Tag Archives: Partnership

Partnership Formation: Basics

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As I mentioned in a previous article, a partnership is the presumed business entity when two or more people operate a business together for a profit. In its simplest form, this means that two people selling fruit on the side of the road and splitting the profits operate a partnership. This presumed partnership structure is governed by state statutes and may provide some unfavorable terms, for example even though one partner contributed 99% of the capital, the profits must be split equally. To remedy this issue states, permit parties to a business to create partnership agreements that control how the partnership will operate rather than the gap filler provisions of state law. 

An oral agreement to conduct a partnership may be valid but will be subject to the Statute of Frauds and so should generally be avoided. If the business of the partnership involves those subjects addressed by the Statute of Frauds, then the partnership agreement and contracts derived from that agreement must comply with the statute. Due to concerns about enforceability and fraud, contracts and agreements regarding the sale of goods, transactions in lands, creation or modification of debt, or work that cannot be completed within a year should be in writing. That is not to say partnerships and contracts created by oral agreement are ineffective, rather they will be harder to enforce if an issue arises. 

Some partnerships like the limited partnership or limited cannot be formed without the use of a written agreement. Those partnerships must comply with statutory requirements which often involve submitting the partnership agreement to the Secretary of State to obtain limited liability status.   

Partnership formation is fairly simple, as it can be created with very little formality, however, there are a few things to consider before forming a partnership or before entering a business arrangement that could be classified as a partnership. 

This is a checklist listing some information to consider and address before forming a general partnership.

