NFIB

Selecting the Best Legal Structure for Growth: Part II - Partnership
10/ 01/ 2002

by Andrew Sherman

This series of workshops will give you an overview and comparison of the basic business formats to consider (proprietorship, partnership, corporation or limited-liability company), both at the outset of a new venture and periodically throughout your company's growth.

Partnership

In a partnership, the assets used in the company are generally jointly owned by two or more parties, and the parties agree to share the profits, losses, assets and liabilities in proportion to their equity in the partnership, unless specified otherwise in the partnership agreement. You can create a partnership with a written or an oral agreement, but a written agreement is preferable.

General Partnership

In a general partnership, any or all of the individual partners may be liable for the debts and obligations of the partnership. For example, if three general partners form a business that later runs into financial difficulty, and only one has the personal assets to satisfy creditors, then that partner will be responsible for 100% of the obligations (not a prorated share based on his or her actual ownership of the company). Whether he or she will later seek reimbursement from the other partners doesn't affect his or her obligations to third-party creditors. There are no formal officers; your partnership agreement assigns the management functions.

General partnerships are typically found in professions that are service-oriented (such as law, accounting and medicine) and not capital-intensive. Many states require that you file a certificate of partnership or similar document; failure to do so may prevent your partnership from availing itself to the courts of the state in which it conducts business. Although the partnership must file a tax return, the individual partners (not the partnership itself) pay in proportion to their ownership as reported on the annual K-1 return filed with the IRS. Income and expenses flow through the partners according to the partnership agreement, and the applicable payroll taxes must be paid directly.

The primary advantages of this arrangement are that you have a high degree of flexibility, profits and losses can be shared disproportionately and flow directly to the partners and you avoid double taxation.

A general partnership's biggest drawback is that each partner bears unlimited personal liability. Also, the partnership technically terminates when one partner withdraws, which heightens the impact of the entry and exit of any partner. And once again, you're limited in your money-raising strategies: Either the partnership takes out a loan, which the partners personally guarantee, or you raise equity capital by admitting a new general partner. Most investors in a partnership prefer a limited partnership because of the controlled liability it offers and because they probably won't have to be involved in day-to-day operations.

Limited Partnership

A limited partnership (often referred to as an LP) includes not only the general partners but also one or more partners not bound by the obligations of the partnership. A general partner usually forms an LP to secure additional capital or to spread risk without forming a corporation. The general partners are still personally liable for all partnership debts, but each limited partner's liability is based on his or her capital contribution to the partnership. All management functions are delegated to the general partner for the day-to-day operations of the business. The limited partners may not exercise any significant management control because it may jeopardize their limited-liability status.

LPs are common in real estate development, oil and gas exploration and motion-picture ventures. Nearly every state requires that you file a formal certificate of limited partnership before the LP is valid. If the partnership isn't legally formed, the limited partners' liability is the same as that of the general partner.

The primary advantage of this structure (from a capital-formation perspective) is that the limited partners' potential liability is limited to the extent of their capital contribution, making them more willing to invest. The primary disadvantage is the general partner's unlimited liability.

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Andrew Sherman is internationally recognized as an authority on the legal and strategic aspects of entrepreneurship and business growth. As a senior partner with McDermott, Will & Emery, he manages a multi-million dollar corporate and transactional practice, representing Fortune 1000 corporations as well as hundreds of technology-driven, netcentric and rapidly growing businesses.

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