One was a master of analytics while the other had an unrivaled business foresight. Together, Apple co-founders Steve Wozniak and Steve Jobs formed one of the most successful business partnerships in the history of the United States.
By choosing to form their business as a partnership, Wozniak and Jobs followed the path of millions of entrepreneurs before them. Partnerships are a popular choice for aspiring business owners and in this module, we’ll discuss the laws affecting partnerships, the three different types of partnerships, their features, formation, termination, partners’ roles, and the duties partners owe to one another.
Laws Governing Partnerships
States regulate partnership creation, organization, and dissolution. Model acts, such as the Uniform Partnership Act and the Revised Uniform Partnership Act, have helped states draft partnership laws. State laws based on these model acts are the default rules if there is no partnership agreement and an agreement can circumvent the default.
The UPA, written in 1914, was the first model act providing guidance on partnerships and by the late 1980s, nearly all states had adopted it. Unless a partnership agreement provides otherwise, the UPA requires unanimous agreement among the partners for:
- extraordinary changes to the partnership;
- assigning partnership property to creditors;
- disposing of good will;
- any act that would make it impossible for the partnership to carry on business; and
- adding a new partner
Additionally, UPA states presume that partners will share equally in business
profits, have the right to receive repayment of contributions, will be indemnified for payments made for the partnership and that they will share equally in the partnership’s management.
The Revised UPA, written in 1997, has gradually supplanted UPA across the country. The revised Act is more detailed than the original UPA, but the acts share many similarities. The Revised UPA, however rewrites the rules on partnership breakups and gives more stability to partnerships.
Under the original UPA, if one partner died or left the partnership, the partnership dissolved. Under the Revised UPA, if a partner dies or leaves, the partnership can terminate or the other partners can buy out the dissociating partner’s interest and continue operating the partnership.
There are three types of partnerships: the general partnership, limited partnership and limited liability partnership. When two or more people work with one another to co-own a business for profit, unless they specify otherwise, they form a general partnership.
The only formal documentation necessary to create a general partnership is the partnership agreement. The agreement provides each partnership’s name, purpose, place of business, each partner’s authority, and each’ partner’s responsibilities. The agreement can also document:
- how profits will be shared;
- how ownership interest is shared;
- partners’ authority to bind the partnership and make decisions on its behalf;
- how decisions will be made in case disagreements or deadlocks arise;
- how to determine a purchase price when one partner withdraws from the partnership; and
- how and when will a withdrawing partner be paid
It isn’t difficult for entrepreneurs to draft a partnership agreement. Template agreement forms are readily available and attorney assistance isn’t always necessary. Not taking the time to draft a partnership agreement and specify these key provisions with an agreement causes the state’s default rules to apply.
First, when there is no partnership agreement, all partners will have joint title to property, equal sharing of profit and losses, and equal control and management. For example, Brad and Kelsey form a general partnership to operate a food truck, but they forego drafting a partnership agreement. To start the business, Brad contributes $5,000 while Kelsey contributes $1,000. Is it fair for Brad and Kelsey to equally share the food truck’s profits when Kelsey invested a fifth of Brad’s to start the business? Additionally, based on her capital contribution, is it fair to Kelsey to be equally liable for the partnership’s debts and losses if the food truck business flounders? Because the default rule may cause this incongruous result, the partners would be well advised to adopt a partnership agreement.
Second, without a clearly written partnership agreement, disputes can easily arise regarding partner responsibilities for specific aspects of the business. The partnership agreement will explain how the partners can resolve their differences if a disagreement arises. When there is no provision for dispute resolution, the partners could pay thousands of dollars in legal fees as they go to court to resolve an issue.
Forming a general partnership has an important tax consequence: flow-through, or pass-through, taxation. A partnership does not pay its own federal income tax. Instead, the partnership’s income, losses, deductions and credits pass through to each individual partner who reports these amounts and pays taxes on them, as part of his own individual personal income tax return.
The partnership is required to complete and submit a Form 1065, which is a partnership income tax return. The partnership reports the income allocated to each partner on Schedule K and then distributes a Schedule K-1 to each partner (with copies sent to the IRS), advising of the amount of income allocated to that partner.
Partners may terminate a general partnership for many potential reasons. They could dissolve it because they agreed in advance to dissolve the partnership on a fixed date. Additionally, if partners had formed the partnership for a specific reason, they could dissolve it if, and when, the partnership achieves its goals.
