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11.2 Partnerships

Learning Objectives

  1. Learn about how general and limited partnerships are formed.
  2. Explore the major differences between general and limited partnerships.
  3. Understand major advantages and disadvantages to doing business as general or limited partnerships.

Figure 11.3

Partnerships allow multiple individuals to conduct business together.

Let’s assume that after her first summer running Lily’s Landscaping, Lily decides that it’s time to take her business to the next level. She has gathered a lot of expertise in running the operations in her business, from placing orders with suppliers to scheduling workers for client projects. She realizes, however, that she’s not very good at marketing or accounting, and that if her business is to grow, she needs to bring someone on board who can create a strong brand and strategy for growth, as well as keep good records of her accounts so that she can plan for the future. Fortunately, her good friend Adam is a double major in accounting and marketing, and after a series of discussions, Adam and Lily decide to run Lily’s Landscaping together.

Lily and Adam have formed a general partnershipAssociation of two or more persons in an unincorporated entity to do business and share profits and losses.. The moment they agreed to run Lily’s Landscaping together, and to share in the profits and losses of the business together, the partnership was formed. Although they formed their partnership verbally, most general partnerships are formed formally, with partners writing down their agreement in a special type of contract known as the articles of partnershipAlso known as a partnership agreement, a voluntary contract (typically written) in which two or more persons decide to conduct business together and share profits and losses.. The articles can set forth anything the partners wish to include about how the partnership will be run. Normally, all general partners have an equal voice in management, but as a creation of contract, the partners can modify this if they wish. As in a sole proprietorship, there is no state involvement in creating a general partnership because there is no separation from the business and the partners—they are legally the same.

General partnerships are dissolved as easily as they are formed. Since the central feature of a general partnership is an agreement to share profits and losses, once that agreement ends, the general partnership ends with it. In a general partnership with more than two persons, the remaining partners can reconstitute the partnership if they wish, without the old partner. A common issue that arises in this situation is how to value the withdrawing partner’s share of the business. Articles of partnership therefore typically include a buy/sell agreementAn agreement between partners to value and sell a partner’s portion of the business in the event the partner withdraws or dies., setting forth the agreement of the partners on how to account for a withdrawing partner’s share, which the remaining partners then agree to pay to the withdrawing partner (or the spouse or heir if the partner dies).

Hyperlink: A Law Firm Partner Is Fired

http://www.law.cornell.edu/nyctap/I96_0191.htm

After a nearly twenty-year career, Evan Dawson was a partner at a major New York City law firm, White & Case. In 1988 the firm tried to persuade him to withdraw as a partner, but he refused. In July 1988 the other partners in the firm voted to dissolve the partnership and then immediately re-formed again, without Dawson as a partner. He had effectively been fired as a partner from a general partnership. Dawson filed a suit against White & Case for an “accounting,” claiming that the “goodwill” of the law firm should be part of the valuation of the partnership. The common law in New York at the time was that professional partnerships like law firms have no goodwill. The reasoning behind the rule is that as professionals, law firm partners develop and cultivate their own goodwill with clients, and if a partner leaves the firm then the goodwill leaves with that partner. The New York Court of Appeals, in its opinion on this case, held that unless the partnership agreement states otherwise, goodwill is indeed an asset of the partnership and has to be distributed when the partnership is dissolved.

A general partnership is taxed just like a sole proprietorship. The partnership is considered a disregarded entityFor tax purposes, an entity that does not need to file its own tax return or pay taxes; profits and losses flow through disregarded entities to the owners. for tax purposes, so income “flows through” the business to the partners, who then pay ordinary income tax on the business income. The partnership may file an information returnTax return that provides information only to the taxing authority., reporting total income and losses for the partnership, and how those profits and losses are allocated among the general partners. As is the case for sole proprietors, tax planning opportunities are limited for general partners.

General partnerships are also similar to sole proprietorships in unlimited liability. Every partner in the partnership is jointly and severally liableA form of liability where creditors or other claimants can pursue their entire claim against one, several, or all possible defendants, leaving defendants to sort out their respective proportions of liability and payment. for the partnership’s debts and obligations. This is a very unattractive feature of general partnerships. One partner may be completely innocent of any wrongdoing and still be liable for another partner’s malpractice or bad acts.

Let’s assume that the general partnership formed by Lily and Adam flourishes and becomes profitable. To grow the landscaping business, they want to bring in Lily’s wealthy uncle as a partner. The uncle, however, is worried about maintaining limited liability. In most states, they can form a limited partnershipA form of partnership formed in compliance with state law that provides limited liability to certain limited partners who agree to refrain from management of the business.. A limited partnership has both general partners and limited partners. In this case, Lily and Adam will remain as general partners in the business, but the uncle can become a limited partnerA partner in a limited partnership given limited liability. and enjoy limited liability. As a limited partner, the most he can lose is the amount of his investment into the business, nothing more. Limited partnerships have to be formed in compliance with state law, and limited partners are generally prohibited from participating in day-to-day management of the business.

Key Takeaways

A general partnership is formed when two or more persons agree to share profits and losses in a joint business venture. A general partnership is not a separate legal entity, and partners are jointly and severally liable for the partnership’s debts, including acts of malpractice by other partners. Income from a general partnership flows through to the partners, who pay tax at the ordinary personal income tax rate. In most states general partners can also bring in limited partners, creating a limited partnership. Limited partnerships must be formed in compliance with state statutes. Limited partners enjoy limited liability but generally cannot participate in day-to-day management of the business.

Exercises

  1. John approaches his friend Kevin and offers Kevin 50 percent of the profits from his new online venture if Kevin designs the Web site for the venture. Kevin says nothing, and later that night begins work on the Web site, which he then sends to John for his approval. Have John and Kevin formed a general partnership? Why or why not?
  2. Do you think it’s ethical for a general partnership to fire a partner by dissolving the partnership and then re-forming without the dismissed partner? Why or why not?
  3. Do modern professional firms such as law firms or accounting firms face the same problems as White & Case did in Note 11.24 "Hyperlink: A Law Firm Partner Is Fired"? Why or why not?