If your business will be owned and operated by several individuals, you'll want to take a look at structuring your business as a partnership. Partnerships come in two varieties: general partnerships and limited partnerships. In a general partnership, the partners manage the company and assume responsibility for the partnership's debts and other obligations. A limited partnership has both general and limited partners. The general partners own and operate the business and assume liability for the partnership, while the limited partners serve as investors only; they have no control over the company and are not subject to the same liabilities as the general partners.
Unless you expect to have many passive investors, limited partnerships are generally not the best choice for a new business because of all the required filings and administrative complexities. If you have two or more partners who want to be actively involved, a general partnership would be much easier to form.
One of the major advantages of a partnership is the tax treatment it enjoys. A partnership doesn't pay tax on its income but "passes through" any profits or losses to the individual partners. At tax time, each partner files a Schedule K-1 form, which indicates his or her share of partnership income, deductions and tax credits. In addition, each partner is required to report profits from the partnership on his or her individual tax return. Even though the partnership pays no income tax, it must compute its income and report it on a separate informational return, Form 1065. Personal liability is a major concern if you use a general partnership to structure your business. Similar to a sole proprietorship, general partners are personally liable for the partnership's obligations and debt.
In addition, each general partner can act on behalf of the partnership, take out loans and make business decisions that will affect and be binding on all the partners (if the general partnership agreement permits). Keep in mind that partnerships are more expensive to establish than sole proprietorships because they require more extensive legal and accounting services.
Protect yourself and your business with a partnership agreement.
Starting a business with a partner? It may be difficult to talk about problems during your honeymoon stage, but that's exactly when you should. A written partnership agreement helps guide you when questions arise.
According to W. Thurston Debnam Jr., a partner with Smith, Debnam, Narron, Wyche, Story & Myers LLP, a law firm in Raleigh, North Carolina, a partnership agreement should answer the following questions:
- What is each partner's investment? Is one investing cash and the other energy? Do any of the partners own equipment that you'll use in the business, and does that fact deserve consideration as part of the start-up investment?
- What are the responsibilities and duties of each partner? Be specific about each partner's role in the day-to-day operations of the company.
- If a partner becomes disabled, how long will he or she get a share of the profits? If a partner dies, what happens to that share? A good way to deal with this issue: life insurance on all partners.
- Can the partners have other outside partnership interests? In particular, can interest be in similar or competitive businesses?
- What will you do if one partner wants to withdraw? Typically, you'll set up a buyout agreement, but it's a very good idea to decide on the terms before the situation arises. You'll also want to include a noncompete covenant.
- How will you restrict partnership-interest transfers? Can a partner transfer his or her ownership to anyone, or can you limit that transfer? This means the remaining partners won't find themselves in partnership with someone they object to. This is frequently used to protect the business in the event that one of the partners gets a divorce and his interest becomes a part of the divorce settlement.
- Can a partner pledge his or her interest as collateral for a loan?
- Are additional contributions mandatory? If the business needs capital in the future, are partners required to make capital contributions?
- How will conflicts be resolved? Most often, an arbitrator is used.
Debnam recommends that every business partnership-regardless of the relationship of the individuals-begin with a written agreement. "It ensures that the partners have the same vision," he says.
But there's another reason for a partnership agreement. "Poorly drawn agreements keep litigation attorneys in business," Debnam notes. "The best reason to have a good agreement is to avoid the legal fees when you have a meltdown.