In the United States, the partnership is one of the three most commonly used types of business organizations; the other two are the corporation and the sole proprietorship. The sole proprietorship is the oldest and simplest business organization. It is formed when one person goes into business and has sole control and responsibility for the business; the corporation is the most complex of the three types of business organizations. A partnership is an association of two or more persons who carry on a business, as co-owners, for profit. It is more complex and usually requires more legal formalities than a sole proprietorship, but, in general, it is less complex than a corporation.
There are two main types of partnerships: the general partnership and the limited partnership. This article describes how each type of partnership is created. It also discusses the law governing each, relationships among partners, partners' potential legal liability, duration of the partnership, and termination of the partnership. In addition, there is brief discussion of two special designations that are allowed under the laws of some states for partnerships involving professionals: the limited liability partnership (LLP) and the limited liability limited partnership (LLLP).
A general partnership can be based on an oral or written agreement among the partners. However, for reasons discussed below, it is always advisable to have a written partnership agreement signed by all partners.
The formation and operation of business organizations are governed primarily by state law. Thus, each of the individual 50 states has unique partnership laws. However, the law of partnerships is relatively uniform throughout the 50 states, because most states have based partnership statutes on the Uniform Partnership Act (UPA), a model act created by the National Conference of Commissioners on Uniform State Laws (Uniform Law Commissioners). The Uniform Law Commissioners have approved various model laws for business organizations including the UPA, the Uniform Limited Partnership Act (ULPA), and others. These model acts are drafted by panels of practitioners, legal scholars, and judges who are respected and experienced in the area of law involved.
The UPA dates from 1914, and the Revised Uniform Partnership Act (RUPA) was adopted by the Uniform Law Commissioners in 1994. The Commissioners approved amendments to the RUPA in 1996 to provide limited liability for partners in a general partnership. Because they became effective in 1997, those amendments are referred to as the "1997 Amendments." As of mid-1999, the RUPA of 1994 had been adopted by at least 25 states; 23 of those states had adopted it with the 1997 amendments. In addition, the RUPA has been introduced as legislation in Hawaii and Indiana.
Under the UPA, a partnership is defined as a voluntary organization formed by two or more persons to carry on a business as co-owners for profit. Most rules set down in the UPA and RUPA apply only if there is no partnership agreement or if an existing partnership agreement is silent with respect to a certain issue or question.
When lawyers use the term "partnership," they are usually referring to a general partnership, and in this section of this article, I will do the same. The act of doing business together, for profit, creates the partnership. In some states, but not all, a partnership may file a Partnership Agreement or Statement of Authority with the office of a designated state official such as the Secretary of State. However, such filings are not required.
A general partnership is a legal entity for limited purposes only. For example, it can have its own assumed (or fictitious) name, and title to real or personal property can held be in the name of the partnership. However, in a lawsuit, the individual partners will be named as defendants.
Depending on the business or profession of the partners, some filings that are not related to partnership status may be required. For example, if the partnership uses a name other than the names of the partners, it must file for an assumed name. (This requirement also applies to sole proprietorships.) In some states, such as Michigan, the filing is done county by county. In other states, such as Montana, one filing can be made to reserve the name for use throughout the state. In addition, occupational licenses must be obtained, such as in the building industry and cosmetology. Similarly, professionals such as medical doctors, lawyers, and accountants, among others, must meet professional licensing requirements. In states that impose a retail sales tax, the business must obtain a sales tax license, collect sales taxes, and remit them to the state.
As compared to the limited partnership or corporation, a major advantage of the general partnership is that it can be organized with minimal paperwork and at a relatively low cost. The partnership, unlike a corporation, can operate in more than one state without having to obtain a license to do business in each state. In general, partnerships are subject to less government supervision and fewer regulations than is true for corporations.
There are some disadvantages to use of a general partnership as a business organization. First, practical considerations limit the number of people who can be involved; a corporation may be needed to accommodate a large number of owners. Second, a partnership can be dissolved at any time. Third, a partner's liability is unlimited. Use of a limited partnership or a corporation may be advisable if some or all of the owners are unwilling to be subject to such liability.
