- April 7, 2016
- Posted by: Seth Heyman
- Categories: Business Law, Startups
General Partnerships vs. Limited Partnerships
Tony decides he needs help opening his online shoe store. He calls his old friend Steve, a marketing guru, who agrees to provide him with marketing services in return for a cut of the profits. He also reaches out to his accountant friend Thor, who agrees to handle the company’s finances. Tony, Steve, and Thor have just formed a partnership. Without doing anything more, theirs is a general partnership. If they take a few additional steps, they can make it a limited partnership. Here is a brief description of each of these arrangements, together with their respective advantages and disadvantages.
A general partnership is formed whenever two or more people come together for the purpose of conducting a common business. As Tony, Steve, and Thor decide to form their partnership, they must agree on which duties each will take on and what percentage ownership they will each hold. Typically this is done with a partnership agreement drafted by a competent attorney, but all too often this crucial step is overlooked. Partnership agreements aside, general partnerships have the following advantages and disadvantages:
General Partnership Advantages
Ease of Formation: All it takes to form a general partnership is a verbal or written agreement to start a business together. There are no filing requirements, annual statements, or additional formalities .
Cost: Although the services of an attorney are recommended, they are not required to form a partnership, and there are no filing fees imposed by the secretary of state.
Taxes: The profits and losses of the business pass through to each partner in accordance with their ownership percentage.
General Partnership Disadvantages
Personal Liability: Each general partner is personally responsible for all the debts and obligations of the business. This means that if Tony makes a mistake, Steve and Thor may be held responsible.
Lack of Continuity: Partnerships can only exist with two or more people. If Steve and Thor decide to quit the partnership, it is dissolved as a matter of law.
Lack of Investment Flexibility: General partnerships are usually financed through capital contributions of the partners, or by debt. They can only use limited partners to raise money for the partnership without giving up management responsibility.
Limited partnerships are composed of a minimum of two types of participants: general partners and limited partners. General partners accept the responsibility for and take all the risks associated with the business. Limited partners are investors who share the risk of their investment, but have no participation in the management of the business; they simply sit back and enjoy the profits and suffer the losses that are set forth in the partnership agreement. Limited partnerships have the following advantages and disadvantages:
Limited Partnership Advantages
Investment Flexibility: A limited partnership can raise additional capital by adding more limited partners.
Charging Orders: If a money judgment is entered against a person with interest in a limited partnership, that person will have to disclose their interest in the limited partnership. The Plaintiff’s attorney can file a judgment lien against that person’s interest. However, most attorneys will not have their clients take this kind of lien because the general partner controls the distribution of profits that come out of the limited partnership. If the general partner sees that a creditor has taken ownership of a limited partner’s interest, he or she can simply elect not to distribute profits, yet still send a K-1 distribution report to the IRS that states that the creditor is responsible for the tax obligation of the distribution that never took place.
Taxes: As with a general partnership, the profits and losses of a limited partnership pass through to each partner in accordance with their ownership percentage.
General Partnership Disadvantages
Personal Liability: The general partner is fully liable for the obligations of the business, although the general partner can minimize this disadvantage by incorporating.
Lack of Control: Limited partners are legally precluded from participating in the management of the business. If a limited partner believes that the general partner is running the business to the ground, there’s nothing he or she can do about it.
Lack of Investment Flexibility: The only way to raise capital is to bring on additional limited partners.