Form a Partnership
The Complete Legal Guide
Form a Partnership
The Complete Legal Guide
Denis Clifford, Attorney and Ralph Warner, Attorney
August 2012, 9th Edition
Everything you and your partners need to go into business together!
Form a Partnership thoroughly explains the legal and practical issues involved in forming a business partnership, creating a partnership agreement and protecting each person's interests. In plain English, the book covers:
- partnerships compared to other business structures
- the financial and tax liability of partners
- contributions of cash, property and services
- what happens if a partner wants out
- how to value partnership assets
- admitting new partners
- buying out a partner's interest
- limited partnerships
- and much more
This edition of Form a Partnership is totally revised and updated to reflect the law and realities of today's business world. Plus, all the forms you need to create a partnership agreement are provided.
“Tells you almost more than you ought to know about getting into—and also out of—partnerships.”- The Washington Post
“Advice (and plenty of sample forms, worksheets and agreements) on everything from getting a business started to kicking out an unwanted partner later.”- Los Angeles Times
“Details what the agreement should include … a step-by-step guide that pilots readers through the partnership agreement.” -San Francisco Examiner
Short-Form Partnership Agreement
Short-Form Partnership Agreement
Sample Partnership Termination Agreement
Your Legal Companion For Forming a Partnership
1. Is a Partnership Right for You?
- Sharing Ownership of a Business
- Business Structure Options
- Comparing Partnerships to LLCs and Corporations
- A Closer Look at Partnerships
2. An Overview of Your Partnership Agreement
- Preparing Your Agreement
- Basic Topics Covered in a Partnership Agreement
- Partners: Their Authority and Relationship
- Name and Purpose of the Partnership
- Financial Considerations
- Expanding Your Business
- Operational and Management Responsibilities
- Withdrawal of a Partner, Buyouts, and Ending a Partnership
- Short-Form Partnership Agreements
- Will You Need a Lawyer or an Accountant?
3. Partnership Name, Contributions, Profits, and Management
- Name, Term, and Purpose
- Profits, Losses, Draws, and Salaries
- Management Responsibilities
4. Changes and Growth of Your Partnership
- Amending the Partnership Agreement
- Admission of a New Partner
5. Changes: Departure of a Partner, Buyouts, and Business Continuation
- Buy-Sell Clauses
- Determining the Value of the Business
- Payments to Departing Partners
- Expelling a Partner
- Continuing the Partnership
- Terminating a Partnership
6. Partnership Disputes: Mediation and Arbitration
- Combining Mediation With Arbitration
7. Partnership and Taxes
- Using Tax Experts
- Partnership Business and Personal Income Taxes
- How Partnerships Are Taxed
- Family Partnerships for Tax Savings
- Tax Consequences of Contributions to a Partnership
- Management of the Partnership Business
- Tax Returns
- Taxation and Sale of a Partnership Interest
- Tax Term Explained
8. Getting Your Business Started
- Permits and Licenses
- Federal and State Tax Requirements
- Bookkeeping and Accounting
- Rent and Lease Negotiations
9. Limited Partnerships
- How a Limited Partnership Works
- The Relationship Between the General Partner and the Limited Partners
- Securities Aspects of Limited Partnerships
- Certificate of Limited Partnership
- Tax Aspects of Limited Partnerships
10. Lawyers and Other Professionals/Doing Your Own Research
- Partnership Tax Experts
- Doing Your Own Research
11. Drafting Your Own Partnership Agreement
- How to Prepare Your Agreement
- After You’ve Drafted Your Agreement
- The Story of a Partnership
Appendix A: Resources
- Resources for Further Research
- Citations to State Uniform Laws
Appendix B: Using the Interactive Forms
- Editing RTFs
- List of Forms
Appendix C: Partnership Agreements
- Partnership Agreement
- Short-Form Partnership Agreement
- Sample Partnership Termination Agreement
Is a Partnership Right for You?
Sharing Ownership of a Business............................................................. 4
Advantages and Drawbacks................................................................... 4
Choosing the Right Partners.................................................................. 5
A Personal Note........................................................................................ 5
Business Structure Options........................................................................ 6
The Sole Proprietorship........................................................................... 7
The Limited Liability Company............................................................... 9
Limited Partnerships.............................................................................. 11
Comparing Partnerships to LLCs and Corporations............................ 13
Limited Liability........................................................................................ 14
Business Continuity............................................................................... 15
Transfer of Ownership........................................................................... 16
Business Formalities.............................................................................. 16
Summing Up............................................................................................ 18
A Closer Look at Partnerships.................................................................. 19
Partnership Basics ................................................................................ 20
Intent to Be Partners............................................................................... 21
The Rights and Responsibilities of Partners—Or, One Partner Can
Bind Another......................................................................................... 22
Personal Liability for Partnership Debts............................................. 23
Partnerships and Taxes......................................................................... 24
Partners’ Legal Relation to One Another........................................... 24
Relationships That Aren’t Partnerships.............................................. 26
Terminating a Partnership..................................................................... 27
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 several 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.
