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Guide to General Partnerships

Basics


A partnership is an association of two or more persons to carry on a business as co-owners for profit. The partners may be individuals or entities.


A partnership is ordinarily created by written agreement, but a partnership may be created by oral agreement or may be implied from the conduct and acts of the partners. Matters not covered by a written partnership agreement are controlled by the Uniform Partnership Act, which provides certain rules for the operation of a partnership and its termination.


All partners in a general partnership are entitled to participate in management. Each partner is an agent for the partnership for purposes of carrying on its business.


All partners in a general partnership are jointly and severally liable for all obligations and liabilities of the partnership. Profits and losses of a general partnership are shared equally by the partners, regardless of the amount of their capital contributions, unless they agree otherwise.


Owner’s Liability


A partner in a general partnership is personally liable for all obligations and liabilities of the partnership. Each partner in a general partnership is jointly and severally liable with the other partners for such obligations and liabilities, regardless of the partner's interest in the partnership. But if a partner is required to pay for more than his or her proportionate share of partnership obligations or liabilities, the partner has a right of contribution from the other partners.


The liability of a partner for partnership obligations and liabilities is personal. The partner's personal assets can be reached for the satisfaction of his or her obligations; the liability is not limited to the amount of the partner's investment in the partnership's business.


Since each partner is an agent for the partnership for purpose of its business, each partner can bind the partnership to contractual obligations. The partnership is liable for claims arising out of torts committed by any of its partners in the course of the partnership business. Therefore, each partner is responsible not only for his or her own contractual obligations and tort liabilities but also those of his or her partners as well.


Control


In the absence of an agreement to the contrary, each partner in a general partnership is entitled to participate equally in the management and business decisions of the partnership, regardless of the partner's interest in the partnership. Any differences arising as to ordinary matters connected with the partnership business are decided by a majority of the partners. Acts in contravention of any agreement between the partners must, however, be agreed upon unanimously by the partners.


Partners may, by agreement, provide that partners' respective interests in capital or profits will be considered in votes on partnership matters. The partnership agreement can also vest management in a managing partner or management committee, which may be useful if the number of partners is large.


Transferability of Ownership Interests


Interests in a general partnership are transferrable, and the transfer of an interest does not dissolve the partnership. Nevertheless, the law protects partners' rights to decide who their partners will be. Accordingly, the transferee of a partnership interest does not, in the absence of the agreement of the other partners, obtain any right to participate in the management of the partnership or to receive information about the affairs of the partnership.


Since the transferee obtains only the right to profits that would otherwise have been distributed to the transferring partner and to that partner's share of the partnership assets upon dissolution, partnership interests are not readily marketable.


Consistent with the policy of protecting partners' rights to determine who their partners will be, the death, dissolution, incapacity, bankruptcy, or withdrawal of a partner causes a dissolution of a general partnership. Such a dissolution can disrupt the operation of the partnership's business pending formation of a new partnership by the continuing partners and may jeopardize the rights to the other partners to continue the business of the partnership absent an accommodation with the successors in interest to the deceased, dissolved, incapacitated, or bankrupt partner or the withdrawn partner. Accordingly, written partnership agreements typically provide that the partnership may continue to operate following the death, dissolution, incapacity, bankruptcy, or withdrawal of a partner, subject to the obligation of the other partners or the continuing partnership to purchase the interest of the partner affected by the event of dissolution.


Organizational and Maintenance Costs


As with a sole proprietorship, the organization of a partnership can be informal. It is generally advisable to have a written partnership agreement specifically setting forth the understandings and agreements of the partners. A written agreement is, however, not required to create a valid partnership. The operation of a partnership does not require any formalities. Decision-making can be informal.


Since there is more than one person involved, accounting systems for a partnership may need to be more formal than would be required for a sole proprietorship. More accurate internal books of account may required in order to account to other partners, particularly if some partners are not actively involved in the day-to-day management or operation of the business.


Generally speaking, general partnerships are required to file only those reports to governmental agencies required of sole proprietorships. The notable exception is the information return that must be filed by a partnership for federal income tax purposes. This return is separate and apart from the returns of the individual partners, but the individual partners are required to report their share of partnership profit or loss on their individual returns.


Tax Attributes


A general partnership is not a separate taxable entity. Although a partnership must file an information return for federal income tax purposes, the partnership is not taxed on its income. Rather, the income or loss of the partnership is passed through and reported on the returns of its partners.


The income and loss of a partnership may be specially allocated between its partners in any proportion the partnership selects, which is of substantial advantage if taxes are a major consideration and the partners' tax situations are not comparable. Special allocations of income and loss are available only with partnerships. They are not available to S corporations even though an S corporation's income or loss passes through to its shareholders.


The fact that partnership income or loss is reported on the partners' income tax returns makes a partnership advantageous for businesses that have losses, although deduction of the losses may be limited by the passive loss limitations. If the partnership has income and the partners are individuals, pass-through may not be advantageous because the income of the business may be subject to self-employment tax as well as income tax. If the business were organized as a C corporation or S corporation, only that portion of the income that is paid as compensation to the shareholders would be subject to employment tax.


Since a partnership is not a separate taxable entity, no gain or loss is generally recognized for federal income tax purposes on the creation or termination of a partnership. Among other things, this permits a general or limited partnership to be converted to another form of business organization, such as a limited liability company or corporation, without adverse tax consequences. In comparison, the termination of a C corporation or S corporation is generally a taxable event.


If a partnership interest is sold, the selling partner will ordinarily have a capital gain or loss for federal income tax purposes. To the extent that the sales proceeds represent amounts received for unrealized receivables (which includes depreciation recapture on partnership assets) and substantially appreciated inventory, the partner will realize ordinary income. In comparison, the shareholder in a C corporation or an S corporation will ordinarily realize only capital gains on a sale of stock. The receipt of ordinary income is disadvantageous for a partner who is not a C corporation because long-term capital gains are taxable at a maximum rate of 15% for federal income tax purposes, whereas ordinary income is taxable at rates of up to 35%.


    Advantages


  • Minimal formalities are required for organization of a partnership, and hence organizational costs are limited.
  • Since a partnership involves more that one person, this form of business entity permits a combination of individual resources and talents, and authority to act is not limited to one person.
  • Decision making and action can be informal.
  • There are no qualification requirements for doing business in other states.
  • Minimal reporting to governmental entities is required.
  • If the partnership agreement so provides, a partnership may continue in existence after the death, dissolution, or withdrawal of a partner.
  • Business profits are subject to only one tax, at the individual partner level, and are not subject to double tax as would be the case if the profits were earned by a C corporation.
  • Business losses are available on partners' personal income tax returns and can offset other income (subject to the passive loss rules).
  • Special allocations may be made for income tax purposes.
  • Disproportionate distributions may be made to partners.
  • A partnership may be converted to a limited partnership, limited liability company, C corporation, or S corporation in what is ordinarily a tax-free transaction.

  • Disadvantages


  • Each partner has unlimited personal liability for all obligations and liabilities of the business.
  • The general power of every partner to act on behalf of the business requires caution in the selection of partners and monitoring of partners' activities.
  • All partners may participate in management, potentially making decision making cumbersome and difficult.
  • A partnership is dissolved upon the death, dissolution, insanity, bankruptcy, or withdrawal of any one partner, if not otherwise provided by agreement.
  • Business profits are taxed as income to the individual partners and, as a result, may be subject to self-employment tax as well as income tax.
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