Partnership is the oldest type of business organization. Its rules under the 6th-century Justinian Code of the Roman Empire are not materially different from those of today. Roman partnership law spread through Europe and was adopted into the British system which the U.S. retained at its founding. Today, every state has a statute governing partnership law.
A partnership is defined as an association of two or more persons (which may include a corporation) to carry on as co-owners of a business for profit. It is an entity separate from its owners. There are many different types of partnerships: general partnerships, limited partnerships, and limited liability partnerships. The general rules apply to all types of partnership. If no specific type of partnership is mentioned, assume it is a general partnership.
While partnerships are considered entities for legal purposes, they are not taxable entities. In other words, the partnership does not pay income taxes. Rather, each partner is taxed on his or her share of profits or losses. This is key to understanding what is known as partnership tax. Under this tax regime, if you are a 50% partner in a partnership that makes $100,000 in profit this year, you will be apportioned $50,000 of taxable income, which you will be responsible to report on your personal tax income tax return.
Creation of a Partnership
Forming a partnership is relatively easy - in fact, it can be created inadvertently. A partnership is created by agreement, either express or implied, oral or written. Contract law applies to partnership formation; hence, the partners must have the capacity to enter into the agreement, the partnership cannot exist for illegal purposes, etc.
A partnership can be formed to last for a specific amount of time, until the completion of a certain task, or indefinitely. Partners are co-owners of the business and have joint control over the business operations and rights to its profits. Even in the absence of a partnership, a person may become a partner by estoppel if he or she holds himself or herself out as a partner.
The most common way of forming a partnership is by a written agreement. A document that creates the partnership and outlines the responsibilities of the partners is known as a partnership agreement. Common terms of a partnership agreement include:
- The name of the partnership and the names of the partners.
- The location of the partnership's headquarters and the law which will govern the partnership.
- The purpose and duration of the partnership.
- The amount of capital that each partner will contribute.
- How losses and gains will be allocated among the partners.
- When distributions of profits will be made.
- How the partnership will be managed and responsibilities divided among the partners.
- How voting rights will be allocated.
- Events that will cause the dissociation of a partner or the termination of the partnership.
The rights and duties of partners are governed by the partnership agreement, but in some cases, there is no written agreement. In such cases, partners may have difficulty proving oral agreements. In the absence of a partnership agreement, state law will dictate the rights and duties of the partners.
Rights of Partners
Unless the partnership agreement states something to the contrary, all partners have equal rights to partnership profits and to management rights. In other words, if one partner contributes $400,000 to the partnership and another contributes $100,000, each partner will receive an equal amount of the profits (or losses) and each will have the same amount of votes when making partnership decisions assuming there is no partnership agreement to the contrary.
Unless otherwise stated in the partnership agreement, there is no right to compensation for partners of a partnership. A partner is expected to contribute time, effort, and skill to make the partnership profitable. Therefore, if a partner contributes 80 hours a week to the partnership's business, the partner is not entitled to any compensation for that work. The partner is, however, entitled to the partnership share of profits (if any).
Partners are permitted access to the financial records. These records must be kept at the principal business office and cannot be removed without approval from the other partners. Similarly, the partnership must keep accurate records and so that each partner can determine his or her share of partnership profits or losses. Property acquired by the partnership is owned by the partnership and not by the partners directly.
Responsibilities of Partners
Each partner is an agent of every other partner and acts both as a principal and agent in any business transaction within the scope of the partnership agreement. You will find that these duties owed by partners are derived from agency law.
Duty to Serve
A partner is expected to perform services for the partnership. This is not true if the partnership states that a partner will contribute capital rather than services.
Duty of Loyalty
Partners must put the interest of the partnership above their own. Partners are fiduciaries to each other. As Judge Cardozo stated, the fiduciary duty is something stricter than the morals of the marketplace. Every partner must account to the partnership for any benefit of any transaction connected to the partnership business. A partner must refrain from competing with the partnership and may not make secret profit while doing partnership business unless all other partners consent (which they usually do not).
A common example involves accounting firms. Most firms' partnership agreement will state that partners cannot provide accounting services except on behalf of the partnership. It may also state that partners are able to provide accounting services not provided by the firm so long as permission from other partners is given.
Duty of Care
In transacting partnership business, each partner owes a duty of care. Partners must faithfully serve to the best of their ability. The duty of care requires that partners refrain from grossly negligent or reckless conduct, intentional misconduct, or knowing violation of the law. A partner is not liable to the partnership for losses resulting from honest errors in judgment.
If a partnership agreement exists, it may reduce the duty of care so long as the duty of care remains "reasonable." Similarly, the partnership may increase the duty of care owed to the partnership. It is common for partnership agreements to excuse partners from liability if they act in good faith and with the honest belief that their actions are the best for the partnership. These provisions encourage reasonable business risk.
Duty of Obedience
No partner can disobey the partnership agreement or fail to follow any properly made partnership decision. A partner is liable to other partners for damages or losses arising from unauthorized activities.
Liabilities of Partners
One significant disadvantage of a general partnership is that partners are personally liable for the debts of the partnership. The acts of one partner's actions for the partnership subject the other partners to personal liability.
Each partner in a partnership is jointly liable for the partnership's obligations. Joint liability means that a third party must sue all of the partners in the partnership, but each partner can be held liable for the full amount.
Partners can also be jointly and severally liable for all partnership obligations. Joint and several liability means that a third party has the option of suing all the partners together, or just one or some of the partners separately.
Note that all partners can be held liable regardless of whether a particular partner participated in, or even knew about the wrongful conduct that led to liability.
Limited Liability Partnerships (LLP)
In order to ease the harsh liability issues mentioned above, different partnership forms were created. The LLP is a hybrid form of partnership designed primarily for professional partnerships (i.e., attorneys, doctors, accountants, etc.). The LLP allows the tax benefits of pass-through taxation, but limits the personal liability of partners.
While general partnerships are formed easily or inadvertently, an LLP must be filed with the state. In Idaho, the partnership must file a Statement of Qualification of Limited Liability Partnership with the Idaho Secretary of State and pay the registration fee of $100. This is the only form filed with the state to create the LLP; it does not have to submit its partnership agreement or any other documents.
An LLP allows the individual partners to avoid personal liability for the malpractice or torts of other partners. A partner, of course, remains personally liable for his or her own wrongful acts, but other partners do not have to worry about their own personal assets being at risk. Imagine that you are a partner at an accounting firm with 4 other partners. One of those other partners commits malpractice and is sued and the company's malpractice insurance is insufficient to cover the damages. If the partnership operates as a general partnership, all partners could be joint and severally liable for the damages. On the other hand, if the partnership is an LLP, the firm's assets along with the personal assets of the partner that committed malpractice will be at risk. However, all other partners' personal assets are safe from collection.
Limited Partnerships (LP)
The LP limits the liabilities of only some of its partners. LPs are old (medieval, in fact) and consist of at least one general partner and one or more limited partners. A general partner manages the partnership and therefore has personal liability for the partnership and all its debts. A limited partner contributes cash or other assets, but does not participate in the management decisions. As a result, the limited partner has no liability for partnership debts beyond the amount that the limited partner invested. The limited partner can lose this limited liability protection by taking part in the management of the partnership.