Basic Entity Choices in California--Part 3: General Partnership
The entirety of my guides will focus on one of the five entity choices I will cover across five different articles. This article provides a brief overview of general partnerships in California.
Organization and StructureA general partnership is an association of two or more parties who jointly own and operate a business. A general partnership is a separate entity from any of the individual owners. All partners, however, are "jointly and severally" personally liable for the debts and obligations of the partnership business entity. "Joint liability" means that each partner is liable for the full amount of the debt or obligation. "Several liability" means that a given partner is fully liable for any debt or obligation that that partner personally guaranteed. Combined, "joint and several liability" means a creditor can satisfy the full amount of a partnership obligation from any partner's personal assets, regardless of which partner made the guarantee. If the creditor recovers a full judgment from only one partner, the onus is then on that partner to seek any reimbursement from the other partners.
When forming a general partnership, you should consider the relationship of the owners to the business itself, as well as the relationship of the owners to each other. In a sole proprietorship, the sole proprietor may hire an employee who is given the authority to enter into contracts on behalf of the business. This is an agency relationship whereby the employee is the agent and the sole proprietor is the principal. The agent can bind the sole proprietorship to an obligation, but the sole proprietor has the right to revoke the agent's authority at any time.
In a partnership, by contrast, the partners' relationship to each other is not that of an agent and a principal. Rather, the partners are not agents of each other, but are agents of the business entity itself. As an agent for the business, each owner is capable of binding the partnership and, therefore, the other owners. Revoking the authority of a partner to bind the partnership is far more difficult than revoking the authority of a mere employee. Because of this power to bind all parties, you should give serious consideration to whether you trust your potential partners and have faith in their business judgment and management abilities.
The laws of the various states impose the fiduciary duties of care, loyalty, and good faith and fair dealing on each of the partners. The way courts will enforce these fiduciary duties can be fairly wide-reaching. For instance, if you are engaged in a business deal that does not involve the partnership or your partners, but could potentially negatively impact them, you could be held liable for a breach of a fiduciary duty.
Although each state has its own set of laws governing general partnerships, many states have codified the Revised Uniform Partnership Act of 1997, which was drafted by the National Conference of Commissioners on Uniform State Laws ("NCCUSL").
As with corporate law, state partnership law has many "default" laws that can be varied by private parties. Like corporate law, however, there are invariable partnership laws as well. For instance, partners cannot "contract around" the fiduciary duties that they owe to each other. Although statutory law provides a solid background, the partnership agreement will usually govern the majority of a partnership's operations. Although there are no laws requiring a partnership agreement to be in writing, it is exceedingly important that it be put into writing.
General partnerships can be a good business entity option where you have a significant amount of trust in your potential partners and know that all parties will contribute equally. It is usually a more attractive option if all partners will be involved in the management of the business, particularly because the decision of one partner affects the other partners. Passive investors, who want an equity interest, but have no role in management, will be more inclined to select a business entity that provides some limitation on personal liability.
TaxationIncome tax authorities treat partnerships as a "flow-through entity," meaning that the partnership entity must file its own tax return and declare its net income, but the partnership entity itself pays no taxes. Instead, the tax burden "flows through" to the partners, who will be taxed on the allocable share of net income. Unlike a sole proprietorship, the partnership is not "disregarded" for income tax purposes, as it must file its own return even though it pays no taxes.
Unlike a corporation, partners are taxed on their allocable share of net income regardless of whether any distributions of income are made to the partners. Recall that shareholders are taxed only when dividends are paid out.
Please be aware that the federal self employment tax applies to all general partners.
Basic Tax Differences Between a General Partnership and an S CorporationUnderstanding the differences between a general partnership and an S corporation and for income tax purposes is essential when making any entity choice decision. This is because federal and state income tax laws allow most business entities to make an election between being taxed 1) as a C corporation (which is uncommon because of double taxation) or 2) as a general partnership (which is far more common because of the flow-through taxation). Limited partnerships, limited liability partnerships, limited liability limited partnerships, and limited liability companies are all given the choice of electing between C corporation taxation and general partnership taxation. Such an election is usually perfunctory because it is almost always in a business's best interests to elect the flow-through general partnership tax treatment.
Because LLC's have limited liability for all of their "members" and are ordinarily pass-through tax entities, they are seen as analogous to S corporations, which also have both of these attributes. For this reason, a number of entrepreneurs will narrow their entity choice decision down to either an LLC or an S corporation. This begs the obvious question of what then are the differences between an S corporation and an LLC.
In terms of liability, the difference between the two is negligible, at least for purposes of an introductory discussion. The real crux of the decision turns then on what is the difference in income tax treatment between a general partnership (which an LLC would be taxed as) and an S corporation.
What follows is a list of some tax differences between a general partnership and an S corporation:
1) Allocations: In an S corporation, shareholders are taxed exactly in proportion to their percentage of ownership in the corporation. In a general partnership, the owners can allocate their tax burdens among themselves; they are not forced to pay tax strictly on their percentage of ownership.
2) Basis Adjustments: In an S corporation, a shareholder's tax basis will not be adjusted when the corporation incurs debt. Furthermore, shareholders in an S corporation are not allowed to adjust their basis at the death of a shareholder; whereas, general partners may make such an adjustment of basis pursuant to IRC 754.
3) Contribution of Property: In an S corporation, a shareholder's contribution of appreciated property, or the distribution of appreciated property from the corporation to the shareholder, is a gain to the shareholder. The distribution of depreciated property from the corporation to the shareholder is not a loss to the shareholder. In a general partnership, a partner's contribution of property to the partnership is not a taxable event. A distribution of appreciated or depreciated property from the partnership to a partner is neither a gain nor a loss, respectively.
Finally, as already discussed, general partnerships are subject to the federal self employment tax; whereas, S corporations are not.
FormationA general partnership is formed when the partners enter into a partnership agreement. A partnership can file a certificate with the Secretary of State, but this is not usually required. Please also consult your state's law regarding whether you must file a d.b.a. statement.
As stated above, the partnership does not legally need to be in writing. That being said, it is always advisable to put the agreement into writing. Doing so records the terms of the agreement in tangible form, and also helps the parties to consider critically all of the relevant issues. There is something about putting ideas and concepts into writing that makes one think more fully and clearly about the issues at stake.
You should consult an attorney to fine-tune the contents of your partnership agreement. Although each agreement is different, some common sections include: 1) the purpose of the partnership; 2) how and by whom the partnership will be funded; 3) how and to whom distributions will be made, 4) how the partnership will be managed and by whom; 5) the conditions under which a partner may withdraw; 6) any accounting or record keeping information, including accounting methods and the fiscal year; and 7) how and under what circumstances the partnership will be dissolved.
SummaryGeneral partnerships offer entrepreneurs a business entity that is relatively easy to form and operate, and carries with it certain tax benefits. A general partnership works well when all parties plan on actively managing the business and already have a significant amount of trust and respect for one another. This is because any partner may bind another partner to any partnership obligation.