Whatever the reasoning, dissolution consists of several steps. The first is “winding up,” which is the orderly settling of the partnership’s accounts and business affairs. During this phase, partners must complete any outstanding legal and contractual obligations, collect accounts receivables, and settle debts amongst themselves.
When the winding up process is complete, two possibilities arise. First, the partnership’s business may be continued by the remaining partners. If they decide to continue it, all rights and obligations of the dissolving partnership are assigned to the successor partnership.
Alternatively, the partnership could be dissolved and liquidated, and its assets sold. In the event of a rightful dissolution and absent an agreement to the contrary, any partner can force liquidation. In the event of a dissolution, should the remaining partners wish to continue the business, they must unanimously agree to do so.
Even if partners dissolve the partnership, their fiduciary duties and liabilities to creditors and other interested parties continue, though a creditor may choose to discharge a dissociating partner by express or implied agreement.
If there are insufficient assets in the partnership to settle obligations and debts, then they are settled with the following priority. First, all outside creditors must be satisfied. If the partnership’s funds are insufficient to satisfy obligations to outside creditors, then each partner must contribute her own money to satisfy debts.
Second in priority are inside creditors, or partners who contributed their own money to the partnership beyond the original amount invested. For example, Paul, Michael, and Vincent form a general partnership to sell hair styling products. In the partnership agreement, they specified that each would contribute $20,000 to start the business. In the first year of operation, there were unforeseen cost increases for ingredients needed to make hair gel and Paul, the wealthiest of the three, loaned the partnership an additional $10,000 so that it could purchase needed materials. Ten years later, all three decide to dissolve the partnership. After first paying back all outside creditors, the partnership will then have to compensate Paul for his $10,000 loan.
Third, each partner who contributed to it will receive the original amount they invested. Finally, if any partnership funds remain, they are distributed to the partners.
The second type of partnership is a limited partnership, a creation of state statute. A limited partnership will bring together passive investors to raise capital for a business and ensure that they remain in the background, while investors who have managerial talent oversee and operate the business.
The limited partnership is more complex than the general partnership. It consists of two types of partners. One is a general partner, who operates the business and has unlimited personal liability for the partnership’s obligations and one is a limited partner, who is not personally liable to creditors, but also does not have rights to control the partnership. Let’s look at an example.
Jared is a recent film school graduate looking for his first big break in Hollywood. A native Chicagoan and rabid sports fan, he wants to produce a drama based on the Chicago Cubs’ 2016 World Series victory. Despite this zeal for the endeavor, he doesn’t have the capital necessary to get the project off the ground, so he’s looking for investors. Jared, like other filmmakers do, can look to the limited partnership as the business entity to drive funding for the movie. He and his co-producers making the documentary would be the general partners, while any investors who just contribute money would be limited partners. The limited partners wouldn’t need to have active roles in the film-making process and can stay in the background while they provide the money necessary to fund the film. Should the limited partnership incur debt and not get made, or if it bombs at the box office, the limited partners would only be liable to creditors for the amount they contributed and nothing more.
The limited partner doesn’t have any rights to control or manage the partnership, but she does have several other powers. First, she has the right to receive information about the partnership. For example, a general partner may prepare and provide monthly statements to keep a limited partner apprised of finances. Second, the limited partner can provide or withhold consent to any general partner decisions and actions. Third, limited partners can also sue in the name of the limited partnership to enforce rights of the limited partners against the general partners. Finally, a limited partner can vote on whether to allow other partners to join the entity. New partners, whether limited or general, may only be admitted with “the written consent of all partners.”
If the limited partner is “actively participating” in management, she can lose her limited status and a court will treat her like a general partner. This is a factual case-by-case examination. She will also lose her status if a creditor can prove that the limited partner represented herself as a general partner or behaved as though she were a general partner. If a creditor successfully shows active participation, then the limited partner will be fully liable for the creditor’s claims.
Like a general partnership, a limited partnership is a pass-through entity. Unlike a general partnership though, it is more expensive to create and manage because a limited partnership must satisfy strict statutory guidelines. First, in addition to the partnership agreement, the limited partnership must file a certificate of limited partnership with the appropriate state office. Every state has its own requirements for a certificate, but states generally require the partners to include the following information:
- The LP’s name;
- The LP’s principal place of business address;
- The name and residence address of each general partner; and
- The name and address of the LP’s registered agent
Limited Liability Partnership
Browsing through websites for law firms and accounting firms, one will notice that the name of nearly every single one ends with the suffix “LLP.” LLP stands for “limited liability partnership.”