Get Updates, Forms, and More at Nolo.com
You can download any of the forms in this book at www.nolo.com/back-of-book/PART.html. When there are important changes to the information in this book, we’ll post updates on this same dedicated page. You’ll find other useful information there too, including blogs, podcasts, and videos
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:
• sole proprietorship
• 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.
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.)
History Lesson #1
Partnerships date to the beginning of recorded history. References are made to partnerships in the Babylonian Code of Hammurabi, approximately 2300 BC. The Jews, around 2000 BC, a pastoral (not a commercial) people, evolved a form of landsharing or grazing partnership called a “shutolin.” Later, commercial Jewish partnerships evolved from trading caravans
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.
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.
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.
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.
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).)
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 grown-up, 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 entity in the business world, called a limited liability company (LLC). LLCs are available in every state and they can be structured as multi- or single member entities, so even sole proprietors can choose to organize as an LLC.
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, taxwise, 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 LLC pays a filing fee of $70, but must also pay a minimum of $800 annually.) Most states require an LLC to file an annual form or report. (This is in addition to state-required LLC income tax returns, discussed below.) Further, a number of states impose annual fees on LLCs and a few impose annual franchise taxes.
Like a partnership, an LLC also should have a written agreement (called an “operating agreement”), which defines the basic rights and responsibilities of the LLC owners. To prepare a sound operating agreement, LLC 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.
If you want to create a limited liability company. You can form your LLC online with Nolo’s Online LLC (available at www.nolo.com) or you can find all the forms and information you need to create your own LLC in Form Your Own Limited Liability Company, by Anthony Mancuso (Nolo).
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.
Business Structures for Professionals
Some professions are regulated by state law and cannot use simple, ordinary partnerships. For example, under almost all states’ laws, doctors cannot form a general partnership. Other health care professionals—dentists, nurses, opticians, optometrists, pharmacists, and physical therapists —are similarly regulated. So are some other professions, normally including psychologists, accountants, engineers, and veterinarians. The scope and details of regulation vary from state to state.
However, laws in every state permit shared ownership by regulated professionals using different business structures. They can form a “professional corporation” or a “professional service corporation,” and, in some states, a “professional limited liability company.” Also, in some states, certain types of partnerships are allowed, sometimes called “limited liability partnerships.” If you are in a regulated profession, see a lawyer.
Whatever legal form a shared professional business takes, the owners must resolve the same basic questions that are involved in setting up a partnership: who contributes what, how work is allocated, how profits are shared, and what happens if an owner leaves. Though you’ll eventually need a lawyer to prepare the formal ownership documents, you’ll benefit by working through these issues yourselves, before seeking legal help
Converting a Partnership to an LLC
It’s fully legal to change the structure of a business from a partnership to an LLC at any time. Essentially, the LLC articles of organization that you must create and file to convert a partnership are the same as those required to create an LLC from scratch. The partnership agreement, perhaps with minor technical modifications, can be renamed the LLC operating agreement. Once a partnership has been converted into an LLC, the owners have limited liability for all future business debts and obligations. The creation of the LLC does not, however, wipe out the owners’ (the former partners’) responsibility for any previous partnership debts or obligations.
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.
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.
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.)
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.
History Lesson #2
In Europe, as in England, partnership law evolved from the customs of merchants, so European civil law regarding partnerships is similar to ours. Civil law recognizes a “societas,” the equivalent of our general partnership, and a “societe en common dite,” the equivalent of our limited partnership.
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 LLC 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 LLC, 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 LLC 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.
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).
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.
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.
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.
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 are modest in most states—typically $100 or so. Some states impose yearly fees or franchise taxes which can be more substantial ($800 in California). 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 LLCs 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 LLC. Filing incorporation papers costs $100 to $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 annual 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 corporate 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.
Resources to incorporate your business. You can form your corporation online using Nolo’s Online Corporation at www.nolo.com. How to Form Your Own California Corporation, by Anthony Mancuso (Nolo), contains excellent information and forms 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.
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 LLCs 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.
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.
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.
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