Choosing a Business Entity: Partnership

By | November 14, 2007

A partnership is a relationship existing between two or more persons who join together to carry on a trade or business. Each partner contributes money, property, labor, and/or skill to the partnership and, in return, expects to share in the profits or losses of the business. A partnership is usually based on a partnership agreement of some type, although the agreement need not be a formal document. It may even simply be an oral understanding between the partners, although this is not recommended.

A simple joint undertaking to share expenses is not considered a partnership, nor is a mere co-ownership of property that is maintained and leased or rented. To be considered a partnership for legal and tax purposes, the following factors are usually considered:

  • The partners’ conduct in carrying out provisions of the partnership agreement
  • The relationship of the parties
  • The abilities and contributions of each party to the partnership
  • The control each partner has over the partnership income and the purposes for which the income is used

Disadvantages

The disadvantages of the partnership form of business begin with the potential for conflict between partners. Of all forms of business organization, the partnership has spawned more disagreements than any other. This is generally traceable to the lack of a decisive initial partnership agreement that clearly outlines the rights and duties of the partners. This disadvantage can be partially overcome with a comprehensive partnership agreement. However, there is still the seemingly inherent difficulty many people have in working within the framework of a partnership, regardless of the initial agreement between the partners.

A further disadvantage to the partnership structure is that each partner is subject to unlimited personal liability for the debts of the partnership. The potential liability in a partnership is even greater than that encountered in a sole proprietorship. This is due to the fact that in a partnership the personal risk for which one may be liable is partially out of one’s direct control and may be accrued due to actions on the part of another person. Each partner is liable for all of the debts of the partnership, regardless of which partner may have been responsible for their accumulation.

Related to the business risks of personal financial liability is the potential personal legal liability for the negligence of another partner. In addition, each partner may even be liable for the negligence of an employee of the partnership if such negligence takes place during the usual course of business of the partnership. Again, the attendant risks are broadened by the potential for liability based on the acts of other persons. Of course, general liability insurance can counteract this drawback to some extent to protect the personal and partnership assets of each partner.

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Again, as with the sole proprietorship, the partnership lacks the advantage of continuity. A partnership is usually automatically terminated upon the death of any partner. A final accounting and a division of assets and liabilities is generally necessary in such an instance unless specific methods under which the partnership may be continued have been outlined in the partnership agreement.

Finally, certain benefits of corporate organization are not available to a partnership. Since a partnership cannot obtain financing through public stock offerings, large infusions of capital are more difficult for a partnership to raise than for a corporation. In addition, many of the fringe benefit programs that are available to corporations (such as certain pension and profit-sharing arrangements) are not available to partnerships.

Advantages

A partnership, by virtue of combining the credit potential of the various partners, has an inherently greater opportunity for business credit than is generally available to a sole proprietorship. In addition, the assets which are placed in the name of the partnership may often be used directly as collateral for business loans. The pooling of the personal capital of the partners generally provides the partnership with an advantage over the sole proprietorship in the area of cash availability. However, as noted above, the partnership does not have as great a potential for financing as does a corporation.

As with the sole proprietorship, there may be certain tax advantages to operation of a business as a partnership, as opposed to a corporation. The profits generated by a partnership may be distributed directly to the partners without incurring any “double” tax liability, as is the case with the distribution of corporate profits in the form of dividends to the shareholders. Income from a partnership is taxed at personal income tax rates. Note, however, that depending on the individual tax situation of each partner, this aspect could prove to be a disadvantage.

For a business in which two or more people desire to share in the work and in the profits, a partnership is often the structure chosen. It is, potentially, a much simpler form of business organization than the corporate form. Less start-up costs are necessary and there is limited regulation of partnerships. However, the simplicity of this form of business can be deceiving. A sole proprietor knows that his or her actions will determine how the business will prosper, and that he or she is, ultimately, personally responsible for the success or failure of the enterprise. In a partnership, however, the duties, obligations, and commitments of each partner are often ill-defined. This lack of definition of the status of each partner can lead to serious difficulties and disagreements. In order to clarify the rights and responsibilities of each partner and to be certain of the tax status of the partnership, it is good business procedure to have a written partnership agreement. All states have adopted a version of the Uniform Partnership Act, which provides an outline of partnership law. Although state law will supply the general boundaries of partnerships and even specific partnership agreement terms if they are not addressed by a written partnership agreement, it is better for a clear understanding of the business structure if the partner’s agreements are put in writing.

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