely draft your own partnership agreement with this book whether or not you live in a state that has adopted the UPA or 1997 Act.

The bulk of the rules in the 1997 Act are, like the rules in the "old" UPA , designed to take effect if you don’t include a specific provision in your agreement covering an issue. (Lawyers often refer to these as "fallback" rules.) For readers of this book, fallback rules, whether included in the UPA or the 1997 Act, should be immaterial; if you follow our recommendations, all major partnership issues should be covered in your agreement. Second, we hope that, with a sound agreement, none of you will ever wind up in court fighting over your partnership. After all, preparing a detailed partnership agreement will help you avoid future conflicts. As you’ll see, we strongly urge you to have arbitration and mediation clauses in your agreement. That way, even if you can’t resolve a dispute, you can still avoid court proceedings.

Following are the significant specific UPA and 1997 Act sections that cannot be varied or waived by partnership agreement. We use the term "significant" because some binding sections cover optional matters. (For example, if you file a partnership "Statement" with the secretary or department of state’s office, mandatory sections apply. However, there is no requirement that you file any statement, and, in reality, no reason to bother.) Under the UPA and the 1997 Act, you cannot:

• Eliminate a partner’s duties of loyalty (Sections 404(b) and (d) and 603(b)(3)). These loyalty sections are really commonsense summaries of the minimum legal and practical duty of trust partners can expect of each other. Anyone who wants to lower or waive these sections should seriously question why they’re forming a partnership.
• Vary the power of a court to expel a partner (Section 601(5)). This section sets forth a number of reasons a court may terminate a partnership, on application of a partner, including such reasons as a "partner engaged in wrongful conduct that adversely and materially affected the partnership business," or a partner’s bankruptcy. All the grounds for which a court may terminate a partnership are so clearly reasonable that there’s no good reason to vary this section.
• Use your partnership agreement to try to restrict the rights of "third parties" (creditors) of the partnership (Section 103(b)(9)). This is a restatement of what the law has always been. You never could design a partnership agreement enabling the partners to evade legitimate partnership creditors.

In sum, the UPA and the 1997 Act must have been fun for legal scholars to prepare (they do love that sort of stuff) and may be vital if partners don’t draft an agreement in the first place or have a sloppy agreement that doesn’t cover key issues. It should, however, have no impact on users of this book. (For a list of state partnership statutes, see Appendix A.)

Oral Partnership Agreements. As a practical matter, partnerships should always have a written partnership agreement. You should know, however, that oral or handshake partnerships are often legal, although highly inadvisable. If there’s even a minor disagreement between the partners, it will probably be very hard to prove what the agreement was—or even that the partnership existed.

Equal Versus Unequal Ownership. Partners don’t have to share ownership equally. You can agree on any percentage of individual ownership or distribution of the profits that you want. Thus, one partner could own 80% of the partnership and four more could own 5% each.

Professional Partnerships. Partnerships can be organized for all sorts of purposes. They can sell products or services just as they can manufacture, mine, or operate as agents. Professional partnerships, however, such as those of lawyers or doctors, are subject to special rules set down by the state, because of the special licensing and regulation of these professions. Usually the most important rule is that everyone in the partnership be a member of the profession.

Compensation of Partners. Partners don’t normally receive salaries per se; usually, they get a percentage of the profits. However, partners often take an agreed-upon amount from the business— commonly called a draw—at regular intervals (for example, monthly, biweekly) against their yearly partnership shares.

Liability. As we’ve said, partners are personally and individually liable for all the legal obligations of the partnership.

Intent to Be Partners

Because partnerships don’t have to file any formal paperwork, there can be some confusion as to whether a true legal partnership exists. And, because one partner can bind the others legally, you’ll want to be very clear about whether you do—or don’t—belong to a partnership.

To create a valid partnership, each person must intend to be a partner. Partners must be volunteers; they can’t be drafted against their will. However, the law allows one’s intent to be a partner to be implied from the circumstances of a business operation. For example, if three people who have no other business relationship each inherit one third of some real estate or a business, they don’t automatically become partners because they’ve never agreed to do business together. But if they then proceed to run the business or develop the land together, they’ve become partners even if there is no written partnership agreement.

Not every active joining of interests makes people partners, either for tax purposes or legally. Here are two examples taken from regulations of the Internal Revenue Service (Treasury Regs., Sections 1.761-1(a)(1); 301.7701-3(a)):

• Mere co-owners of property are not partners, even if they lease the property and share rents, provided they don’t actively carry on a business on or with the property.
• Sharing the expense of a project does not automatically create a partnership or joint venture. For example, if two adjoining landowners construct a ditch merely to drain surface waters from their property, there is no partnership for tax purposes.
• In general, if a person receives a share of the profits of an (unincorporated) business, it’s an indication that the person is a partner in the business. The complexities of business relationships, however, can make this rule tough to apply.

