Partnership

WHAT IT IS

A partnership consists of two or more persons carrying on a business or trade together, and sharing the risks and benefits.  The basic idea of a partnership is exemplified by the general partnership, in which each partner owns the business, manages the business, and carries out business conduct.  The partners decide and plan everything together.  They share the work, the burdens, and the profits. A general partnership is a democracy.  But, unlike governance of a sole proprietorship, more than one person handling partnership business can mean potential disharmony.  Partnership laws grew to govern the partners’ rights and responsibilities to each other, the entity, and others.

In some ways, partnerships are kind of like joint sole proprietorships.  In most states the “default rules” indicate that if one partner dissociates or decides to withdraw from the partnership, the partnership dissolves.  In this sense, the business is treated as a direct expression of the partners, and nothing more; when they stop working together, no business exists.  Additionally, as with a sole proprietorship, there is no distinction between the partners’ and the partnership’s liabilities.  Each partner is jointly and severally liable for the partnership’s obligations.  Any partner can act on behalf of the business to create obligations that bind the business and the other partners.  Each partner’s personal assets are vulnerable to every partner’s actions.  They all have unlimited liability as if they were a group of proprietors inseparable from their business and each other.

Overall however, partnership laws recognize a business between partners as separate from the partners themselves. As such, this form of doing business generally establishes a distinct entity.  Many partnership statutes explicitly state that the partnership has an identity apart from the partners, that partnerships may sue and be sued in their own names, and that partnerships can own property that does not belong to the partners, and which partners have no right to transfer away.

Partnerships may have varying classes of ownership with differing voting rights, distribution entitlements, etc.

Partners may generally transfer only their economic interests, meaning that a purchaser of a partner’s interest receives only the partner’s rights to distributions, not the partner’s rights to make management decisions.

Partnerships generally take the form of general partnerships (described above) and limited partnerships. Limited partnerships allow certain partners to invest in a general partnership and share in profits and losses without participating in management or conduct, and without taking on partnership liability.  Some states also recognize limited liability partnerships [1] and other variations on the theme.

Because a general partnership involves unlimited personal liability (like a sole proprietorship conducted without a separate legal entity) but also involves a separate legal entity, it is considered a hybrid entity.

WHO CAN DO THIS

The idea of a partnership stems from individuals working together, but the “persons” that can participate in partnerships do not have to be individuals; they can be any combination of individuals and legal entities.

If two or more persons are engaged as co-owners in a business or trade for profit without having formed a separate legal entity like a corporation or LLC, they are typically engaged in a general partnership. [2]

General partnerships must have at least two partners.  All partners are general partners.

In a general partnership, admitting new partners often requires unanimous consent.

Limited partnerships must have at least one general partner and at least one limited partner.  Responsibilities of each are described below.

WHO HANDLES WHAT

Default general partnership laws often give partners equal rights to shares in management and conduct, and either per capita or equal shares in profits and losses.  The partners may generally alter a default arrangement by specifying their intentions in a partnership agreement.

Unless specified differently in the partnership agreement, each general partner typically has the ability to act as an agent of the partnership, binding the partnership and all partners.

In limited partnerships, the limited partners are essentially investors who share in profits and losses, but do not share in management and control or in business conduct, and do not have the right or power to act for, or bind, the partnership.  The general partners share in management, conduct, and profits and losses, and may generally act as agents on behalf of the partnership.

TO WHOM YOU ARE RESPONSIBLE

Partners (general and limited) each have rights to information concerning the partnership’s business.  The partnership is responsible for keeping books and records, and must generally provide partners access to partnership information.

In most states, each general partner owes duties of loyalty and care to the partners and partnership.  These are the general partners’ fiduciary duties.  A partnership agreement may generally not eliminate or reduce partners’ fiduciary duties, but it may often specify types of activities (provided these are not manifestly unreasonable) that the partners agree do not violate their duties.  Additionally, it may likely specify that after full disclosure of all material facts, a certain number or percentage of partners may authorize or ratify acts that would otherwise violate such duties.

Fiduciary duties may be expressed slightly differently in different states, and these differences may be important.