Under the UPA and RUPA, unless a written partnership agreement stipulates otherwise, certain general rules apply with respect to management, profits, and losses. First, unless otherwise stipulated in writing, each partner has an equal voice in the management of the partnership's business. Second, unless otherwise stipulated in writing, all partners share equally in profits and losses of partnership. If Sam and Mary form a partnership to run a pizza business, each makes contributions, whether in cash, or real or personal property. Each is expected to contribute services (work for the partnership). However, regardless of the contributions (in property or services) of each partner, Sam and Mary share equally in the profits and losses.
These general rules underscore the need for a written partnership agreement (sometimes called "articles of partnership") even though it is not legally mandated. With a written agreement, the partners can design management and profit-sharing arrangements that meet specific needs. Almost any terms are permissible so long as they are not illegal or contrary to public policy.
Certain kinds of provisions should go into any partnership agreement. Here are some categories that should be covered:
Each year, a partnership must file an "information return" with the Internal Revenue Service to report the partnership's profits or losses. The information return must also report all dividend income and capital gains or losses. However, the partnership does not pay taxes. If there is a profit, each partner reports his or her share on his or her personal income tax return, and the partner pays taxes on the those amounts as personal income. If there are losses, each deducts those losses from his or her personal income. When there are losses, the partnership form for doing business provides an advantage for partners, because the losses can be used to reduce the total amount of the partner's income. However, the partners' profits are taxed each year whether they are distributed or not. For example, if a partnership with two partners has $50,000 in profits and decides to retain those profits and use them to expand the business, each must report $25,000 as personal income and pay taxes on that amount. In such cases, the partnership creates a disadvantage for the individual partners.
The main disadvantage of a partnership is that, if the business fails, each partner can be sued by creditors for contract or tort debts. The law says that the partners are "jointly and severally" liable for the debts of the partnership. This means that all partners or even just one partner can be forced to pay all of the partnership's debts out of his or her personal income and resources. For example, if the partnership owes $200,000 to a creditor, the creditor can sue all three creditors jointly for that amount. Or, the creditor can sue one partner or any combination of two partners for the entire $200,000. A partner who pays all of a debt or an unequal share of a debt has a right to seek contribution from the remaining partner or partners who have not paid. However, joint and several liability creates a major risk for a partner who has substantial resources such as real property, income, or other assets. If he or she enters a partnership with a partner who has few or no resources outside of the partnership, the wealthier partner may end up paying all of the partnership's debts if the partnership fails. A right to contribution is of no practical value if the other partners have no assets.
The partners in a general partnership are agents and principals of one another. The UPA and RUPA state that each partner has a fiduciary relationship to the partnership and must act in good faith and for the benefit of the partnership. (The RUPA gives more details on this than does the UPA.) In management decisions, each partner has one vote, and most decisions are based on a majority vote. However, certain major decisions, such as a decision to merge with another partnership, require a unanimous vote.
Unlike a corporation, a general partnership does not have "perpetual" existence. Under the UPA, the death, retirement, personal bankruptcy, or insanity of any one partner causes the dissolution of the partnership. This is an area in which the RUPA differs from the UPA. Under the RUPA, dissolution does not occur automatically when a partner leaves. Under the UPA, if a new partner is added, the organization is dissolved and the surviving partnership is considered a new legal entity. Even if a written partnership agreement stipulates that the partnership will continue for a set number of years, the partnership can be dissolved upon petition of one of the partners. The partnership's business, however, is not terminated upon dissolution. Dissolution means the legal organization under which the partnership has been operating ceases to exist.
However, dissolution can lead to termination after winding up unfinished business and liquidating business assets. Contracts are completed or settled, and debts are paid. Finally, any remaining profits and assets are distributed among the partners. During this process, no new business can be transacted.
