Your Startup — What Legal Structure Is Best?
Part 4 of a Four-Part Tutorial
Partnerships
Of all the multi-party legal structures available to a startup, the easiest to establish is a partnership. It is also easy and inexpensive for partnerships to stay in compliance with regulatory statutes.
Technically the formation of a partnership requires nothing more than an oral agreement between two or more other parties to go into business together. Unlike an LLC or a corporation, a partnership does not file paperwork with the state to become a legal entity. States and the courts consider any business a partnership if it has multiple owners and has not been legally recognized as an LLC or a corporation.
Types of Partnerships
Partnerships come in two basic varieties: general partnerships (GPs) and limited partnerships (LPs). Some states also recognize a third type called limited liability partnerships, or LLPs, and a special variant of it called professional limited liability partnerships (PLLPs).
A general partnership is the simplest to form. Its partners jointly manage the decision-making of the partnership and are equally empowered to act as agents on its behalf. That is, any partner can obligate the partnership as a whole by entering into contracts, authorizing purchases, or even disposing of assets.
A limited partnership has two tiers of partners. One is the general partner, who alone can act as an agent on the partnership's behalf. The other partners (known as "limited partners") play a more passive role, which may be nothing more than providing investment capital.
Limited liability partnerships are a special form of a general partnership. They provide each partner a measure of limited liability that is unavailable in general partnerships. We will examine this issue more fully in a moment.
Limited liability partnerships (or LLPs) are of relatively recent origin. Texas, the first state to recognize LLPs, gave them statutory approval in 1991. Since then a number of other states have followed suit. But these states have not settled on a uniform set of rules to govern LLPs. As a result, the levels of limited liability within an LLP differ significantly from state to state.
Professional limited liability partnerships (PLLPs) are a special type of LLP designed specifically for certain qualifying professions. Among these are doctors, dentists, attorneys, engineers, architects, and accountants.
Few startups will likely be interested in forming an LLP or PLLP. For those who do pursue these options, a special degree of due diligence is in order early on. Because statutory provisions for these types of businesses are so new and still evolving, seek thorough professional counsel before proceeding with one.
Partnerships and Liability
A notable drawback to partnerships is their reduced level of liability protection for the owners. This is one reason that LLCs have surpassed partnerships as the legal structure of choice for small businesses.
General partnerships, in particular, offer no liability protection whatsoever. Each partner is fully responsible for any legal or financial claims that are made against the company.
This means that if one partner creates an obligation or enters into an agreement on behalf of the partnership, all of the other partners are personally and individually responsible for the partner's action, including any financial exposure that it may have created. It also means that each partner is fully responsible for any debt that the partnership incurs or for any court or tax assessment imposed on the company.
A notable drawback to partnerships is their reduced level of liability protection for the owners.
Since a general partnership has no limited liability, a partner's own personal assets are exposed to risk should the partnership fail or be unable to satisfy a claim against it. Contrast this to a multi-owner LLC, where the owners' personal assets are protected from claims and levies on the LLC.
In limited partnerships there is a reduced level of liability for at least some of the partners, the so-called "limited partners." An LP has a general partner who assumes full liability for any financial encumberance, claims, or levies resulting from activities of the business. The limited partners, on the other hand, are usually protected from any liability that exceeds the amount of their investment in the partnership.
LPs are especially common in small businesses with a number of silent partners whose only contribution is their capital investment. Someone opening a franchise, for example, might serve as the general partner in an LP, with several limited partners providing the money to purchase the franchise.
Because the general partner in an LP assumes full liability for the partnership, the general partner is also the only partner who can act as an agent to obligate the partnership to contracts, purchase agreements, court settlements, and the like. The limited partners play a passive role.
The reason that limited liability partnerships (LLPs) have gained statutory status (at least in some states) is to insulate partners in a general partnership from liability for grossly inappropriate actions on the part of another partner. Such actions might include perpetrating a wholesale fraud or knowingly undertaking an illegal transaction.
Professional limited liability partnerships (PLLPs) extend this liability protection to a professional partnership, such as a dental practice. Within a PLLP other members of a practice are shielded from liability for the gross negligence of another dentist in the group.
The thing to notice is that no form of partnership grants full liability protection to every owner. Even in a limited partnership, full liability rests on shoulders of the general partner. And in LLPs and PLLPs the partners are only protected from liability for gross misconduct on the part of another partner.
Therefore, where limiting liability is a primary concern, an LLC or a corporation may be a preferable structure for your startup.
Partnership Agreements
Even though a simple oral agreement is sufficient to form a partnership, it's imperative that you transform your oral agreement into a written agreement at the very outset. Otherwise your partnership experience is not likely to be a happy one.
In a partnership the written agreement plays the same role as the By-Laws of a corporation or the Operating Agreement in an LLC. Among other things it spells out the way that the partnership will be structured and carry on its affairs.
State laws do not require you to have a written Partnership Agreement, which is why startups easily ignore this step. But most states do have default rules which they will apply to a partnership that has no written Agreement.
These rules may or may not be to your liking, as they entail such things as the formula by which the partnership distributes its earnings to the partners. You protect yourself from state-imposed rules, therefore, by having your own Partnership Agreement that you have thought through and put together carefully.
Most states have default rules which they apply to partnerships with no written Partnership Agreement.