Example:
Al lends money to Jane and Joan’s partnership business. That alone clearly doesn’t make him a partner—unless the loan is really a disguised ownership investment in the business. A key factor here is if a definite time is established when the loan is due. If not, the loan looks like an investment. But suppose Al is worried about Jane and Joan’s business sense, so he imposes some controls along with his loan (for example, he requires some new inventory controls or the installation of a time clock for employees). Does this render Al actively involved in the management of the business, and hence a partner? The answer is—it might. The IRS takes the position that when a lender imposes "excessive controls" on a loan, he or she becomes a partner. The IRS hasn’t defined exactly when controls become "excessive," so be wary.

The Rights and Responsibilities of Partners—Or, One Partner Can Bind Another

Each partner has full power to represent and bind the partnership within the normal course of business. (UPA Section 9.) This is one obvious reason trust is so vital in a partnership. One partner can obligate the other partners, even if they never authorized him or her to do so. Indeed, in many circumstances, a partner can bind a partnership even when the other partners told him or her not to.

Example:
Al, Fred, and Mike are partners in a printing business. They discuss buying an expensive new press and vote two-to-one against it. Fred, the disgruntled loser, goes out and signs a contract for the press with a company that has no knowledge of Al’s and Mike’s vehement opposition. Because this is within the normal course of business, Fred’s act binds the partnership.

It is legal to limit the powers of any partner in the partnership agreement. (UPA Section 18(3).) However, those limits are unlikely to be binding on people outside the partnership who have no actual knowledge of them. Legally, outsiders are entitled to rely on the apparent authority of a partner, as determined by the customs of the particular trade or business involved or the normal course of (that particular) business. When Fred bought the printing press, the salesman—as long as he had no actual knowledge of the partnership’s limits on Fred—relied on Fred’s apparent authority; a partner of a printing business can reasonably be expected to have the authority to buy a press. However, if Fred wanted to bind the printing partnership in a deal to open a chain of massage parlors, an outsider probably wouldn’t be able to rely on his signature alone as binding on the partnership, because this would be outside the normal course of the partnership’s business. (For more on a partner’s authority to bind the partnership, see Chapter 3.)

Personal Liability for Partnership Debts

Each partner is personally liable for all partnership debts and obligations that the partnership cannot pay. This is not a rule that the partners can change as far as debts to third parties go. Partners are not liable for the personal, nonpartnership debts and obligations of another partner. However, if one partner is having financial problems outside the partnership, creditors can seek to get at that partner’s share of the partnership, and this can severely disrupt the business. In addition to business debts, partners are also personally liable for any money damages that result from the negligence of another partner, as well as damages that result from fraud or other intentional acts a partner commits in the ordinary course of partnership business.

Example:
Jane and Alfonso are partners in a retail flower business. Jane has no money; Alfonso is rich. The partnership just opened, and the partners haven’t gotten around to buying insurance yet. While Jane is driving the flower delivery van to pick up flowers on partnership business, she hits and severely injures a pedestrian, who then sues and gets a substantial judgment. Alfonso is personally liable for any amount unpaid by the business—that is, what’s left unpaid after all partnership assets have been used. If he doesn’t have sufficient cash, or liquid assets, to cover the judgment, his other property, from real estate to cars—with the exception of whatever is protected by state debtors’ exemption laws—can be seized to satisfy it.

A silent partner—one whose membership in the partnership is not revealed to the public—is every bit as liable for partnership debts as any other partner. However, a subpartner (sometimes called an assignee) is not. A subpartner or assignee is a person who agrees with one member of a partnership to share in that partner’s profits. Although the assignee or subpartner has the right to receive a portion of the partner’s profits, he or she does not have any rights or responsibilities as a partner. This is a separate agreement between the partner and the subpartner and does not, legally, involve the subpartner in the partnership. Creating this kind of arrangement can get complicated, so see a lawyer if you’re interested in doing this.

Partnerships and Taxes

Partnerships do not pay federal or state income taxes. However, every partnership must file an informational partnership tax return (Form 1065) once a year. Any profits or losses from the partnership flow through the partnership to the individual partners. Thus, only the individual partners pay taxes on partnership profits. (See Chapter 7.)

Unlike corporations, there cannot be double taxation of partnership profits, once at the partnership level and then a second time when partnership profits are distributed to the individual partners. Under the tax code, partners’ incomes or losses may be, for IRS purposes, either earned, investment, or passive. Briefly, if all partners materially participate in the operations of the business—which is certainly the rule for most small business partnerships—partners’ incomes will be considered earned. As we explain in Chapter 7, it’s generally desirable from a tax point of view to have earned income rather than passive or investment income.

Partners’ Legal Relation to One Another

Partners are fiduciaries vis-à-vis one another. This bit of legal jargon means that they owe complete loyalty to the partnership and cannot engage in any activity that conflicts with the partnership’s business. As one court put it, "The rule of undivided loyalty is relentless and supreme." Another wrote, "Many forms of conduct permissible in a work-a-day world for those acting at arm’s length are forbidden to those bound by fiduciary ties…Not honesty alone, but the punctilio of an honor the most sensitive, is thus the standard of behavior." (Meinhard v. Salmon, 164 N.E. 545 (1928).)

