The Legal Ins and Outs of Forming a Partnership You can create a partnership based on an oral agreement, but it's much smarter to put it in writing.

A partnership is a business form created automatically when two or more persons engage in a business enterprise for profit. Consider the following language from the Uniform Partnership Act: "The association of two or more persons to carry on as co-owners of a business for profit forms a partnership, whether or not the persons intend to form a partnership." A partnership--in its various forms--offers its multiple owners flexibility and relative simplicity of organization and operation. In limited partnerships and limited liability partnerships, a partnership can even offer a degree of liability protection.

Partnerships can be formed with a handshake--and often they are. In fact, partnerships are the only business entities that can be formed by oral agreement. Of course, as with any important legal relationship, oral agreements often lead to misunderstandings, which often lead to disputes. Thus, you should only form a partnership that is memorialized with a written partnership agreement. Preferably, you should prepare this document with the assistance of an attorney. The cost to have an attorney draft a partnership agreement can vary between $500 and $2,000 depending on the complexity of the partnership arrangement and the experience and location of the attorney.

How Partnerships Are Managed

Partnerships have very simple management structures. In the case of general partnerships, partnerships are managed by the partners themselves, with decisions ultimately resting with a majority of the percentage owners of the partnership. Partnership-style management is often called owner management. Corporations, on the other hand, are typically managed by appointed or elected officers, which is called representative management. Keep in mind that a majority of the percentage interest in a partnership can be very different from a majority of the partners. This is because one partner may own 60 percent of a partnership, with four other partners owning only 10 percent each. Partnerships (and corporations and LLCs) universally vest ultimate voting power with a majority of the percentage ownership interest.

Of course, partners and shareholders don't call votes every time they need to make some small business decision such as signing a contract or ordering office supplies. Small tasks are managed informally, as they should be. Voting becomes important, however, when a dispute arises among the partners. If the dispute cannot be resolved informally, the partners call a meeting and take a vote on the matter. Those partners representing the minority in such a vote must go along with the decision of the partners representing the majority.

Partnerships do not require formal meetings like corporations do. Of course, some partnerships elect to have periodic meetings anyway. Overall, the management and administrative operation of a partnership is relatively simple, and this can be an important advantage. Like sole proprietorships, partnerships often grow and graduate to LLC or corporate status.

Varieties of Partnerships

There are several varieties of partnerships. They range from the simple general partnership to the limited liability partnership.

The general partnership. By default, a standard partnership is referred to as a general partnership. General partnerships are the simplest of all partnerships. An oral partnership will almost always be a general partnership. In a general partnership, all partners share in the management of the entity and share in the entity's profits. Matters relating to the ordinary business operations of the partnership are decided by a majority of the partners. Of course, some partners can own a greater share of the entity than other partners, in which case their vote counts according to their percentage ownership--much like voting of shares in a corporation. All partners are responsible for the liabilities of a general partnership.

The limited partnership. The limited partnership is more complex than the general partnership. It is a partnership owned by two classes of partners: general partners manage the enterprise and are personally liable for its debts; limited partners contribute capital and share in the profits but normally do not participate in the management of the enterprise. Another notable distinction between the two classes of partners is that limited partners incur no liability for partnership debts beyond their capital contributions. Limited partners enjoy liability protection much like the shareholders of a corporation. The limited partnership is commonly used in the restaurant business, with the founders serving as general partners and the investors as limited partners.

A limited partnership usually requires a state filing establishing the limited partnership. Some states, most notably California, allow the oral creation of a limited partnership. Of course, establishing a limited partnership with nothing more than an oral agreement is unwise. Oral limited partnership agreements will very likely lead to disputes and may not offer liability protection to limited partners.

Limited partnerships have fallen out of favor recently because of the rise of the limited liability company. Both forms share partnership-style taxation and partnership-style management, but the LLC offers greater liability protection because it extends liability protection to all its managers. Thus, today LLCs are often selected instead of limited partnerships.

Because of the complexity of limited partnerships, the formation of one is not something you should undertake on your own. The formation of a limited partnership is best left to a qualified attorney.

The limited liability partnership. Yet another form of partnership is the limited liability partnership. A limited liability partnership is one comprised of licensed professionals such as attorneys, accountants and architects. The partners in an LLP may enjoy personal liability protection for the acts of other partners but each partner remains liable for his own actions. State laws generally require LLPs to maintain generous insurance policies or cash reserves to pay claims brought against the LLP.

