Characteristics of General Partnership
A general partnership is the most fundamental corporate entity. General partnerships are formed when two or more individuals agree on a shared interest in a commercial business venture. The partners also agree to share both profits and losses.
General partnerships have additional specific characteristics that make them easy to identify, such as:
- General partnerships do not require government filing. Instead, general partnerships can be created by the actions of the partners.
- General partnerships require more than one person to form them.
- When creating a general partnership, the partners’ agreement can be implied and does not need to be placed in writing or verbally expressed.
- General partnerships are “default,” meaning that partners do not have to consciously “form” the partnership, and sometimes they do not even realize the partnership was formed.
For example, Ben raises money for his hockey team by mowing lawns all summer. Unfortunately, there are too many lawns and insufficient time, so Ben asks his friends to help him mow lawns. The three boys agree to pool all proceeds from mowing lawns.
Although this is an informal business, Ben and his hockey teammates just started a general partnership. However, they might not even know what type of business they just started.
Rules of General Partnerships
General partnerships include rules that establish the rights of all company partners. Partnership rules also may include voting procedures among partners and how partners can collect profits from the business.
How profits are split up among partners dictates the entity’s type of business. For example, Betty begins using a metal detector to find valuable items on the beach. If Betty finds peoples’ belongings, she finds the owner, but usually, all she finds is discarded but valuable metal and copper.
Betty asks Roger to join in her scavenging on a different stretch of beach, and she offers him her metal detector. Betty tells Roger she will give him 45% of the value of what Roger finds.
Betty agrees to share ownership, and Roger is ostensibly now a partner in a general partnership. However, Betty would be considered a sole proprietor if Betty had decided to pay Roger $5.00 an hour and then give him only 12% of the metal profits he collects.
Partnership Agreement
When company partners agree to establish a general partnership, they usually sign a partnership agreement document. This document establishes the start of the partnership. The agreement also establishes that all partners are committed to the business.
That is not all partnership agreements do, however. These documents serve to govern the business in a variety of ways, including:
- Providing organization and structure for the company
- Establishing duties, responsibilities, and roles of the partners
- Including important provisions about dissolution, buyouts, and more
What information should be included in a partnership agreement?
Most partnerships rely on founding documents created when the partners form the business. When partners have questions, or the business encounters trouble, the partnership agreement often contains the answers.
However, some businesses do not have partnership agreements, and these companies must rely on the rules in their state. States have different rules regarding how partnerships must operate and how the relationships between partners work.
While state rules are helpful, they sometimes conflict with the partners’ goals, so we recommend creating a comprehensive partnership agreement whenever one is forming a general partnership. A licensed attorney can help business partners create a thorough partnership agreement that everyone can agree on.
Partnership agreements are usually unique and in tune with the goals and needs of each particular business and its partners. However, most partnership documents share these basic elements:
- Company Name. Every business needs a name, so make sure all partners agree on it. Also, do not forget to check with your state’s Secretary of State’s office whether the name is available. If the name is not that of the partners’, then the business will have to file for a doing-business-as-of DBA name.
- Ownership Interests. Allocate the ownership interests in the partnership agreement, so there are no questions later in the process. Be sure to include the number of contributions for all of the partners.
- Partners’ Authority. Including all of the decision-making, provisions will dictate which partners can act on the company’s behalf, bind the partnership, and more.
- Partners’ Entitlement. Typically, partners are entitled to equal amounts of losses and profits. However, the partners can agree on different allocations and note them in the partnership agreement. In partnerships, company partners can agree to different percentages of losses and profits compared to the ownership structure. Also, ensure the partnership agreement addresses the amount of profit or asset distribution and the timing of said distributions.
- Management Duties. In the agreement, spell out the responsibilities of the different partners. Sometimes, with different personalities comes different expectations. Map out the partners’ duties in the agreement, and there will be less disagreement later.
- Adding New Partners. Include the process of adding new partners: what is required? For example, how many partners need to agree, and how are the new partner’s interests determined?
- Future of the Company. Often, new partners do not want to think about future concerns, but they should. Consider what will happen to the business if a partner leaves or is forced out, for example. What happens to their profits, and what happens to the partnership? What about dissolution?
- Buyout. Including the projected terms of a buy-sell agreement will help if, at some point, it becomes necessary to buy one partner out of the company. These provisions are important and will save time and aggravation later on. Be as specific as possible regarding percentages, profits, and what is needed to finalize the buyout. For example, do all partners need to vote?