In addition, the Partnership Agreement addresses issues that are unique to partnerships themselves.
- How will the value of the business be established if one partner asks to be bought out?
- What happens to the partnership if one partner dies?
- Under what conditions can partners be expected to make additional capital contributions to the partnership?
As much as anything, a well-framed Partnership Agreement spells out in advance the remedy for things that might go wrong in the partnership. Partnerships start off with high hopes and exuberant optimism. In the midst of these emotions, it's counter-intuitive to pause and talk through a litany of things that could disrupt the partnership or relationships within it.
But those of us who consult widely in businesses can tell you that partnerships do go bad. And they do so far more often than you might imagine — often in some highly unexpected ways. Moreover, when partnerships do go bad, the situation usually devolves quickly into a very thorny mess that gets uglier by the minute. It's at moments like this that Operating Agreements are worth their weight in gold.
So what should your Partnership Agreement include? There is no all-encompassing list. But the following items should certainly be included.
- What name will the partnership operate under? Partnerships, like any other entity can do business under a properly registered assumed name. Many partnerships, of course, are merely known by the names of the principal partners. But even here the exact styling of the name should be set out in the Partnership Agreement.
- What specific contributions is each partner making to the partnership? These may not be financial contributions alone. They may include such things as property, equipment, furniture, office or storage space, vehicles, services, or even a key network of contacts.
- What percentage of ownership will be allocated to each partner? Partners are free to divide the ownership of their company however they wish. But it's vital that these percentages be established early to accommodate any buyout of a partner at a later time.
- How will profits be apportioned? Will profits be distributed solely on the basis of one's ownership percentage? Or will some other formula be used? Nothing prevents the Operating Agreement from setting whatever profit-sharing plan the partners desire.
- When can a partner withdraw his or her share of profits from the company? Can these draws be made incrementally through the year? Or will profits be distributed only at the end of the year? And if drawn incrementally, at what intervals?
- How much authority will each partner have? Can partners enter into agreements or contracts for the partnership without the consent of the other partners? If not, what are the circumstances under which the consent of other partners must be sought?
- How will decisions be made? Which ones will require the unanimous support of the partners? Which ones require only a majority vote? Or a super majority?
- How will votes be counted in partnership decisions? Will each partner have an equal vote? Or will votes be weighted according to percentage of ownership?
- Under what terms or conditions can new partners be added? How will percentages of ownership be reallocated to accommodate additional partners?
How will the death, disablement, or withdrawal of a partner be managed? In circumstances like these, what buyout options will the partnership have? Over what length of time can the buyout occur?- In the event of a buyout, how will the value of the partner's interest be determined? Who will be charged with making this determination?
- Will particular partners have general responsibility for a specific aspect of operations? For example, will one partner be largely responsible for marketing and business development? Will another partner be primarily responsible for administration and finance? Clarification of these issues can be helpful in knowing who is expected to take the initiative when certain events transpire in the course of business.
- What will be the procedure for resolving disputes within the partnership? Are partners precluded from taking court action against one another before submitting their dispute to mediation or arbitration? If so, how will a partner go about initiating mediation or arbitration?
Paying Federal Taxes as a Partnership
The Partnership Agreement should spell out how and when profits will be apportioned and distributed. The partnership must annually file Form 1065 with the IRS summarizing the partnership's income and expenses for the year. This is an information return, not a tax return. Attached to Form 1065 is a Schedule K-1 for each partner, showing that partner's portion of the profits or losses for the year.
The partners themselves receive a copy of the K-1 and report that income or loss on Schedule E of their personal income tax. Partners are responsible for taxes on their percentage of the profits, whether all of these profits were actually disbursed or not.
Of course, if a partner is also employed by the partnership, the employee receives a W-2 and pays personal income tax on these wages. Partners are not subject to the restriction for S-Corps, in which benefits are considered taxable income to a shareholder-employee who holds at least 2% of the company's stock.
Other Considerations
Because of the collegial management structure of partnerships, the interplay of personalities and values among the partners is a life-and-death issue. Hundreds of partnerships go aground weekly because of personality conflicts, disagreements about ethics, or differences over work styles.
Therefore, it behooves you to be well-acquainted with anyone with whom you enter a partnership. This means much more than having known your potential partners for a long time. How well do you know their values? Their priorities? How industrious they are? How they respond under pressure? How they react when held accountable? How well they manage employees? How easily they delegate? How carefully they maintain records? How well they handle upset customers or vendors?
In a day-to-day work environment, differences over issues like these can quickly lead to resentment, frustration, or outright distrust. Before formalizing an agreement to be partners, consider working together less formally on some time-limited projects to see if the members of your proposed partnership are truly compatible.
Use the negotiation of the Partnership Agreement as a further opportunity to learn more about one another. Pay particular attention to how people react as the group works through thornier issues in the agreement. It's not uncommon, indeed, for this negotiation to become so prickly that one or more parties recognize that going forward with the partnership is ill-advised.
And if you should be cautious about going into any partnership, be doubly cautious about going into a partnership with family members. Any of us who consult with troubled businesses will tell you that nothing is more unpleasant than a family business in which the principals are at war with one another. More than once I've seen conflict among partners wreck not only a business, but marriages and long-term family relationships, as well.