Partnership Agreements

Your partnership agreement should detail how business decisions are made, how disputes are resolved, and how to handle a buyout. You'll be glad you have this agreement if for some reason you run into difficulties with one of the partners or if someone wants out of the arrangement.

The agreement should address the purpose of the business and the authority and responsibility of each partner. It's a good idea to consult an attorney experienced with small businesses for help in drafting the agreement. Here are some other issues you'll want the agreement to address:

1. How will the ownership interest be shared? It's not necessary, for example, for two owners to equally share ownership and authority. However you decide to do it, make sure the proportion is stated clearly in the agreement.

2. How will decisions be made? It's a good idea to establish voting rights in case a major disagreement arises. When just two partners own the business 50-50, there's the possibility of a deadlock. To avoid a deadlock, some businesses provide in advance for a third partner, a trusted associate who may own only 1 percent of the business but whose vote can break a tie.

3. When one partner withdraws, how will the purchase price be determined? One possibility is to agree on a neutral third party, such as your banker or accountant, to find an appraiser to determine the price of the partnership interest.

4. If a partner withdraws from the partnership, when will money be paid? Depending on the partnership agreement, you can agree that the money be paid over three, five or ten years, with interest. You don't want to be hit with a cash flow crisis if the entire price has to be paid on the spot in one lump sum.

How Partnerships Are Governed

Partnerships are governed by the law of the state in which they are organized and by the rules set out by the partners themselves. Typically, partners set forth the governing rules in a partnership agreement.

Often the governance rules determined by the partners differ from the governance rules set by state law. In most cases, the rules of the partners override state law. For example, state law typically dictates that a partnership's profits are to be divided among partners in proportion to their ownership interests. However, the partners are free to divide profits by a formula separate from their ownership interests, and the decision of the partners will override state law. Thus, the governance rules in state law are default provisions that apply in the absence of any rules set by the partners in a partnership agreement.

This fact underscores the need for a partnership agreement. Otherwise, the partnership will by default be governed by state law. The laws set forth by state law may not be appropriate for every partnership. For the most part, however, the default state rules are fair and well-balanced.

An Important Concept: The Law of Agency

Agency refers to one's status as the legal representative (the agent) of an entity or another person. The party on whose behalf an agent acts is called a principal. One is said to be the agent of a partnership or other entity if one has the legal authority to act on behalf of that entity.

An agent can bind a partnership to contracts and other obligations through his actions on behalf of a partnership. Of course, when an agent acts on behalf of a partnership or another company, the company is bound by the acts and decisions of that agent. A third party dealing with an agent of a company can rely upon the agency relationship and enforce the obligations undertaken by the agent--even if the agent made a foolish or selfish decisions on the company's behalf. If the agent acts within the scope of the his authority, the partnership becomes bound by the actions, no matter how foolish.

The law of agency applies to corporations and LLCs as well as to partnerships. However, a discussion of the law of agency is particularly pertinent to partnerships because in a general partnership, all of the partners usually have the status of agent with respect to the general partnership. The law of agency applies differently to corporations. Shareholders in a corporation are not necessarily officers and directors of that corporation, and agent status will not automatically apply to them. So, partners in a partnership must be careful to delineate authority and keep abreast of their co-partners' decisions.

That said, partnerships can grant specific authority to specific partners, if such a grant appears in the partnership document. Without and agreement to contrary, however, any partners can bind the partnership without the consent of the other partners, as described above.

Summing Up: The Pros and Cons

Pros:

• Owners can start partnerships relatively easily and inexpensively.
• Partnerships do not require annual meetings and require few ongoing formalities.
• Partnerships offer favorable taxation to most smaller businesses.
• Partnerships often do not have to pay minimum taxes that are required of LLCs and corporations.

Cons:

• All owners are subject to unlimited personal liability for the debts, losses and liabilities of the business (except in cases of limited partnerships and limited liablity partnerships).
• Individual partners bear responsibility for the actions of other partners.
• Poorly organized partnerships and oral partnerships can lead to disputes among owners.

All portions of this article were excerpted fromEntrepreneur Magazine's Ultimate Book on Forming Corporations, LLCs, Sole Proprietorships and Partnerships, except for "Partnership Agreements," which was excerpted from Start Your Own Business.