Which Business Structure is Right for Your Business? Part Two: Partnerships
Last month, we wrote a blog post launching a three-part series about the merits and drawbacks of the various legal structures that new business owners have to choose from. We began by examining the pros and cons of the corporation, and in this installment, our New Jersey business lawyers will be taking a look at another major commercial structure: the partnership.
A general partnership is the most basic and straightforward form of partnership. In some cases, this is an asset; but much of the time, the general partnership is too simplistic to accommodate the needs of business arrangements which are not intended to be minimal or temporary in nature.
The general partnership can be described as highly simple because in this arrangement, everything — the bad and the good — is automatically split between partners, right down the middle. For some, this is a “no muss, no fuss” approach; but for many entrepreneurs, dividing matters of ownership, control, profits, and liability down a 50-50 line, regardless of relative investment, is a disagreeable operating condition.
Additionally, it’s important to be aware that general partnerships do not actually require a legal agreement to exist between partners. Nonetheless, you should strongly consider drafting a partnership contract, because if anything changes or goes wrong in the future, you will need the support of a written contract to refer to in the event of a partner dispute. For example, if one partner alleges breach of duty but has no formal contract to cite, it is unlikely to be demonstrable in court. But what do you need to consider about general partnerships when creating your agreement?
First, you need to understand that in a general partnership, you are accepting vulnerability to financial losses. In other business structures, such as a limited liability company, business debts are restricted to the entity itself. In a general partnership, however, the partners themselves can be held personally liable for the debts of the partnership. This means that should your general partnership make a poor investment, or be sued, creditors can come after your personal assets, like your car or your bank account. This liability is evenly divided among the partners, whether there are two or 10.
In addition to liability, authority and company control are also evenly divided among partners, unless a clause in the partnership agreement dictates otherwise (which is another reason why you should create a written agreement). In a general partnership, each partner has the same power to accept clients, make negotiations, and even to make agreements and decisions which are legally binding. For this reason, it is extremely important that general partners are able to clearly and frequently communicate regarding business matters.
This brings us to another point about the nature of general partnerships. Because these entities are founded on the ability to work effectively as a team, it is probably not prudent to create a general partnership with a person whom you may personally dislike, however professionally talented they may be. It can also be disadvantageous to partner with an individual whose skills and abilities are identical to your own. The best general partnerships are often composed of partners who bring diverse, complimentary talents to the table, and who are able to work harmoniously together on a personal level.
While general partnerships are required to file yearly tax returns reporting matters like income and deductions, the partnership entity itself does not pay tax. Instead, general partnerships are treated as a “pass-through” entity, similar to S-Corps, in which only the individual partners are taxed. Because partners are not actually classified as employees, W-2 forms are not necessary. Instead, partnerships must submit Form 1065.
On a related note, because employees are not classified as partners, partnerships can give employees the incentive of obtaining partner status through excellent performance.
Limited Partnership (LP)
The limited partnership seeks to eliminate some of the liability inherent in general partnerships by blending a mixture of general and limited partners within one partnership entity. In a limited partnership, general partners have more power than limited partners — but they also have more personal liability if something goes wrong. It’s a calculated trade-off, and if you are considering entering or launching a limited partnership, you need to think carefully about whether you, personally, prefer to take on limited or general partner status.
In a limited partnership, sometimes referred to as a partnership with limited liability, there must be a minimum of one general partner, in addition to the limited partners. The general partners have a far greater degree of authority, responsibility, and overall company involvement than the limited partners. Limited partners do not have the power to make management decisions, and cannot typically authorize matters such as hiring employees, adding partners, or accepting clients.
While limited partners sacrifice power, this drawback is counterbalanced by freedom from personal liability for partnership debts. For individuals who prefer to be in control, and who are willing to accept greater financial risks, general partner status may be preferable. For individuals who prefer eliminating their liability at the expense of losing managerial authority, limited partner status is a more suitable role.
When it comes to taxation, limited partnerships are essentially handled like general partnerships, in that the partnership itself is not taxed, but the individual partners. However, limited partners, unlike general partners, are not required to pay self-employment tax.
Limited Liability Partnership (LLP)
Depending on the type of business you intend to create, limited liability partnership (LLP) status may not be available to your entity. This is because the LLP structure is only applicable to certain types of commercial services, including:
In an LLP, partners enjoy the equally divided decision-making power afforded to general partners, while also reaping the benefits of liability protection. Not only does this liability protection shield against debt liability, it also shields against liability for matters which are not explicitly financial in nature, such as malpractice or negligence. This means that if Lawyer A at a given LLP firm is implicated in attorney malpractice, Lawyers B and C will be protected against litigation, rather than being “roped in.” The same applies to doctors, architects, and other types of professionals.
However, it’s important to understand that while LLP status can protect other partners, the partner who has committed malpractice or other misconduct is not protected from their own actions. To continue with the example above, Lawyers B and C would be protected from Lawyer A’s liability, but Lawyer A would still be liable for his or her own actions and any resulting debts.
Limited Liability Limited Partnership (LLLP)
The tongue-twisting limited liability limited partnership, or LLLP, is the final and arguably most complex form of partnership. As its comprehensive name implies, the LLLP combines aspects of limited liability partnerships with limited partnerships in the interest of putting a cap on personal liability.
LLLPs are the least widely-used partnership structure. (Tellingly, a Google search for the phrase “general partnership” returns 236 million results, while a search for “limited liability limited partnership” returns fewer than six million.) This is because LLLPs are mainly created by real estate businesses, and are not currently recognized by every state.
LLLPs offer two-way debt and asset protection. If the company is sued, the partners cannot be held personally liable. On the other hand, if an individual partner in the company is sued, the company’s assets cannot be pursued. Furthermore, general partners within the LLLP have limited liability for both company and partner debts, in spite of their general status.
Not every state currently recognizes LLLPs as a business structure, including New Jersey. However, the laws pertaining to business structures are constantly in flux.
If you are thinking about creating or joining a partnership, there are many variables which must be carefully considered, such as taxation rules, debt liability, and even personal temperament. At Maselli Warren, our New Jersey business attorneys have over 25 years of experience helping people to understand employment law and to make the best legal and financial decisions for their companies and themselves. To schedule a consultation with an experienced business lawyer, call our law offices at (800) 891-2657, or contact us online.
In the next installment of this series, we’ll be examining the limited liability company.