Example:
Fred and Tom agree to be partners in a real estate purchase. In the course of conducting negotiations for that purchase, Fred learns of another real estate buy, a real bargain. Legally, Fred cannot simply wait until the partnership expires and purchase the second property himself. He has a fiduciary duty to tell Tom any valuable information he learns while acting on partnership business. Similarly, if Fred proposes to buy Tom out of the partnership, he can’t legally do so without telling Tom about the bargain he’s found. The rule of caveat emptor (let the buyer beware) doesn’t apply to a partner. Fred must act in complete good faith, including volunteering any significant information about the partnership, its worth, and business possibilities, which he is aware Tom doesn’t know.

There is voluminous litigation on the rights and duties of partners to each other—sad evidence that partnerships can go sour. Here are some representative no-nos, things a partner cannot legally do. Notice that common sense indicates these are not ways in which honest people deal with each other:

• A partner cannot secretly obtain for him or herself an opportunity available to the partnership.
• Partnership assets cannot be diverted for personal use of the partners.
• Partners cannot fail to distribute partnership profits to other members of the partnership.
• Each partner must disclose any and all material facts affecting the business to the other partners.

Caution: Would-be partners beware. The courts have often ruled that those who have seriously discussed forming a partnership must adhere to the same exacting standards of good faith that bind partners, even if they never signed an actual partnership agreement. For example, if two people seriously plan to open a saw shop and find a perfect location, it’s probably a breach of fiduciary duty for one person to try and cut out the other by leasing the place as a sole proprietor. Just when this partner-like responsibility arises isn’t totally clear, but when real negotiating begins, that probably means there are fiduciary duties of trust involved. You’ll have to trust your partners eventually, and it makes sense to start building that trust by full disclosure and square dealing right from the start.

Paperwork

As you’ll see, the technicalities of establishing and maintaining a small business partnership are not unduly burdensome. Once you agree on and create your partnership agreement, that’s pretty much it as far as legal paperwork is concerned. You don’t have to file any formal papers with any governmental bureau, department, or agency, except that the partnership must file appropriate paperwork with:

• the IRS, to obtain a taxpayer I.D. number (IRS Form SS-4)
• the appropriate local agency, if the partnership operates under a fictitious name (a name other than those of the partners). For example, if Wang, Olivier, and Simmons call themselves Ace Electric, they’ll have to meet state requirements for all businesses operating under a fictitious name. (See Chapters 3 and 8 for more on choosing a business name and fictitious name statements.)

Of course, partnerships have to comply with the same small business and tax paperwork common to any other business. This includes getting a state tax resale permit if they will sell goods, filing payroll and unemployment tax returns if they will hire employees, and generally dealing with all the rest of the bureaucratic procedures that go along with starting and operating a business. (See Chapter 8.) And, of course, there’s internal record keeping, including sales, accounts receivable, general ledger, and other accounting, also required of any business.

Relationships That Aren’t Partnerships

Just as it’s important to know what qualifies as a partnership, it can be crucial to recognize a "mock" or "phony" partnership.

Tax Scam Partnerships

Legitimate partnerships, like any other business form, can limit or reduce taxes in some circumstances. However, partnerships are particularly vulnerable to being ruled invalid by the IRS if they are phony relationships designed primarily to lower tax liability.

For example, Daniel and Marie live together. Daniel is a poor artist who makes very little from his paintings; Marie runs a profitable dress store and pays substantial taxes. Can Daniel and Marie legally declare they’re now in a partnership to run the dress store and, for tax purposes, each report half the store’s profits as their separate incomes, thus lowering their overall tax burden? As you might expect, if the purpose of a partnership is only to evade or reduce taxes, the IRS won’t recognize it as a business entity. There must be some genuine sharing, either of management and control of a business or investment in it, for there to be a tax-valid partnership; the partnership can’t exist solely in bookkeeping terms. ( IRS v. Tower, 327 U.S. 290 (1946).)

See An Expert: See a lawyer before creating a family limited partnership. These are complex, tricky legal creatures. You need to consult with an attorney to see if one will work for you.

Nonprofit Enterprises

Enterprises not primarily designed to make a profit also fail to qualify as partnerships. Such an endeavor is either a "nonprofit corporation" (if it’s incorporated) or an "unincorporated association" (if it isn’t). This latter group includes religious, charitable, educational, scientific, civic, social, athletic, and patriotic groups or clubs, and trade unions and associations.

Resource: Want more information about nonprofit corporations? See How to Form a Nonprofit Corporation, by Anthony Mancuso (Nolo).

Terminating a Partnership

In addition to establishing sensible rules for you to follow during the life of your partnership, your partnership agreement governs what will happen if the partnership ends. By termination of a partnership, we mean that the business no longer functions as a partnership. The partnership books are closed, and the partners go their separate ways. One of the other partners may continue the former partnership business in some other form, or, as is probably more common in cases of partnership termination, the business may end as well.