A lot of business lawyers cringe when a business owner calls a business associate a partner. That’s because partner has a very specific meaning under the law. When a business owner calls another a partner, they don’t usually mean the legal meaning. So…what is that legal meaning? What is a partnership?
Moreover, what’s so scary about it? Why shouldn’t you use the word loosely to describe a business associate?
We’ll give the answers below. If, after reading this article, you still insist on forming a partnership, we have an article on how to do that too.
Let’s first start with the definition of a partnership.
- What is a Partnership?
- By Default, a Partnership Is a General Partnership
- Form a Limited Partnership If You Have Silent Investors
- What is the Cost of Starting a Partnership?
- Advantages of a Partnership
- Disadvantages of a Partnership
- If You’re a Small Business with Multiple Owners, You’re Better Off with an LLC or a Corporation
What is a Partnership?
A partnership is a business format where two or more parties agree to do business together and then actually carry out doing business together. You don’t even have to file any paperwork. If you go around calling the other person a partner and then work together, sometimes, the law will treat you as a partnership.
Yes, this means you could accidentally get into a partnership. That’s why business lawyers cringe when they hear business owners use the word partner loosely.
By Default, a Partnership Is a General Partnership
The default type of partnership is called a general partnership. You can form a general partnership without any formal paperwork.
Partners in a general partnership share profits and losses, which are divided equally among the partners. Partners also share all business liabilities. When one partner isn’t able to meet their business obligations, the other partners must step in and meet the obligations for that partner.
This means that, when a general partnership loses money or has to repay a loan and if one partner doesn’t have the money, the other partners have to put up the difference. Your liability is unlimited, and your entire personal assets are on the line. So, if you really want to be in a general partnership, pick your partner carefully.
In a general partnership, when one partner leaves, the entire partnership ends. The process is called dissolution.
Form a Limited Partnership If You Have Silent Investors
A second type of partnership is called a limited partnership. Here, you have a general partner who runs the business. You also have investors, called limited partners, who contribute money but have no say in how the business is run.
Personal liability for the general partner is unlimited. Personal liability for the limited partners is limited to the amount they invested in the partnership.
Usually, to get around the liability issue, the general partner is a corporation. Since the liability of a corporation is limited, the liability of the general partner is limited.
What is the Cost of Starting a Partnership?
If you start a general partnership and use the default laws in your state to run the partnership, then the cost of starting that partnership is $0. Setting up a limited partnership will cost more because you’ll have to file formation documents with your state.
Most General Partnership Startup Costs Are Low
Typically, the default partnership name is the last names of all the partners, and this comes for free.
If you want to do business under a trade name, you’ll have to file an assumed name certificate. The filing fee is usually less than $100.
You’ll need a taxpayer ID number. You can get it for free in just a few minutes by filing an online form with the IRS.
You can open a bank account for free. The bank will have standard forms for you and your partner(s) to sign, and they can walk you through it.
So, you can theoretically start a general partnership for $0. However, we don’t recommend you do it this way.
It is better to run a partnership under a partnership agreement. Usually, a limited partnership must have a partnership agreement, but, even with a general partnership, it’s a good idea to have one. The agreement lets you override a lot of your state’s default partnership laws that can cause headaches later.
Hiring a Lawyer Costs More but Usually Can’t be Avoided
Expect to spend $1,000+ to have a lawyer tailor a partnership agreement for you. Lawyers charge based on their time. So, there’s a higher likelihood that the ones who cost less are giving you a template agreement with minimum tailoring.
If the lawyer claims they don’t need to talk to you and don’t at least give you and your partner(s) a questionnaire on how all of you want to run the partnership, then don’t hire the lawyer. They’re not tailoring their template to your needs.
Your legal costs will go up even more if you want to form a limited partnership and/or use a corporation or LLC as a general partner to limit liability. After all, forming a corporation or an LLC has its own legal costs.
If you think you need to form a corporation or LLC to limit your liability, we think you should just do business as an LLC or corporation instead. It’s more straightforward this way.
Advantages of a Partnership
The major advantage of a partnership is its pass-through tax structure. The partnership doesn’t pay income taxes. Instead, each partner pays taxes individually, as themselves and on their own share of the profits. Other than this advantage, most businesses spend their time avoiding being accidentally classified as a partnership.
Even on the pass-through tax structure, there are other modern-day business formats that can accommodate this need. For a small business, look into the LLC or the S corporation for pass-through taxation. These will almost certainly be better formats for you.
Form a partnership only if you can’t qualify as an LLC or S corporation.
Disadvantages of a Partnership
The major disadvantage of a partnership is that the partners are individually liable for all partnership debts and obligations. You can limit your liability by buying insurance, but the insurance won’t cover above a maximum amount or won’t cover certain types of losses.
You can also limit the partnership liability by using LLCs or corporations as partners. But, this can get complicated (i.e. expensive) to set up. For one reason or another, larger companies or companies with foreign investors tend to have to use this sort of complexity.
As a small business, there are easier ways for you to get both pass-through taxes and limited liability.
If You’re a Small Business with Multiple Owners, You’re Better Off with an LLC or a Corporation
Now that we’ve explained what is a partnership, you can see that this business format can carry a lot of liability issues. In fact, there’s very little reason for a small business to do business as a partnership.
By default, the IRS treats a multiple-member LLC as a partnership. This means that you get the benefit of pass-through taxation plus you can limit your business liability. If you don’t like or don’t qualify as an LLC, look into forming an S corporation. S corporations also limit liability while allowing a pass-through tax structure.
Even for professions that traditionally form partnerships—professions like the law or accounting—there are other formats that limit liability better. So, these days, professionals tend to stay away from forming a general partnership too.
Now that we have explained what is a partnership, have we talked you out of forming one? No? Well, if you still insist on running your business as a partnership, here’s our step-by-step guide on how to form one.
DISCLAIMER: This article does not constitute legal advice. Instead, it contains general information. The information gives you the background you’ll need to hit the ground running when you do go get advice from a lawyer. Only lawyers properly licensed in your state/country are qualified to give you legal advice.
Questions? Comments?