- Disagreements. Like it or not, all partners suffer through disputes; some are more serious than others. Therefore, include provisions about resolution, mediation, arbitration, and more. The more specific partners can be about the rules, the less conjecture will occur when disputes occur.
What is the Difference Between a General Partnership and an At-Will Partnership?
Business partners can form general partnerships purely through intent. When individuals join to perform a mutual task for shared profits, they create a general partnership. Even entities who perhaps did not intend to be partners are recognized as part of a general partnership at will.
- The At-Will Trait. When a partnership is “at-will,” there is no official agreement for how long the partnership will last or how long the individuals will be partners. Also, company partners can leave the business at any time.
- Ownership and Authority. In an at-will partnership, the owners share the company’s ownership equally, regardless of different contribution levels.
For example, if Greg and Matt form a partnership, and Greg provides the assets while Matt does much of the work, their company can still be considered an at-will partnership.
Each partner in an at-will company can manage the firm, bind the company in agreements, and generally act on behalf of the business.
- Decision Making. At-will partners can all participate in managerial decisions. Typically, most routine decisions require a majority partner vote to be finalized. However, major decisions impacting the future of the business require unilateral partner support.
- Owners’ Liability. Partners in at-will partnerships possess unlimited personal liability for the actions of their partners. Plus, at-will business partners are liable for the debts of the company. If a partner decides to bind the partnership, that situation may create a liability for all the partners. For example, Jen makes a hasty deal with a client and binds the company. Now, if debt arises from this deal, all partners will be liable for that debt, not just Jen.
- Fiduciary Duties. Fiduciary duty implies that the partners act in each other’s best interests and place the business’s health and preservation above their interests. Fiduciary duties are often included in partnership agreements, and they help to prevent partners from self-dealing or stealing from the company in some manner.
Why Are Buyout Agreements Important in General Partnerships?
When business partners seek to execute a buyout, they look back at their partnership agreement to ensure that it contains a buy-sell provision. If it does, the instructions are established for them already.
Typically, the initial step is to estimate the value of the business. Then, an independent valuation helps the partners establish a standard company value they can agree on.
When partnership documents do not include buy-sell provisions, the partners must negotiate a buyout with the departing partner, which can be challenging. Contact an experienced business lawyer for help with this important negotiation.
What do Buy-Sell Agreements Normally Include?
- The value of the company
- Buyout terms and instructions
- The price of the buyout
For example, Rich, Ryan, and Bryan are general partners in a restaurant in Mammoth Lakes, CA. When the three chefs formed Ski to Steak, they negotiated a partnership agreement and a buyout agreement.
Unfortunately, after four excellent years, the restaurant bombed. As a result, Bryan lost all his passion for food service and sought a new career. However, Bryan was worried about losing his ownership interest and going broke while he looked for a new gig he was passionate about.
Rich and Ryan consulted the partnership agreement and reviewed the buyout terms in the agreement they created years ago. Since the agreement featured clear terms that the three partners had agreed on, Rich and Ryan could buy out Bryan successfully, and all parties remained happy.
A buyout can still occur if the partnership agreement does not include a buyout plan. However, the process will be more challenging, and the partners should contact a skilled attorney for help negotiating the terms of the deal.
When Forming a General Partnership, What Other Steps Are Necessary?
New business partners are often excited to begin working, but starting normal company activity is only a fraction of the partnership setup process. Here are a few actions that busy partners sometimes overlook when starting a partnership:
- Draft a partnership agreement. Do not just verbally agree on vague concepts. Instead, take this task seriously and create a detailed, written document.
- Reserve the business name and decide if the company will feature the partners’ names or use a DBA name. Contact local and state governments as needed.
- Get a business license. This act is important because companies that do business without proper licensing can be shut down.
- Register for a taxpayer ID number and a federal EIN
- Ensure that the business, depending on its type, has the correct licenses and permits. For example, a restaurant requires different permits than a clothing store.
- Ensure the business abides by the state’s specific rules, requirements and regulations. For example, each state has different rules for establishing new companies and how these companies can conduct business.
What is the Meant By Term Partnership?
How long the partnership will last is up to the members. At-will partnerships do not have an end date; rather, they go on until the partners agree on dissolution.
Some business partners agree to specify a certain period for the business, known as a term partnership.
Term partnerships dictate how long the company will last, but they also ask partners to pledge to remain partners during that time. If partners do not include these periods in the partnership agreement, the company is known as “at-will.”
