Partnerships
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Terms:Agency: Pass-through Entities: Profit Share: Subchapter K: |
Introduction to Partnerships
A partnership is a business form whose organizational structure originates from the laws of agency and agency relationships. The typical partnership is made up of two or more individuals who operate the business as co-owners.
The partnership is, in some instances, considered an entity unto itself. For example, the partnership may own land in its own name and may be sued as an independent entity. See Unif. Partnership Act of 1997 § 307. However, certain liabilities of the partnership, such as its debts, obligations and tax burdens, are attributed solely to the owners of the partnership. Because of these features, partnerships are sometimes referred to as "pass-through" entities; meaning that certain rights and responsibilities pass directly to the partners, without obligating the partnership.
Additionally, it is important to note that there are several business entities that operate under the name "partnership," of which the main forms will be discussed here. Given this situation, however, it is incumbent upon the legal practitioner to know exactly what form of partnership is being discussed. In this section, and in general legal conversation, a "partnership" refers to what is more properly known as a "general partnership."
As an agency relationship, partnerships can be very different in their actual size and shape. Agency relationships can be truly informal.
EXAMPLE: If Tom asks Bob to go and collect his car from the auto mechanic, an agency relationship has been created. Though there is no formal contract, Tom, the principal, has empowered Bob, the agent, to go and get the car.
At the opposite end of the spectrum, some agency relationships and partnerships can be highly nuanced arrangements where various powers, rights, and responsibilities are divided between a whole host of individuals and, in some cases, companies. A standard partnership between two persons is an agency relationship, but so is a partnership in a “Big 5” Accounting firm that has thousands of individual partners.
EXAMPLE: Two major law firms, each with hundreds of partners, have decided to merge. The resulting firm, even if it has more than a thousand members, may still elect the partnership form if they are prepared to keep all regular partnership documents up to date.
Businesses that might be partnerships:
- A small legal or accounting firm
- A real estate sales firm
- An organization formed by two individuals or companies to carry out a specific business purpose
(Regarding the last item, one should distinguish between a partnership and a joint venture, which is an informal type of partnership. The joint venture need not be registered with the state and is only for a limited purpose.)
Characteristics
As described above, the various elements of a partnership are sometimes at the entity level (i.e. attributable to the partnership itself) and are sometimes left to the individual partners. What results is a slightly complicated formula, which necessitates that the legal professional be truly familiar with the following characteristics.
One thing to keep in mind that helps guide the nature of a partnership is that, as stated above, a partnership draws its origins from legal agency theory. In other words, the relationships between partners are governed by formal or informal contracts that bind the obligations of the partners both one to another, and to the partnership itself.
Formation
Given that the partnership is based in agency and contract theory, it should not be surprising that the only requirement for entering into a partnership is "contractual capacity." This means that for a person to legally enter a partnership, that person must be of the age of the majority (typically 18) and be otherwise competent (i.e. mentally capable of understanding the obligations he or she is entering into.)
EXAMPLE: John, who is 23, has decided to found an Internet startup company with Evan, who is 16. Evan is critical to the success of the company as he is a computer genius with an IQ of 178. Despite Evan’s knowledge and brain power, John and Evan cannot elect a partnership as their business form as Evan is not yet legally able to form binding contracts.
It is possible to form a partnership without a formal written document. While some states require or prefer the creation and/or filing of a "partnership agreement," it is often the case that simply acting in concert with a combined business objective will result in a partnership being implied by the law. However, this is only the case if there was intent on the part of the parties involved for a partnership to have been formed. See
In most cases, the creation of a partnership agreement is the prudent path to creation of the partnership. Such an agreement is designed to stipulate the exact nature of the partnership, its business purpose, and most importantly, to spell out the legal obligations of the partners to each other and the partnership. The reason for creating such an agreement is that it becomes a critical means of establishing the roles and responsibilities of each partner and their legal obligations, either in the day-to-day operation of the firm or in any resulting litigation.
Finally, as discussed above, individuals who are acting together for some combined, for-profit purpose, need to be aware that in some situations, the law and the courts will imply the existence of a partnership even where no formal partnership agreement exists. Such a partnership, sometimes referred to as a partnership by estoppel, will be inferred by the way the individuals involved share the organization's profits, losses, property, etc. Furthermore, a partnership may be implied simply by one of the members "holding himself out" as a partner - i.e. saying that a partnership exists even though no formal partnership agreement has been executed. See
EXAMPLE: Tony and Linda have gone into business together to build ski lodges. They did not form a partnership or write a partnership agreement, nor did they intend to create a partnership at all. However, Linda, as the money behind the operation, begins to go to cocktail parties and talk about how her new “business partner” Tony, is amazing at building ski lodges and how their business, Ski Lodge Partners, is going to be a huge success. Even though no partnership was intended, Linda may have created a partnership by estoppel based solely on her comments.
Ownership and Operation
In a general partnership, ownership and operation of the firm is principally vested in the partners themselves. Generally, the property owned by the partnership - "partnership property" - includes all those items, tangible property, intangible property, and cash, that are held by the partnership and intended for the partnership's use. See
This intent element is of some importance as ownership of the property, like the partnership itself, may be implied without the partners having specifically earmarked the property for inclusion in the partnership property. Thus, partners who contribute property or capital to the firm need to act with caution when their intent is to loan and not include the property in the partnership. This is an important distinction because partnership loans are paid off in a different manner and sometimes, at a different time than are monetary investments in the partnership. See Unif. Partnership Act of 1997 § 401.
EXAMPLE: As part of a new partnership, Hank loans his delivery truck to the firm for its use in delivering products. The partnership continues to use the truck for five years and eventually assumes the responsibility of paying for insurance on the truck. If Hank intended the truck to be an asset of the partnership, then it certainly is one. Moreover, given the nature of the use of the truck and the fact that the partnership paid the insurance, a court, if asked, might imply that the truck has become partnership property unless Hank clearly documented that it was only on loan to the firm.
