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The Case for Forming a Partnership Image

The Case for Forming a Partnership

Posted by: Christopher J. Kamath

Entrepreneurs have many different options for setting up a business in today’s market place. And although corporations and limited liabilities companies are more popular, the partnership is still a useful form of business that allows people with complementary talents and a combined vision to pool their skills, money, and other resources, while also sharing in the risks and financial burdens accompanied by starting a new business.

Types of Partnerships

One of the benefits of using a partnership model over a corporate model or an LLC, is that partnerships tend to be simpler to operate and less costly to create. At its most basic level, a partnership is formed when two or more people carry on as co-owners of a business for profit. There is no requirement of a written agreement between the partners, and unlike corporations and limited liability companies, partners are not required to file organizational documents with the Minnesota Secretary of State.

The default form of partnership in Minnesota is the general partnership. As previously mentioned, no organizational document needs to be filed with the state and no formal written agreement is needed between the partners. Absent such a written agreement, each partner has equal rights to make decisions for the partnership and shares equally in the profits and losses of the partnership. One of the biggest disadvantages of a general partnership is that the partners are jointly and individually liable for all the debts and obligations of the partnership. General partnerships do not provide liability shields.

In contrast, limited partnerships have at least one general partner and one limited partner. The general partners have the ability to make decisions on behalf of the partnership; the limited partners do not have any management or voting rights.  The general partners are still jointly and severally liable for all obligations of the limited partnership, but the personal assets of the limited partners are shielded from the obligations and debts of the limited partnership. Limited partners typically share in the partnership’s liability only up to the amount of their investment in the in the business. In order to establish a limited partnership, the partnership must file a Certificate of Limited Partnership with the Secretary of State.

Both general partnerships and limited partnerships can register with the Secretary of State to create a liability shield to protect the general partners’ personal assets.  These partnerships are referred to as limited liability partnerships (LLP) and limited liability limited partnerships (LLLP). All partnerships are taxed as pass through entities. The partnership’s income, losses, deductions and credits flow through to the individual partners’ returns and are taxed at the individual’s rate.

The Importance of a Partnership Agreement

Assuming you have decided to enter into a partnership, the first thing you and your prospective partner should do is seek professional assistance in preparing a written partnership agreement. A partnership agreement is a legal document that controls the relations among the partners and how the partnership is governed. At a minimum, it is recommended that a partnership agreement describe how profits and losses are allocated to the partners, how new partners are admitted to the partnership, how partners may withdraw from the partnership, whether there are any restrictions on the sale of a partner’s ownership interest in the partnership, and how management conflicts are to be resolved between partners.

The following real-life example demonstrates that it is advisable to spend the time and money necessary to create a written partnership agreement even if the partnership has been operating smoothly for many years without one:

David and his son, Paul, had been farming together through an informal partnership. There was no written agreement formalizing their partnership. After all, they were family and did not feel the need to create a written agreement; both parties understood how the relationship worked.

In 2009, two farmers, Robert and Jeff, approached David about the possibility of combining farming operations. David was getting older and liked the idea of having Robert and Jeff join the partnership so he could become less involved in the day-to-day farming activities; however, the parties agreed to test the waters before entering into a formal partnership.

Robert and Jeff decided to lease their land to David and Paul. In return, David and Paul paid rent on the leased farmland and hired Robert and Jeff as consultants to operate the leased land. Although the combined operation was very successful, the parties’ relationship soured after a couple of years, ending when David and Paul terminated Robert and Jeff as consultants.

Robert and Jeff subsequently sued David and Paul for approximately $6 Million, half of the profits earned during the period of their combined operation. Robert and Jeff alleged that they were entitled to the profits because they were former partners of David’s and Paul’s partnership.  A jury agreed, finding that the parties had entered into an informal partnership.

In Minnesota, two people can form a partnership even if neither of them intended such a partnership to exist. The determining factor is whether or not they carried on as co-owners a business for profit. David and Paul could have potentially avoided the this result by formalizing their partnership at the outset and restricting how individuals become partners.

Conclusion

A partnership is still a useful entity through which to conduct a business because it can be one of the simpler and less expensive ways to co-own a business. With the advent of limited liability partnerships and limited liability limited partnerships, general partners can also enjoy similar liability protections to what members of an LLC receive; however, no matter the type of partnership employed, a written partnership agreement is essential to the long-term success of the business.

This information is general in nature and should not be construed as tax or legal advice.