Company partners can dissolve at-will partnerships at any time, and usually, the partners turn to the partnership agreement for instruction on the process.
For example, Pablo and Shaquille form a landscaping partnership, and both partners agree that the company will last until the end of the summer when the last lawn is complete.
Pablo and Shaquille have created a term partnership, and both men are responsible for staying with the company and remaining partners until the company’s tenure ends.
However, Pablo and Shaquille’s agreement does not specifically state that their partnership must end when the last lawn is complete. If the agreement states that the partnership was over at that point, the partnership is considered at will. Therefore, Pablo and Shaquille could leave at any time without penalty.
How Can Partners End a Partnership?
Written Agreements Matter
Partners can terminate partnerships in different ways, and the deciding factor is whether the business has a written agreement to fall back on or not.
One partner may dissociate and terminate the partnership if there is no partnership agreement. When a business partner dissociates, they tell the other partners that they want to leave.
When a written agreement exists, the ending of the business depends on the document. Sometimes, an event occurs that triggers dissolution, for example. Other times, the partners terminate the partnership for a specific reason.
Written agreements often provide useful instructions for ending the partnership.
For example, Rex, Gary, and Miles have a partnership agreement that explicitly dictates that if one partner wishes to leave, the other two partners can and should continue with the business unless the business is not profitable. Therefore, when Gary dissociates, Rex and Miles continue with the company, and everyone understands why.
However, leaving a general partnership is not overly complex, even without a written agreement. However, the partner should know that when they leave, they will still be liable for obligations the business collected while the partner was present.
The Challenges of Termination
When one or more partners decide the time has come to an end, it is not as simple as a handshake or a signature. First, the company must be “wound down.”
Winding down a business usually consists of the following:
- Paying debts and liabilities
- Fulfilling all obligations that are left
For example, Nick and Manny run an auto-supply store and are general partners. When they decide to wind down the business, they follow the terms of their partnership agreement. However, before closing the shop’s doors, they must fulfill all remaining orders, ensure that their suppliers are paid off, pay off all bills and credit accounts, and notify all clients and customers that they have fixed their last brake pads.
General partnerships are easy to form, but they saddle their members with personal liabilities for their company obligations. These debts are one drawback to the general partnership structure, and all company owners must decide if a general partnership makes sense for their business career.
Dissolution Actions and Conditions
In general partnerships, the partners may choose to dissociate at any time. However, certain actions can trigger dissolution, as well. These include:
- The company can’t continue doing business
- The wind-up process has begun
- There has been a change in the partners
- A partner has died or retired
- The company’s activity is illegal
- A court order was filed for misconduct or violation of the partnership terms
The above terms are subject to change by the partnership agreement. Also, when partners wrongfully dissolve a general partnership, the remaining partners can continue with the company and partnership.
In most states, a partnership interest cannot be transferred or passed to an individual’s relatives or heirs when a partnership dissolves. However, after one partner dissociates, most states allow partners to attempt to reform the business and continue after selling off the departing partner’s interests.
Additionally, when partners pass away, become incapacitated, or transfer their interests for some other reasons, the other partners may be able to legally dissociate. However, exceptions include circumstances when a partner dissociates from incapacitating; in this case, the company may not automatically dissolve.
For example, Colin and Casey form a partnership, and in the partnership agreement, they stipulate that either partner can leave the business at any time they desire. The agreement also contains instructions for how the company can continue and how existing partners can buy out the departing partner’s shares.
Colin and Casey were wise to include these provisions in their partnership agreement. If these provisions did not exist and one of the partners decided to leave, the partnership would dissolve.
Partnership agreements allow partners to change the company’s default rules, which is one reason why these documents are vital to a healthy company.
Who Owns a General Partnership?
The business partners own general partnerships and reach a consensus regarding each member’s ownership share. Normally, partnership agreements include these percentages.
If a partnership agreement does not exist, then the partners must abide by default partnership rules which give each partner equal ownership over the company. Equal ownership rights allow all partners to share losses and profits unless otherwise agreed upon.
Default ownership interests cannot be shifted to third parties without the consent of all company partners. Trying an unapproved transfer of an ownership interest can mean the dissolution of the partnership.
For example, Ziggy and Bob decide to sell flowers together. The two men form their general partnership quickly and do not sign a partnership agreement. Therefore, the default rules of general partnerships say that Bob and Ziggy are equal owners of the business.