Ultimately, given this broad definition of ownership in the partnership, there is very little that is not includable as a partnership asset. What remains with the partners is, in the end, their partnership "interest" - their share of profits and surplus - in the partnership. This partnership interest, which generally amounts to a dollar figure, is the only element of the partnership that is truly the personal property of the individual partner and is therefore available for transfer or attachment. The partner’s interest, as a dollar figure, is then placed in that partner’s “capital account,” which is adjusted up and down based on the subsequent gains, losses, and expenses created by the partnership.
Regarding operation, each member of the partnership has an equal right to participate in the management of the firm, absent some contract or agreement to the contrary. See Unif. Partnership Act of 1997 § 401(f). Likewise, profits from the partnership are split equally, in the absence of an agreement to the contrary. In the end, partners may agree to split control and profits by any means they choose. However, such an agreement needs to be explicit and must be agreed to by all partners. For an example of a statutory scheme for splitting partnership assets upon dissolution, see
Taxation
The IRS has a fairly complicated system of taxation for garnering revenues from a partnership. At its most basic level, however, taxation of a partnership is straightforward. Essentially, the partnership, as a pass-through entity, does not incur a tax liability separate from that of its members. In other words, taxes on profits and other business transactions accrue to the individual partners rather than the partnership. In the end, this means that the tax rates and other tax attributes of the individual, and not the partnership, control the rate and timing of taxation on the partnership's operations.
From a mechanical standpoint, this rule of partnership taxation may be a benefit or a detriment to the individual partner. As profits and losses are distributed, they will attach to the individual and will not result in any potential tax benefits as they might in a corporate setting. Additionally, it is important to note that tax obligations - both profits and losses - accrue to the individual whether or not there is a distribution made by the partnership. In other words, if the partnership earns a profit but chooses not to distribute the profit - otherwise holding it in reserve (for example, for continued operating needs) - a tax obligation will still attach to the partners. Thus, even though they have not received any cash dividend, the partners may face a tax bill that they must pay. Typically, this predicament is remedied by the partnership making a distribution to each partner sufficient to cover his/her tax bill while retaining the remaining profits.
EXAMPLE: P Partnership, a partnership made up of partners X, Y, and Z, has had a mixed year. It has suffered capital losses in the sale of two buildings it owns, but has garnered substantial revenue from the other three buildings that it continues to own and manage. The company decides to allocate the loss to each of the partners this year, according to their ownership profit percentages, but not to make any actual distributions of the operating profits (choosing to keep them to buy a new building). Partners X, Y, and Z will be required to report the operating loss as well as their individual percentages of the profits on their tax returns this year. This will be required despite the fact that the partnership failed to pay them any actual money.
Liability
As agents, each partner's actions bind both the other members of the partnership and the partnership itself. The result of this agency relationship is that each partner may create contracts, act in tortious manner, or otherwise obligate the entire partnership for that partner's individual acts. See, e.g.,
One of the dangers of the partnership form is that the individual partners are said to have "unlimited liability" for the obligations of the partnership. In a practical sense, this means that while the only property that is attributable directly to the partner is that partner's capital account, each partner is liable for the full amount of any obligation that accrues to the partnership as a whole. Ultimately, any partner in the firm may find herself liable, without an upper limit, for the full liability of the firm.
EXAMPLE: Nadia and Colby are partners in a company. Nadia decides that the company needs a new look and hires a top-end design firm to rework its logo, product packaging and marketing material, all while Colby is away on vacation. When Colby returns and finds out, he is angry at Nadia, but fails to say anything about the changes. A month later when the design firm tries to collect its pay, the partnership refuses. Ultimately, if the design firm sues, Nadia, the partnership, and Colby will each be liable for the bill.
Capitalization and Fund Raising
Capitalization of a partnership is accomplished by the individual capital contributions that are "paid in" to the partnership by incoming partners. At the formation of the firm or as new partners are added, each partner is required to provide a cash infusion, which then determines that partner's partnership interest. Over time, as profits are made and losses are accounted for, these transactions will result in changes to the partner's capital account. If, through its continued business, the partnership does not garner sufficient funds to cover its operating expenses or obligations, the firm may choose to seek additional funds either from banks in the form of loans, or by making additional calls for capital from the individual partners.
Liquidity
As we discussed above, the only property owned by an individual partner is his/her partnership interest. See
EXAMPLE: Leon is sued by his personal creditor to collect back due amounts on a loan. When Leon loses the suit and is unable to pay, the creditor tries to take Leon’s very expensive desk that he uses at his partnership’s offices along with his capital account in the partnership. While the creditor will be able to reach Leon’s capital account, it will not be able to reach the desk as it is partnership property.
In its most strict sense, the partnership is a truly illiquid investment. While partners may generally be added at will by the partnership, the act of any individual partner to remove himself from the partnership (i.e., by bankruptcy or otherwise liquidating his interest, or death) severs the partnership and results in automatic dissolution of the firm. For these reasons, partnerships are generally structured to act for a limited purpose and for a limited amount of time. Partnerships are not of an unlimited duration in the way that corporations are.
A Special Note on Partnerships - Fiduciary Duties
One special issue that applies to partnerships is the fact that partners, as individuals and collectively, owe fiduciary duties to the partnership and to each other. This means that members of the partnership are not allowed to profit at the expense of other members nor are they allowed to act in a manner that would injure the partnership in the conduct of its business. We will discuss fiduciary duties to a much greater extent in a later chapter. For now, however, keep in mind the fact that partners must act for the good of all members of the firm and for the benefit of the partnership itself.