What exactly is a partnership? How do you start one? And should you enter a partnership as a general partner or a limited partner?
Here’s everything you need to know.
What is a partnership?
A partnership is a business owned and operated two or more taxpayers.
The mom and pop laundromat down the street from your apartment is probably a partnership. The house painting business you started that one summer in college with a friend was probably a partnership, legally-speaking, even if you didn’t file any paperwork or officially declare it to be one.
If a business isn’t incorporated, isn’t a sole proprietorship, and has two or more people making day-to-day decisions about its operations, it’s probably a partnership.
Why do people form partnerships?
People like partnerships because they’re the single quickest, easiest way for two or more people to go into business with one another.
You don’t need to file any forms with your state to start a partnership. All you need is a verbal agreement. You might be part of a partnership right now without even knowing it!
People also like partnerships because they don’t have to pay any taxes. Instead, the IRS allows the losses and profits of a partnership to “flow through” directly to its owners, who then report those profits or losses on their personal income tax returns.
So what’s the catch?
Partnerships also come with risks, and most of those risks boil down to liability.
If you go into business as a sole proprietor, you’re only on the hook for your own mistakes. If you go into debt, a creditor can usually only come after you and your assets.
Partnerships involve multiple people, which means you’re liable (that’s legal speak for ‘on the hook for’) someone else’s mistakes as well. This shared liability is one of the biggest risks that people assume when forming a partnership.
Throw in the fact that people often form partnerships with close friends and loved ones, and that disagreements between partners are inevitable, and it quickly becomes clear that this isn’t a process that you want to rush or seal with just a handshake.
How do I form a partnership?
Because they’re not required to put anything in writing when starting a partnership, small businesses will often “wing it” and stick to a verbal agreement. After all, you’re going into business with someone you trust—what could go wrong?
The answer is: a lot.
No matter how much you trust your business partner—especially if you trust your partner—you need to get everything in writing. And to do that, you need to sign a partnership agreement.
What is a partnership agreement?
A partnership agreement is a lot like the bylaws of a corporation. At minimum it should establish four things:
- The name of the partnership
- How the profits of your partnership will be distributed
- How its losses will be shared
- What happens when someone wants to sell or get rid of their stake in the partnership
A well-written, exhaustive partnership agreement should also cover topics like:
- The nature of your business
- How long the partnership will last (if it has an expiry date)
- What kinds of partners it will contain (more on that below)
- What each partner is expected to contribute in terms of capital, time, resources
- Who is responsible for what, in a managerial sense
- Rules for what happens when it’s time to dissolve the partnership
- How disagreements should be resolved
LawDepot’s handy partnership agreement generator should give you a sense of what goes into a typical partnership agreement.
As tempting as it might be to write one up yourself, never sign a partnership agreement without first having a lawyer look at it.
A lawyer can help you craft a partnership agreement that fits your business’ specific needs, anticipates any problems your business might run into later, and save you a lot of trouble if you or one of your partners ever decide to sue one another down the line.
Most importantly, a lawyer can help you figure out what kind of partnership you should form with your business partner.
The three kinds of partnerships
What kind of partnership you form will depend on what kind of partners it contains. In general, your partnership can contain three different kinds of partners:
These partners share in the profits and losses of the business, are involved in the day-to-day management of the company, and are personally liable for the business’ debts.
Also sometimes called silent partners, limited partners don’t participate in the day-to-day management of a business—they usually just contribute money. Their liability is also limited to the amount of their initial investment.
For example: let’s say you’re a limited partner in your friend’s A.I.-powered dog grooming startup, which you’ve invested $2,000 into. If your friend ever goes bankrupt, creditors can only come after you for that $2,000 equity stake. The rest of your assets are protected.
Limited liability partnerships
These partners are involved in the day-to-day management of a business or have a financial stake in a company, and they enjoy limited liability.
What is a general partnership?
A general partnership is a partnership where:
Each partner is a general partner.
Each partner has equal management rights, no matter how many shares of the company they own.
Each partner is equally liable for the debts of the partnership.
If you form a partnership with one other person based purely on a verbal agreement and don’t file a partnership agreement, the law automatically considers both of you to be general partners with a 50-50 stake in the business, and your partnership is considered to be a general partnership.
People form general partnerships for two main reasons:
They’re easy to form
Like we mentioned earlier, you can form a general partnership with a simple verbal agreement. Compared to incorporating or forming an LLC, establishing a general partnership is cheap, fast and easy.
Forming one could lower your tax bill
Any profits you make as a general partner pass through directly to you and are taxed at your personal income tax rate, which can result in a lower tax bill than the one you’d get if you incorporated.
But there are also drawbacks to forming a general partnership. The two main ones are:
You’re on the hook for someone else’s debts
General partners and general partnerships are exposed to more liability than any other kind of partner or business entity—more than sole proprietors, even. If one of your partners screws up and puts the business into debt, their creditors can come after you for the full amount, even if you had nothing to do with taking on that debt in the first place.
You’re on the hook for any other mistakes they make too
If you’re a general partner, you might also be liable for any negligence or malpractice committed by your partners or employees over the course of their work. You can buy general liability insurance to counteract some of this risk, but you can never completely eliminate it.
What is a limited partnership?
A limited partnership—sometimes referred to simply as an “LP”—is a partnership where:
At least one partner is a general partner, and one partner is a limited partner.
Each partner does not have equal management rights. General partners participate in the day-to-day management of the business, while limited partners are forbidden from participating in management.
Only general partners are responsible for the debts of the partnership.
Unlike general partners, who split the profits between themselves, limited partners receive a predetermined payment for their investment, similar to the dividend investors receive when they invest in a corporation.
Why do people form limited partnerships?
They protect you from liability
Entering a partnership as a limited partner is a great way to contribute to a business without risking any of your personal assets. If you’re okay with the idea of contributing money to a business without taking a role in its day-to-day operations, limited partner status is for you.
You don’t have to pay self-employment tax
Because they receive dividend-like payments in exchange for their investment in the business, limited partners don’t have to pay self-employment tax like general partners do.
What are the drawbacks of limited partnerships?
They’re not as easy to form as general partnerships
The rules around forming limited partnerships vary widely by state and can get complicated. Some states require you to secure a partnership agreement, a Certificate of Limited Partnership, a state ID number and workers’ compensation insurance to form a limited partnership. Some states don’t require any of those things.
Look up your state and industry on the U.S. Small Business Administration website here to figure out which licenses and permits you need to submit to establish a limited partnership.
You’re still on the hook if you’re a general partner
There’s no limited liability for a general partner in a limited partnership. If you get into trouble with your creditors, they can still come after your LP’s assets.
You could lose your limited partner status
If a limited partner starts taking an active role in a limited partnership—which can happen if they ever disagree with how the general partner is running the business—they risk losing their limited status and being held responsible for the business’ liabilities just like a general partner.
What about limited liability partnerships?
A limited liability partnership (LLP) is similar to an LP, except for two major differences:
All of the partners in an LLP enjoy limited liability.
All of them are allowed to participate in the day-to-day management of the business without losing their limited liability status.
This makes LLPs really popular with accountants, architects, lawyers, financial service providers and any other professionals who want to insulate themselves from any negligence or malpractice committed by their partners. (Ever wonder why every law firm is an LLP? This is why.)
That’s also why so many states are picky about which professions are allowed to form LLPs. If the idea of forming an LLP sounds appealing to you, check with your state to make sure whether you’re allowed to in the first place.