However, after a year, Ziggy and Bob have a meeting and agree that they have different business strategies and goals. Bob wants to be very hands-on and spend all his time nurturing their flower shop, while Ziggy would prefer to work 2-3 days a week and contribute more assets than hours.
After a week of negotiation, Ziggy and Bob sign a new partnership document. The agreement establishes Bob as 80% owner of the business and Ziggy as 20% owner. Therefore, they have replaced the default rules with what they feel works best for them.
Whom Manages Businesses Classified As General Partnerships?
The general partners of a business control the entity, meaning that the partners possess the following:
- The ability to make business decisions
- The ability to govern the partnership
- The ability to dictate the partnership’s strategy
- The ability to act as a general agent for the business
The partners also have the right to add provisions to the partnership agreement that can alter or reduce a partner’s influence. All partners are, however, able to:
- Engage in transactions with third parties
- Engage in relationships with third parties, such as sales agreements, loans, or contracts
If the partnership agreement addresses the third parties, the partners may be able to stop these acts from occurring or help limit the partner’s ability to make these transactions. However, in some cases, the partners need to notify third parties.
For example, Mildred and Andy form a general partnership when the two discover their mutual love of plants and open a plant shop in Beverly Hills, CA.
Based on the rules of their partnership, Mildred and Andy have a shared, equal right to make partnership decisions and therefore shape their company’s path. So, for example, if Mildred meets with a plant seller and decides on a purchase contract, that act is within her means.
Even if the partnership agreement limits Mildred’s authority in select ways, it does not limit her authority to act with third parties.
If Mildred makes too many purchases and Andy wants to limit her authority with third parties, he would have to provide notice of a new agreement to those third parties. Therefore, Andy would need to speak with Mildred, and the two entrepreneurs must agree that Mildred’s spending is out of control and hurting the business.
What Are Partners’ Normal Responsibilities in a General Partnership?
While advantageous for many entrepreneurs, general partnerships also come with obligations for each member. For example, as a member of a general partnership, an individual has a responsibility to preserve the sanctity of the business and act in full support of it. These obligations are important and are known as fiduciary duties.
Fiduciary responsibility means that business partners must consider the partnership’s interests before considering their own interests.
For example, Victor and Sonny opened an investment firm as general partners. One investor, Vivian, comes to the office and speaks with Sonny about Sonny working for her. Vivian wants Victor to use his expertise as her financial advisor.
As Sonny thinks about how the extra money could help his family, Vivian also informs him that she does not like Victor and does not want Victor handling her funds. Vivian asks Sonny if he can be the only one to invest for her, and she does not want Victor to receive any profits from her investments, either.
Sonny realizes that although a family vacation sounds great this year, he cannot violate his fiduciary duty to the business and his trusted partner Victor. If Sonny takes Vivian as a private client, he will breach his fiduciary agreement. He will also be, he explains to Vivian, violating his professional relationship with Victor, not to mention his friendship.
Vivian is not pleased, but Sonny has made the correct decision. Business partners are often tempted by opportunistic clients and opportunities for careless investments. However, if Sonny decided to work one-on-one with Vivian, he would risk exposing his new general partnership to debts and liabilities that could doom the business and damage the firm’s reputation.
Sonny tells Vivian not only must he refuse her request, but he does not think he should continue doing business with her. Sonny then tells Victor about Vivian’s request, and Victor admits that Vivian tried the same thing on him last week. The two partners agree to end all business transactions with Vivian and search for an honest, well-intentioned client to replace her.
What is the Personal Liability of General Partners?
General partnerships, like sole proprietorships, do not offer the company members personal liability protection. In general partnerships, each partner is then responsible for the debts and obligations of the company.
Furthermore, each partner is liable for the company’s total debt if it comes to that. Plus, the partners are liable for all debts if the business goes bankrupt. These unique concepts are known as several liability and joint liability.
Additionally, the partners are responsible for any tortious conduct related to the company or its members and liable for any obligations by company agents.
The liability may still stand even if a partner supersedes the authority established in the partnership agreement. Therefore, based on all of these factors, general partnerships contain an element of risk for partners.
For example, Cian and Ryder form a new partnership delivering fruit and vegetables to urban areas. The two men hire an employee, Fitz, to drive the delivery truck. However, Fitz is reckless, and on his second delivery, he hits another car and injures the driver.