The LLP is a general partnership that registers with a state to provide all partners with limited liability protection. LLPs first appeared in Texas in response to the large amounts of losses general partnerships incurred because of the 1980s’ savings-and-loan crisis. In the crisis’s aftermath, thousands of Texas attorneys had their personal, nonexempt assets seized for their partners’ malpractice. To prevent this from occurring again, attorneys sought legislative changes to limit their vicarious liability. By 1999, all fifty states and the District of Columbia had enacted statutes authorizing LLP registration.
One example of a state LLP statute is Nebraska’s, which provides: “a partner in a registered limited liability partnership is not liable directly or indirectly, including by way of indemnification, contribution, assessment, or otherwise, for debts, obligations, and liabilities of or chargeable to the partnership or another partner or partners, whether in tort, contract, or otherwise, arising from omissions, negligence, wrongful acts, misconduct, or malpractice performed or committed while the partnership is a registered limited liability partnership.”
At its core, a limited liability partnership is a combination of a general partnership and a limited partnership. For example, the government continues to tax partners on a pass-through level and entrepreneurial professionals seeking to form one will draft a partnership agreement. However, unlike the limited partnership, the LLP allows limited partners to actively participate in the business without the risk of becoming personally liable for partnership obligations, or another partner’s liabilities.
States differ in what they require for LLP formation but typically, the additional necessary step to form an LLP is to file an application with the Secretary of State establishing:
- the name of the partnership;
- the address of its principal office;
- the street address of its registered office;
- the name and street address of the registered agent for service of process in the state;
- a brief statement of the business in which the partnership engages;
- any other matters the partnership determines to include; and
- a certificate of registration as a limited liability partnership
The LLP is similar as well to another business entity, called the Limited Liability Company (or, LLC), which we will discuss later.
Partner Fiduciary Duties
Regardless of the partnership’s form, each partner owes several duties to other partners and a breach of any duty entitles the non-breaching partners to a remedy. A court will scrutinize and strictly construe any partnership agreement that alters these fiduciary duties.
- Duty of Care
The first duty is a duty of care. The standard of care states impose is that of gross negligence, where a partner must refrain from reckless conduct or intentional misconduct that hurts the partnership or the interests of the other partners.
For example, states have enacted legislation requiring businesses to be proactive and keep records of job applications, resumes, and other employment materials for at least one year after reaching a hiring decision. A partner in a general partnership who handles human resources matters and who disregards the law and discards these materials less than one year after hiring an employee not only violates the law, but also breaches a duty of care.
- Duty of Loyalty
The second is a duty of loyalty, requiring a partner to account to the partnership and hold partnership property in trust for the partners’ benefit. Additionally, the partner must place the success of the partnership above personal interests and should avoid any conflicts of interest between partnership duties and personal activities.
For example, assume that Amber is a law partner in a firm. She knows that the firm is looking to rent a bigger office and she finds a building for sale suitable to serve as the new office. Instead of letting her partners know of it though, Amber purchases the building as a personal investment. If her law partners find out, they could successfully claim that she has breached the duty of loyalty to the partnership because Amber placed her own financial interests above the partnership’s.
- Duty of Good Faith and Fair Dealing
The third is a duty of good faith and fair dealing, requiring each partner to act honestly, candidly, and fairly towards one another in all partnership dealings. Additionally, a partner must avoid reaching agreements through threats or other forms of intimidation that can cause duress.
- Duty of Full Disclosure
The fourth fiduciary duty is a duty of full disclosure, requiring partners to disclose all risks and benefits of actions affecting the partnership to one other.
For example, Devon wants to buy out Lisa’s interest in an accounting firm they operate as a general partnership. To comply with the duty of full disclosure, Lisa must disclose any, and all, material information that relates to the value of her partnership interest that Devon couldn’t learn over the normal course of business. So, if Lisa doesn’t disclose to Devon that a rival accounting firm is relocating to an office closer to them and could more effectively threaten their business, and Devon has no way of knowing this, then Lisa would be in breach of this duty if she doesn’t tell her.
A court has numerous remedies available for a partner’s breaches and the remedy an aggrieved partner can receive depends on the breach. For example, if a partner breaches a duty of loyalty by concealing profits from another partner, the aggrieved partner can recover monetary damages, or the court can impose a constructive trust on the breaching partner’s profits.