Partnership

PARTNERSHIP: The Pros and Cons

by Mary Hanson

No written agreement is required to form a partnership. Although entering into a written agreement is one way to form a partnership, a partnership may be formed through the actions of the partners, or even appearances, as they operate the business together. Even if individuals have an agreement that says "we are not a partnership," the law may find that there is a partnership, and hold one or more partners liable for some business-related obligation.

The simplicity and flexibility in creating a partnership may be one of the main advantages of the partnership as a form of business. However, the disadvantages of simplicity and flexibility must be carefully considered.

Although an agreement is not required, without a written agreement, partners cannot determine their rights, duties, obligations, and liabilities, except for what is covered by state law. This is not normally enough, since the law on partnerships is not detailed (especially compared to the law on corporations, which sets out the rights and duties of shareholders, officers, and directors in detail). California's new partnership law, which went into effect on January 1, 1997, provides more clarifying law on the rights and obligations of partners and partnerships, but even with these changes, the law on partnerships is still not thorough enough to establish all rights and duties. This allows partners a great deal of flexibility to structure the business as they would like it. But it leaves many questions unanswered if there is not an adequate written agreement setting out the details.

The other main attraction to the partnership as a form of business is partnership tax treatment. From a tax standpoint, the partnership is as straightforward as the sole proprietorship. There is no tax at the partnership level. All tax consequences are passed through to the individual partners. The benefit of this pass-through tax treatment is that there is only one level of tax.

Even this pass-through feature which is so often desired has a negative side. The negative side is that if a business is reinvesting profits into non-tax-deductible expenses, the partnership may show taxable income but have no cash. Each individual will have to pay taxes on the taxable income from the partnership reported on the individual's tax return - even though no income is distributed to the partner from the partnership!

Partnership Risks

The risks of operating as a partnership include both legal issues and business issues. From a legal standpoint, partners are exposed to liability in a manner that is often unacceptable. From a business operation standpoint, co-ownership of a business with one or more partners can be so difficult that the business cannot succeed.

First, the legal concerns include the following:

* Under the law, partners are agents of the partnership, and as an agent, each has authority to act on behalf of the partnership. A partner can enter into binding agreements, hire and fire employees, accept orders, extend credit, etc. One partner's poor business decision making, poor judgment, poor negotiation ability, or poor management ability can doom the partnership and also expose all partners to significant liability.

* Partners face "joint and several liability," which means that each partner is personally liable for the full amount of any obligation of the business. Even if a partner has only a small percentage ownership, he or she can be held responsible for 100% of a partnership liability. A partner can be held liable for partnership liabilities due to contracts, debts, taxes, employment, or claims arising from product liability, accidents, services rendered by the business, or even acts of other partners on behalf of the business.

* Partnership law does not adequately set out the rights or obligations of partners. Without a thorough partnership agreement, a partner can find that he or she has no right to insist that another partner perform work, work certain hours, protect confidential information, contribute additional capital, reimburse the partnership for liabilities, etc.

* Partnership law does not protect your investment in a partnership, unless you can prove that your partner violated the law, defrauded you, or engaged in criminal acts. While the law may protect you from fraud by a partner, it will not protect you from mere incompetence in operating a business.

* Once you have operated a business as a partnership, you are not free to walk away and start up the same business on your own if things don’t work out. The customers, goodwill, and other aspects of the business belong to the partnership and cannot legally be taken by one of the partners.

In addition to legal risks associated with operating as a partnership, there are many potential difficulties that can arise in trying to operate a business with partners. The following are a few of the most common problems:

* Decision making can be difficult. You and your partner may not agree on how to run the business. You may find that your partner is making decisions and implementing changes on his or her own, without your concurrence. Or you may be the one who wishes to make quick decisions, while your partner insists on meetings to analyze each decision.

* Your partner may have difficulty dealing with employees, vendors, customers, or others. He or she may interact with others in a manner that you find inappropriate.

* Your partner may have different values. Your partner may not work as hard as you do. He or she may wish to operate the business in a different way or in a way you consider unacceptable. Your reputation may even be harmed by the actions or reputation of a partner.

* Your partner may not have the capability or competence he or she seemed to have before you went into business together. Or the capability he or she has in one area, such as sales, may not be enough when the business faces challenges in other areas such as finance, marketing, or personnel management.

* Your business may be too small to support more than one owner. If you are working hard and your partner's efforts are less effective, will you both still take the same compensation? What if that level of compensation is satisfactory to your partner, but not enough for you?

Alternatives

There are other ways to set up a business as alternatives to partnership. The first and best alternative is going into business alone. Do you really need a partner to get into the business? If you feel that having a partner seems more secure or comfortable, I can assure you the partner will become a source of discomfort and insecurity.

If the partner will provide funds that are truly unavailable unless you go into this business as a partnership, then you need to review the pros and cons of going ahead with co-ownership. Make sure the amount of funds is enough to justify the co-ownership relationship, and make sure the relationship will only be entered into if all the funds are contributed. If you decide on co-ownership, consider alternative forms of business other than the partnership form.

Another alternative to co-ownership is a contract for services. If the partner is to provide services, a contract for those services should be considered. Many business partnerships could have been structured as contracts between the parties. By having contracts between the parties, the difficulties of partnership and co-ownership are avoided. In addition, if the other party does not perform, the contract can be terminated and free you up to engage the services of someone who can and will provide the required services.

As a rule, don't get into a partnership unless you absolutely have to. Don't even get into an incorporated business or other business entity with others as co-owners unless you absolutely have to.

Only go into a partnership if the arrangement meets the following criteria:

* A thorough partnership agreement has been agreed upon. It will be executed before beginning business as a partnership and all funds will be contributed at that time.

* You know (and the agreement makes clear) what your partner must put into the partnership, as contributed funds, services, and responsibilities. In your opinion, the partner does have the skills, contacts, assets, or financial strength that he or she is to provide to the partnership.

* You know (and the agreement makes clear) what you will get out of the partnership as compensation, distribution of profits, and management control.

* You understand what your partner thinks and hopes he or she will get out of the relationship (and it makes sense to you).

The End

** Note on the new California partnership law **

This article on partnerships does not go into detail on California's new partnership law. If you deal with businesses who are (or wish to be) partnerships, you should review the new partnership law. It introduces some major changes in partnership law in California. The law also provides that after January 1, 1999 all general partnerships (no matter when they were formed or what the law was when they were formed) will be governed by the new law.

Mary Hanson, MBA, Attorney at Law (310) 543-1355 Torrance (Los Angeles County), California USA