  1. Who are the Partners?
    1. What is the full name, legal and how are they known in the community
    2. What are the financial resources and/ or liabilities that they currently have or will contribute to the partnership?
    3. What is their family circumstance? (Are they married, divorces, estranged, expecting children, etc. Each can substantially impact the business. If a partner is getting divorced they may be forced to liquidate their interest in the partnership.)
    4. What are the relevant skills or experiences of each partner?
  2. What is the business?
    1. What business activities are anticipated now and in the future?
    2. What is the name of the partnership? Is that name available?
    3. What is the primary location of the business? Are there other locations where the business will operate?
    4. What will the business need to start?
    5. What will the business need to operate? What buildings, equipment, inventory will be necessary to maintain the business?
    6. How will business assets be acquired? Will partners contribute cash, property, or services and how will those be used to acquire assets? Will the partnership buy equipment, lease it, or will it be part of a capital contribution?
    7. How much cash will the business need to start up? How much will it need during the first month, six months, and year? What reserves will it need if there is a delay in cash flow?
    8. If the business expands in the future, how will that be accomplished? Will that funding come from profits, borrowing, or contributions by partners?
  3. What are the important dates for the partnership?
    1. When will the business begin?
    2. How long will the business operate? 
    3. Are there specific dates or events that will cause the business to terminate?
  4. What about Capital?
    1. What property, cash or otherwise, will each partner contribute, and when? If partners contribute services, what is the value of those services and what are the tax implications?
    2. How will value be determined by contributed property or services? How will liabilities associated with that property be apportioned between partners?
    3. How will additional contributions or withdrawals from the partnership operate? If partners are withdrawing some or all of their contributions, can that happen before the business is dissolved and wound up?
    4. How and who will determine whether additional contributions will be required?
    5. If partners are unable to make the required contribution, will collateral security be an alternative?
    6. What are the rights of partners and the partnership if a partner defaults on the contribution?
    7. Should partners receive interest on their contributions? (Unless provided in a partnership agreement most state laws do not require this treatment.)
    8. Can partners lend money to the partnership? What are the terms and conditions for such lending?
  5. How will distributions be handled?
    1. How often will distributions occur? How much or what percentage of available cash will be distributed? How will those amounts and dates be determined and by who?
    2. Can property be distributed rather than cash? If so how will liabilities be handled?
    3. How will refinancing, sale, or other capital proceeds be distributed if different than cash?
    4. Are there minimum guaranteed returns or preferred returns for partner contributions?
    5. Will partners receive a salary or its equivalent? Can partners draw against future distributions?
    6. Are partners entitled to reimbursement for ordinary business expenses?
  6. How will profits, losses, and taxes be treated?
    1. How will profits be divided among partners, and will those allocations remain constant or will they change during the life of the partnership? If they change, what is the triggering event?
    2. How will losses be allocated? Will losses be allocated based on the partner’s share of profits, initial contributions, equally, or some other formula? Will loss allocations change during the life of the partnership? If so, what will trigger that change?
    3. Will partners have special tax allocations or treatments? (This tends to cause a lot of taxing problems after the first couple of years. If it may be an issue, talk to a qualified accountant and or tax attorney for advice.)
    4. Will any tax items be specially allocated to one or more partners? (See above)
    5. How will profits, losses, and tax items be allocated between assignors or assignees of partnership interests?
  7. How will the accounting and banking be handled?
    1. What will be the fiscal and tax years of the partnership?
    2. How will partnership books be maintained? Will the partnership use an accrual or cash basis? Who will be the primary bookkeeper?
    3. What financial statements will be provided to the partners and how frequently? (In addition to the requirements of State and Federal laws.)
    4. Will the partnership have periodic audits, reviews, or investigations by accounting firms? If so, when, how will they be accomplished, and how will they be financed?
    5. What are the rights of partners to access or copy the books and records of the partnership?
    6. Where will deposit accounts be maintained and who will have signature authority? Will the partnership have investment accounts, if so with whom and who will have control?
  8. How will the partnership be controlled or managed?
    1. What are the rights of partners to management? Will partners have an equal voice, will all decisions or certain decisions require unanimous consent, will decisions be made by managing partner(s) or by a majority/ supermajority in number or interest of partners?
    2. What authority will partners have? Will all or only some partners have the authority to bind the partnership?
    3. What will be the process to select or remove managing partners?
    4. What bond or other security will be required to be a partner?
    5. How will partner meetings be held, when, where, and who can call a meeting? (Additional notice and quorum requirements should be considered.)
    6. What rights do partners or the partnership have to indemnification by the other? What requirements or procedures should operate as a prerequisite to indemnification?
    7. What additional agreements or other actions will be permitted or forbidden by the partnership agreement?
    8. How much time must partners dedicate to the business and what other activities may partners engage in, including competing activities?
    9. How will disputes be resolved and is there a preferred method, such as litigation, mediation, arbitration, etc?
  9. How will new partners be admitted or partner interests be transferred?
    1. What are the conditions for a new or additional partner to be admitted?
    2. What are the restrictions on the sale, transfer, encumbrance of partnership interests?
    3. What are the rights of assignors or assignees of a partnership interest, and under what conditions will an assignee become a substitute partner?
    4. Will partners or the partnership be given a right of first refusal before assignments or transfers of partner’s interests occur?
  10. How will partners withdraw or be expelled from the partnership?
    1. What provisions are needed to expel a partner, on what grounds, and by what method?
    2. Can partners withdraw from the partnership? If so what notice is required?
    3. What activities may a withdrawing or expelled partner engage or be prohibited from engaging in, eg starting a competing business?
    4. What will happen to the business in the event a partner dies, becomes disabled, is expelled, files for bankruptcy, withdraws or otherwise disassociates with the partnership? What options are available to the remaining partners? May they continue the partnership or liquidate it? If the partnership continues, how long may the disassociated partner or estate participate in the management and business of the partnership, and may their interest be purchased?
    5. What right will partner’s have to purchase the interest of a deceased, disabled, expelled, bankrupt, or withdrawing partner, and whether the partnership may be a purchaser?
    6. How will the purchase price of a partnership interest be determined? 
    7. How will payment of the purchase price be made and whether security for future payments will be required?
    8. What rights do former partners have for indemnity against future liabilities or will they remain liable for their share of all or some liability? Will funds be withheld from the purchase price of a partnership interest to address contingent claims?
  11. What are the requirements for Life insurance?
    1. Are partners required to purchase life insurance and name the partnership as beneficiary? May the partnership purchase life insurance for its partners?
    2. How will uninsured partners be treated?
  12. What happens when the partnership winds up and liquidates?
    1. What acts other than the expiration of the term of the partnership will result in liquidation and winding up of the partnership? Examples include an agreement by a certain number or percentage of partners, sale of all or substantially all the partnership assets, the death, disability, bankruptcy, withdrawal, or expulsion of a partners. What will happen while winding up and what rights do partners have to continue the business or purchase the interest of an affected partner?
    2. What are partners entitled to on liquidation of partnership assets? Do liquidators receive special compensations?
    3. What are the rights of partners to specific property on liquidation?
    4. What property may be distributed in kind and whether property may be distributed disproportionally or subject to liabilities?
    5. What priority will partners have to distribute property on winding up and liquidation?

The Basics: Simple Types of Business Organizations

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If you are anything like me, you might be confused about different forms of business entity. Law school students and attorneys frequently stumble when faced with a new or unfamiliar form of business structure, and with the frequency of changes in the law, this situation occurs more often than you might think. Business organizations or associations, depending on where you live, is an area of law that focuses on the rules involved in the formation and operation of different business types. Courses on this subject are taught in many law schools and it is a frequently tested subject on the bar. It is often overlooked by students in law school and by entrepreneurs who do not appreciate the importance of the subject.

To resolve some of that confusion this post will address four very simple types of business. This is by no means an exhaustive description and these businesses differ from state to state, however, these businesses are widely recognized.