To prevent problems when a partner dies or leaves the partnership for any reason, a partnership agreement should include a buy-sell agreement provision. By law, this provision must be in place when the partnership is created. It describes the manner of compensation for the survivors of a deceased partner or for the withdrawing partner. A formula is established to determine the amount of payment, and a payment schedule is established. Often, partners provide for the possible death of a partner by taking out a life insurance policy on the life of each partner. The policy is made payable to the partnership or to the surviving partners, enabling the partners to pay the amount required in the buy-sell agreement to the survivors of the deceased partner, and remaining partners are financially able to continue to do business.
The Revised Uniform Partnership Act (RUPA) includes a formula for valuing a partner's interest during a buyout. (This was not included in the UPA.) As with other UPA and RUPA provisions, this formula is applied only if this topic is not covered in a written partnership agreement.
The limited partnership is an alternative to the general partnership. Use of limited partnerships increased substantially during the 1970s when investors were seeking tax shelters. However, since the 1970s tax reform legislation has reduced the value of the tax shelter afforded to limited partnerships. In 1999, the primary reasons for choosing limited partnership today were based on investment return, cash flow, and the ability to protect some of the investors from unlimited personal liability for the partnership's debts. In many instances, a potential partner for a new partnership wishes to contribute financially to a partnership, but he or she does not want to risk unlimited personal liability for its debts. The Revised Uniform Limited Partnership Act (RULPA) has been adopted in 48 states, providing a great deal of uniformity in this area of law throughout the United States.
The limited partnership shares some of the characteristics of a general partnership and some characteristics of a corporation. Like a corporation, the limited partnership must be formed pursuant to state statute. The applicable law is the individual state's version of the RULP as well as the written partnership agreement. Unlike a general partnership, a limited partnership must be based on a written agreement that is signed by all partners (limited and general) and is filed with the designated state office such as the Secretary of State or Corporations and Securities Bureau. Forms must be completed supplying information about the partners, assets and resources of the limited partnership, the purpose of the business, and other relevant information. Statutory requirements must be followed "to the letter" before the forms will be accepted and approved by the state office. Upon approval, a certificate of limited partnership is issued and the limited partnership comes into existence. In the event that the forms and agreement are filed but not approved, the business will be treated as a general partnership, and all partners will be treated as limited partners.
One filing for the entire state (through the designated state office) is needed to acquire an assumed name for the limited partnership. Thus, in states such as Michigan, where filing for an assumed name for a general partnership is done county by county, obtaining an assumed name for use throughout the state is easier for the limited partnership than for the general partnership.
However, in many ways, the limited partnership is similar to a general partnership. The managers of the limited partnership are called general partners and their potential liabilities are the same as those of partners in a general partnership. Also, general and limited partners share in the profits of the business in the same way as is done among partners in a general partnership.
Under the RULPA, the limited partnership must have at least one general partner who manages the business and is subject to unlimited personal liability for the liabilities of the business. It may also have one or more limited partners who contribute capital only (cash or assets) and do not participate in management. The one or more limited partners are subject to liability only to the extent of their individual investments.
This protection from unlimited liability applies so long as the limited partner does not participate in management in any way. This means that the limited partner, unlike a shareholder in a corporation, cannot vote on business matters and cannot have any say in management decisions. This prohibition on participation in management must be observed carefully and stringently. If a limited partner participates in the partnership's business or investment activities, he or she loses his or her status as a limited partner and is treated as a general partner with respect to the partnership's liabilities. For example, at least one state's courts have held that the act of speaking to a potential creditor on behalf of the partnership constitutes participation in management. Further, the partnership name cannot include the surname of a limited partner. The overall objective is to avoid any act or representation that might lead the public to believe that the partner participates in some way in management of the business.
With the exception of specific liabilities attributed to the partnership itself, the tax treatment of limited partnerships and of individual partners is almost identical to the treatment extended to general partnerships and their partners.