The duty of loyalty generally includes responsibilities akin to the duties to:

1. Account to the partnership and hold as trustee for it any property, profit, or benefit derived from conducting partnership business, using partnership property, or winding up the partnership;
2. Act fairly when dealing with the partnership in its conduct or winding up, in spite of having any adverse interest, or acting on behalf of a person with an adverse interest;
3. Refrain from competing with the partnership before dissolution.  (The rules often indicate that if a partner appropriates for him or herself a partnership opportunity, that partner is utilizing partnership property.  Any partnership opportunity may be recognized as partnership property.

Under the duty of care, in conducting or winding up partnership business, general partners must generally refrain from engaging in grossly negligent or reckless conduct, intentional misconduct, or knowingly violating the law.

General partners are each jointly and severally personally liable for all partnership debts, obligations, and liabilities.  This means that an injured party or partnership creditor may go after all or any one general partner’s personal assets to settle a partnership obligation.  There is no limit to the extent to which any general partner’s personal assets may be at risk.

Limited partners who do not participate in management or business conduct generally do not owe fiduciary duties to the partnership or the other partners, and are generally not personally liable to the partnership, other partners, or third parties.  Their liability is limited to the extent of their financial interest in the business.

In most states, general and limited partners owe a duty of good faith and fair dealing to the partnership and the other partners [3] and in carrying out the terms of any contract.

The partnership is liable for any general partner’s actionable conduct and for partnership debts, obligations, and liabilities to clients, customers, creditors, and anyone who incurs injury as a result of partnership goods or services, or wrongful or negligent actions.

The partnership, general partners, and limited partners are responsible for complying with any and all applicable laws, rules, regulations, and procedures.

YOUR POWER TO AFFECT THE BUSINESS STRUCTURE

Partners would typically execute a partnership agreement to reflect their intentions.  Generally, there are a limited number of statutory provisions that a partnership agreement may not alter or waive.  Aside from these, partners may determine the parameters of their ownership and management structures, relationships, rights, and obligations.

HOW LONG YOUR BUSINESS LASTS

A general partnership must generally be dissolved when one of the partners withdraws.

A limited partnership must generally be dissolved:

1. When an event agreed to in the partnership agreement occurs;
2. When all general partners and certain limited partners consent; or
3. When the only general partner withdraws and the partnership agreement does not provide an allowed path for continuation.

HOW YOU GET PAID

Partners receive distributions from the partnership.  They share in the business’s income, gains, losses, deductions, and credits.  These are allocated as indicated by the partnership agreement.  The partnership may generally allocate shares in any manner so long as the allocations have substantial economic effect or satisfy the family partnership rules, as applicable. [4]  If the agreement is silent, each partner’s share is generally determined under state law according to their interest in the partnership.

Partners are self-employed; they are not employees of the partnership. [5]

ACCOUNTING

Partnerships must keep track of income and expenses consistently from year to year using an accounting method that clearly reflects the business’s income and expenses.  A cash, accrual, special, or hybrid accounting method (selected when filing the first informational partnership tax return) may be appropriate.  However, partnerships with at least one corporate partner and gross annual receipts of over $5 million may not be allowed to use the cash method of accounting. [6]

TAXES

The partnership does not pay its own income taxes.  Instead, partnership income passes through the entity and is taxed to the partners at their personal tax rates.  Partners pay income tax on their shares of partnership income, even if that income is undistributed (retained within the partnership).  Partners may be responsible for income tax/estimated tax and self-employment tax. [7]

As designated in the partnership agreement, the partnership may specifically allocate items of income, gain, loss, and deduction, so long as these have substantial economic effect. [8]  If the agreement is silent as to allocations, they are generally determined in proportion to partnership interest or otherwise according to the tax code.

Certain income tax calculations and elections are determined at the partnership level, and the partnership must file an informational return along with any required employment and excise tax reports and applicable payments.

No gain or loss is generally recognized by the partnership or a partner upon a partner’s contribution of property in exchange for partnership interest. [9]  This applies upon formation and subsequent contributions over the life of the business.  Certain exceptions may apply. [10]

Sale of appreciated partnership assets generally do not result in taxable gain to the partnership. [11]

Property distributions are generally tax free.  When calculating basis, partners may include contributed capital and their share of all partnership debts. [12]  (This results in advantageous partner loss deductions when compared with S-corp shareholder basis calculations and associated loss deductions.)

The partnership’s tax year is based on the partners’ tax years.  If the partnership is made up of individuals who prior to entering the partnership filed taxes using the calendar year, the partnership must generally use a calendar year.