As a brief introduction, there are two different ways to form a business. First, an individual or group of people can simply start doing business. Second, an individual or group of people can file documents with a government agency, typically the IRS and their state’s Secretary of State, to form a business. The first way is free, however, it does not protect the owners from common issues like liability, improper actions by employees, tax issues, etc. The second type requires a little more thought and a filing fee or two but allows greater protection because it lets the business owners set the rules of the business. This is a huge benefit because courts examining a business entity will often rely on old inflexible rules that may run contrary to what the business owners wanted or intended. Let’s jump into the four main groups shall we?

  1. Sole Proprietorship

The Sole Proprietorship is one of the simplest business organization. The sole requirement, (no pun intended) is that an individual begins doing business. This could be complicated web development, the opposite of what I do, or the individual may start selling things at the local flea market. The essential component is that they are the sole owner of the business and they are doing business. The IRS has a slightly different definition, but one that for all intents and purposes is the same. It reads: “A sole proprietor is someone who owns an unincorporated business by himself or herself.”

Sole proprietors are liable for almost everything. Because there is no separation between the owner and the business the owner is responsible for any violation of law, or harm that he or she causes. Individuals who sue the business may collect from the business and if the business doesn’t have enough money then the individuals can collect from the business owner. This means that business owner is also responsible for their employees, and are liable for the taxes and fees associated with those employees.

The sole proprietorship is very good for individuals who don’t want to go through the hassle of filing multiple tax returns. All of the profit and loss of the sole proprietorship is passed on to the business owner.

2. Partnership

Partnerships are the multi-person compliment to the sole proprietorship. A general partnership is formed when two or more people start a business together, so long as ownership is shared between them. However, people may form limited partnerships by agreeing to certain rules that govern the relationship between the partners. Ownership is split proportionate to the number of partners, so if there are two partners then ownership is 50/50.

In a general partnership every member is liable. This means that creditors, like the IRS or people who have sued the partnership, can collect from the assets of the partnership and if there is not enough money in the assets, they can then collect from the partners as well. To prevent this result a lot of partnerships choose to file as limited partnerships (lp) of limited liability partnerships (llp) because they can limit their liability to the assets of the partnership. Put simply, the partners will only lose what they have put in.

Partnerships pass their income to the partners. So the partnership does not pay any tax instead the partners pay their income tax on their portion of the partnership income. However, partnerships can choose to be taxed like corporations which means the partnership pays tax on what it has made and then the individual partners pay additional tax on what they are paid by the partnership.

3. LLC (Limited Liability Company)

The LLC is a fairly new business organization. Unlike the previous two, it has existed for the past 43 years. LLC stands for Limited Liability Company, if you mistakenly say corporation you will receive odd looks and a few eye rolls. The LLC is created by filing paperwork with the state. This differs from state to state however most states require that the business owners file with the state’s secretary of state. Along with basic information about the business including its purpose, name, and some contact information, the business must also have articles/certificate of organization, this is essentially the founding document.

LLCs limit the liability of the owners. The owners are usually liable up to the amount of the LLC’s assets. This is very useful especially for businesses that operate in riskier areas, where they are more likely to be sued.

LLCs may be taxed as a corporation or as a partnership, however, the default rule is that they will be taxed as partnerships. So, the LLC’s owners pay the taxes for the LLC through their personal income tax. The LLC’s profit passes through to the owners, is treated as a wage or salary.

4. Corporations

Corporations are well known and both hated and loved. People love to own stock of corporations but hate what corporations do. Corporations function similarly to an LLC. They are formed by filing specific paperwork. These documents include the article of incorporation (aka the founding document), Bylaws (the rules), and other agreements or documents as necessary. At the same time as the filing of the articles of incorporation with the Secretary of State, the corporation must sell its stock. Stock is ownership in the business. Stock is often referred to as shares or securities, and it represents a right to vote and be paid for that ownership.

The owners, or shareholders, of a corporation have limited liability. They cannot be required to pay more than the what they have already contributed to the company. For example, corporations like Purdue pharmaceutical have been sued repeatedly for their part in the opioid crisis and those companies have lost a lot of money. However, the creditors, or the people suing, are limited in the amount of money they can get, they cannot collect from the owners of the stock after they have exhausted all of the companies money.

Corporations are subject to double taxation. The corporation is taxed on its profits, and then the shareholders are taxed on the money they receive from the corporation as their share of those profits.

Conclusion:

Each of these business organizations has its own advantages and disadvantages. Sole Proprietorships give the owner absolute control over their business but they are liable for all debts or actions against the business. Partnerships allow a lot of control but are also liable for almost everything. LLCs limit liability but cost more to make and have limitations on the owners’ ability to control the business. Corporations provide a lot of liability protection however control is as centralized.