A recent development in partnership law is the creation of "master limited partnerships." In such arrangements, a promoter gathers interested parties who own a number of smaller limited partnerships and combines them into a new, larger limited partnership. The interests in the master limited partnership are then publicly traded over-the-counter or on a stock exchange. (When limited partnership interests are offered to the public, the offering as well as the limited partnership interests being sold must be registered with the Securities and Exchange Commission (SEC).) Master limited partnerships have been used, for example, for oil drilling ventures. In addition, some corporations have done "spin-offs" of segments of their operations to form master limited partnerships.
In 1991, Texas became the first state to offer a new option to professionals in a partnership; it is called the Limited Liability Partnership (LLP). The LLP is treated like a partnership except that partners are protected from personal liability for the torts of partners in the firm. By 1997, a majority of the states had adopted some kind of LLP law, although those laws differ from state to state. By 1999, at least 18 states or jurisdictions had adopted the 1997 amendments to the RUPA that provide for LLPs, thus creating more uniformity. Those states and jurisdictions include: Alabama, Arkansas, Colorado, the District of Columbia, Idaho, Iowa, Kansas, Maryland, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Oklahoma, Oregon, The U.S. Virgin Islands, Vermont, and Washington. Also by 1999, Arizona, California, and Virginia had adopted LLP equivalents.
Going further, a more limited number of states offer another alternative called the Limited Liability Limited Partnership (LLLP). The LLLP designation is similar to the LLP, except that it is available to limited partners in a limited partnership.
If one of the partners in a Limited Liability Partnership (LLP) is sued for a tort (malpractice), his or her partners are not jointly and severally (meaning separately) liable for that partner's debt. This protection applies so long as the partners are not supervising, directing, or otherwise involved in the negligent activity. This is significant when the firm does not have enough insurance coverage to pay all of a large judgment against the offending partner. The partner who engages in malpractice is, however, personally liable for his or her own tort.
For an LLP to exist, the LLP must be registered with the state office designated by statute (usually the Secretary of State or the State Corporations and Securities Bureau). The filing is called a "statement of qualification." In addition, LLP status must be indicated in the partnership's name using the words "Limited Liability Partnership" or the initials "L.L.P." In general, it is relatively easy to convert a general partnership into an LLP.
The LLP is treated like a general partnership for tax purposes. Comparing the LLP to a Professional Corporation (a corporate form that protects professionals from the torts of co-owner professionals), the LLP provides a tax advantage to its owners, because earnings are taxed as personal income, as is the case with other partnerships. In a professional corporation, the corporation pays taxes on earnings before they are distributed to the owners (shareholders). The shareholders, in turn, pay personal taxes on what they receive. Thus, the LLP can provide a tax advantage to partners.
If a partnership is considering seeking LLP status, the provisions of each state's laws must be studied carefully, because the laws vary. In most cases, LLP laws are in the form of amendments to a state's existing partnership laws.
The Limited Liability Limited Partnership (LLLP) is a type of limited partnership. The difference between the LLLP and a limited partnership is that a general partner in the LLLP enjoys the same protection from liability as a limited partner with respect to the torts of his or her professional partners. The tort liability of each partner, whether he or she is a general or limited partner, is limited to the amount of the partner's investment in the firm. Only a few states have adopted LLLP laws. They include Colorado, Delaware, Florida, Missouri, Texas, and Virginia.
Choice of a form for doing business is a decision that must be based on the needs of its owners as well as legal and tax considerations. This article has provided general descriptions of general partnerships and limited partnerships, and it introduces the reader to the Limited Liability Partnership (LLP) and the Limited Liability Limited Partnership (LLL). However, a form for doing business should be chosen only after careful consultation with an attorney who is familiar with the relevant business association laws of the state(s) in which the owners wish to do business and the client's needs. Further, competent legal help will be needed to advise on the filing requirements for limited partnerships as well as on-going, periodic reports to state agencies and the Internal Revenue Service. In addition, an accountant can help business owners examine the tax consequences that may result from the choice of a business form.
[ Paulette L. Stenzel ]
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