REQUIRED ANNUAL STATE BUSINESS FILINGS AND FORMALITIES

General Partnership

Most states do not require annual general partnership reports or filings, or entity fees.

Partnerships must maintain certain required books and records and provide partners access to partnership information.

Limited Partnership

Limited partnerships are generally registered with Secretaries of State and must file annual reports, along with required fees.  Additional records and filings may be required upon various partnership events.

Limited partnerships must maintain certain required books and records and provide partners access to partnership information.

NOTEWORTHY

General partnerships increase each partner’s liability and dissolve easily with the loss of a partner.  For these reasons, individuals must consider liability exposure before proceeding as general partners.  Entities that already have limited liability might take advantage of a general partnership to engage in a joint venture for a limited purpose or duration, or might serve as general partners in limited partnerships. Partnership taxation presents certain advantages, such as pass-through of income and losses, favorable basis calculations, general tax-free exchanges of contributions for interest, and general non-recognition of gain to the partnership upon sale of appreciated assets.

It is essential to consider all relevant factors when determining Choice of Entity.

[1] Limited liability partnerships are similar to general partnerships, with a twist.  They are often associations of professional service providers.  Public policy does not allow these practitioners to avoid liability in connection with their services regardless of the form of business they choose.  Yet, unlike a general partnership which holds each partner liable for the conduct of the entire partnership, the limited liability partnership allows two or more professional service providers to work together without taking on each others’ liability exposure.

[2] For IRS information regarding when a partnership is formed consult I.R.S. Pub. 541 2-3 (2010), Partnerships, available at http://www.irs.gov/pub/irs-pdf/p541.pdf. For detailed state rules regarding partnership formation, consult your governing statute.  The Illinois Uniform Partnership Act of 1997, 805 ILCS 206, may be accessed online at http://www.ilga.gov/legislation/ilcs/ilcs4.asp?DocName=080502060HArt%2E+1&ActID=2292&ChapterID=65&SeqStart=100000&SeqEnd=1300000.   

[3] In most states, the covenant of good faith and fair dealing is an implied duty applicable to any contractual agreement.  Partnership agreements are contracts, and statutory partnership laws essentially require that partners implicitly accept the statute’s legal terms.  For more information on the obligation of good faith and fair dealing, see, e.g., Restatement (Second) of Contracts, § 205 (1979) (stating that “every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement.”); UCC § 1-304 (!977) (“[E]very contract or duty within the [UCC] imposes an obligation of good faith in its performance and enforcement.”); UCC § 1-201(19) (1977) (“Good faith means honesty in fact in the conduct or transaction concerned.”); UCC § 2-203(b) (1977) (“Good faith in the case of a merchant means honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade.”); See also, Ronald B. Kowalczyk & Melissa Piwowar, The Application of the Implied Covenant of Good Faith and Fair Dealing in Contract Cases, 16 J. DuPage County B. Ass’n (2003-04), available at http://www.dcbabrief.org/vol161203art1.html.

[4] I.R.C. §§ 704(b) and (e) (1986).

[5] See Paying Yourself, available at http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Paying-Yourself#2. 

[6] An overview of acceptable partnership accounting methods is available via the Instructions for Form 1065, U.S. Return of Partnership Income, http://www.irs.gov/pub/irs-pdf/i1065.pdf. 

[7] https://www.irs.gov/businesses/partnerships

[8] I.R.C. § 704(b) (1986).  Special allocations must have substantial economic effect.  I.R.C. § 704(b)(2) (1986).

[9] I.R.C. § 1-721.1(a) (1986).

[10] A partner’s services or promised services exchanged for partnership interest may result in income taxable to the partner.  I.R.C. § 1-721.1(b)(1) (1986).  Services exchanged for partnership profits may be taxable to the partner in certain circumstances.  I.R.C. § 83 (1986).

[11] I.R.C. § 731(b) (1986).

[12] See I.R.C. § 752 (1986).  The partnership may also make certain basis adjustments.  I.R.C. § 743(b) (1986).  Partnership basis adjustments may have both advantages and disadvantages.  See ABA Tax Section, Section 754, Making the Election or Not (2009) available at http://www.americanbar.org/content/dam/aba/events/real_property_trust_estate/joint_fall/2009/spratt_20090907145241093.authcheckdam.pdf.