Unfortunately, the injured woman takes legal action against Fitz. If the lawsuit goes through and Fitz receives a judgment against the company, then Cian and Ryder will be personally responsible for this new business debt. Since the company is brand-new, the two farmers might not have the money or assets to pay the debt. In this case, Cian and Ryder’s assets would be at risk.
How Are General Partners Paid?
Company partners receive a “draw” of the company funds, typically profits. This draw is also called a “distributive share.”
The draw’s amount usually depends on the ownership percentage of the partner. However, some partners create provisions that allocate profit distributions differently. When they do so, partners can agree to receive a higher percentage of profits or losses if all members agree. However, changing the ownership structure must be justified.
For example, if Ted works 20 more hours per week than the other partners, the company may see that he receives a higher percentage of company profits. In this case, the other partners already work 75 hours a week and do not want to spend more time at the office; they also do not have any problem with Ted receiving a higher draw for his efforts.
General partners, however, cannot receive their profit distribution through a salary. Only employees who are not partners may receive a salary.
Regarding taxes, general partnerships are advantageous because profits and losses can be freely allocated. This advantage means that partners’ entitlement to profits and losses does not have to relate to the rate of the partner’s ownership interest.
For example, Jen and Rosco form an equally owned partnership: a food truck. The two partners hire one worker named Ziggy.
At the end of its first year in business, the food truck has made $50,000. Ziggy was paid $5,000 based on his salary, and Jen and Rosco each received $10,000 based on their draws. Even though Jen and Rosco work in the food truck, deal with suppliers, and even sometimes serve tasty sandwiches, the two owners are not salaried.
What is a special allocation, and how does it work?
In general partnerships, each partner, by default, has equal ownership over the partnership, and they share in profits and losses. However, some partners add unique provisions to the partnership agreement to change how the partners distribute the money within the business. These changes are known as “special allocations.”
For example, Gilly and Wendy own a small massage parlor. They are equal owners, and each owner provides massage services to clients. However, Wendy is more of an expert masseuse, and Gilly is just learning the ropes.
Since Wendy works longer hours and also spends time teaching Gilly how to execute a proper massage, the two partners decide that the default payment structure will not work for them. Instead, they use the special allocation to pay Wendy more for her extra hours and efforts.
Importantly, companies must be able to justify to the IRS why they used a special allocation. If there is no valid reason for a unique loss or profit allocation, there could be problems during tax time.
Consult an accountant or a business lawyer if you have questions about using the special allocation for your partnership.
How is a Partnership Taxed?
General partnerships use “flow-through” taxation. The partnership subtracts expenses from revenue to equal profits and losses.
Then, the partners must report their shares of losses or profits from the partnership on their tax returns. In addition, the general partnership has to fill out a tax return called IRS Form 1065.
Again, an accountant, tax specialist, or business lawyer can help answer questions regarding the tax reporting process for general partnerships.
For example, Norman and Jimmy form a general partnership: the two men sell outdoor grills. Grilling is popular this year, and the partnership makes $50,000 in its first year.
Norman and Jim, as equal partners, are entitled to $25,000 each, which is the amount they will report on their individual tax returns in the form of K-1 forms. However, Jim and Norman cannot forget that the partnership also has to file an informational tax return, informing the IRS of its yearly revenue.
Norman and Jimmy file the K-1 for the partnership first and send it to the IRS, the state revenue department, and each other as partners. Then, the IRS sends Norman and Jimmy their forms.
The tax process for general partnerships can be complex at first, so we recommend contacting an experienced business attorney for help.
When Should General Partners Call a California Business Litigation Attorney?
At Nakase Wade, our California corporate attorneys and business lawyers help general partners navigate all challenges, from creating a partnership agreement to filing taxes and even dissolving the partnership.
General partnerships are popular among business partners in all industries, but that does not mean that they are always easy to maintain and run. From the moment you begin to form your general partnership, you need a business lawyer on your side whom you can trust.
From disputes among partners to figuring out special allocations to amending partnership agreements, general partners face their share of challenges when managing the business. At Nakase Wade, we will answer your questions and provide the correct information for moving forward. While running a partnership can be difficult, finding a skilled attorney who understands your business goals should be easy. Our attorneys recognize that general partnerships are only as strong as the individuals who create them and that each individual is a trusted, valuable team member.
Contact Nakase Wade today for a free consultation. We had worked with numerous general partners before and ensured that their companies got started on the right foot and continued to run smoothly.
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