Entity Formation | January 13th, 2019
So you’re starting a small business— now what? If you’re going into business with another party whether it’s a friend, investor, or business partner, you’ll need to think about the type of business partnership you’ll want to form. And we’re not necessarily talking about the way you collaborate together or how to make design decisions for your new workspace. We’re diving into the legal partner considerations business owners should know before forming a business entity, otherwise known as a business partnership.
Forming a business partnership impacts your legal responsibility for the business— including financial losses, profits, and important management decisions. Choosing the right (or wrong) structure for your partnership could mean great rewards (or painful losses for your business)— so getting it right from the start is one of the most important decisions you’ll make as a business owner. Let’s dive into what each kind of partnership means so you can make the most informed decision for your small business.
Looking for information on specific types of partnerships? Use the links below to navigate.
- What Is a Business Partnership?
- General Partnership (GP)
- Limited Partnership (LP)
- Limited Liability Partnership (LLP)
- Forming a Business Partnership
- How To Form a Business Entity
What Is a Business Partnership?
A business partnership is a legal relationship formed between two or more business owners. This relationship defines how they operate to collectively own their business. There are several types of business partnerships, but each should include details about who’s responsible for business debts, how much of the profit owners are entitled to, how the business is taxed, and how potential legal issues are handled. Like every major decision, each business partnership type has different pros and cons to consider. Let’s discuss the basics and important factors of each to help you get a better idea of what’s right for you and your business partner(s).
General Partnership (GP)
A general partnership is one of the most common types of partnerships as the liabilities are pretty straightforward and the legal formation tends to be easier than the other partnership types. A general partnership, or GP, consists of two or more business owners who share the same level of responsibilities for their business.
This responsibility extends from management decisions to debt obligations and financial profits concerning the business. In other words, each partner is equally responsible for the management of the business and for paying any debts owed by the business. While this type of partnership does involve a lot of personal responsibility, it can be beneficial for business taxes and can often be an effective way to manage business operations.
Advantages of a general partnership
- Simple to establish
- Management decisions can be easier to implement when all parties share responsibility
- Pass-through taxes: No income tax attributed to the business itself— each partner files profits and losses on their personal income tax return. Plus, these taxes are issued at a lower rate.
Disadvantages of a general partnership
- Partners are individually responsible for the debts and obligations of the business. If the business can’t pay back business debts, the liability falls onto the individual owners to resolve the debts.
- Substantial personal liability that can become complicated if one partner decides to withdraw from the partnership or is unable to manage the business.
- Any individual partner can bind the entire business organization to a legal obligation.
If you want to be the only owner in control of the day to day operations and finances of your business, you may consider opting for a sole proprietorship instead. This type of business formation means you (as the owner) and your business are one in the same— business income and losses will be taxed on your personal tax return and management will be under your discretion completely. This is the simplest form of business operation, but keep in mind it can be challenging to run and fund a small business entirely on your own.
Limited Partnership (LP)
A limited partnership gives business partners a bit more flexibility to define their liability concerning business operations and financial responsibilities. Each of the limited partners can put restrictions on their responsibilities, which could protect them if the business ends up owing money or becomes involved in a legal matter. However, at least one business partner must take on general partnership status. The general partner will hold primary responsibility for all debts and business obligations. While this does mean they risk absolving a lot of financial responsibility, the general partner also has the right to control the business— including the management decisions and direction. All parties (general and limited partners) will benefit from the business profits.
Advantages of a limited partnership
- Limited and general partners benefit from business profits
- Business decisions can be easier when under the jurisdiction of a single partner
- General partners can operate the business under their control with limited input from investors and other partners.
- Limited partners are well-protected if the general partner does not manage the company effectively
- Greater funding potential from limited partners and investors, unlimited shareholders
Disadvantages of a limited partnership
- General partners hold a heavier burden when it comes to financial responsibility and business management, leaving their personal assets unprotected.
- Limited partnerships require more documents to form
- Less protection from excessive taxation
Limited Liability Partnership (LLP)
A limited liability partnership involves two or more partners that each hold a certain degree of personal liability for the business. An LLP is similar to a general partnership, but with the added peace-of-mind that each partner is protected from holding total responsibility for business debts and obligations. For example: imagine the business owes $5,000 to an outside investor or lender and there are 5 business partners in the LLP. Rather than a single (general partner) having to pay the amount due, each partner might be personally responsible for $1,000 if the business itself is unable to repay the $5,000 debt. Each LLP functions differently to assign responsibilities for the business— so in reality, one partner may pay $2,000 while the other pays $1,500.
The same tax advantages from a general partnership extend to an LLP partnership as well— meaning each partner takes on business taxes on their personal tax return. Filing business taxes on your personal return can be complex, so owners may turn to tax preparation services to strategize their filing and save on tax dues.
Advantages of a limited liability partnership
- Personal liability protection for business participants
- Individual partners are not responsible for the wrongful acts of other partners
- No single partner is solely responsible for business debts— this responsibility is shared by each partner
- Each partner has authority in running business matters and making decisions— which can inspire a collaborative environment, but can also become a challenging dynamic.
Disadvantages of a limited liability partnership
- Can complicate business decisions when involving multiple business partners
- State considerations for LLPs vary — some do not recognize LLPs depending on the industry, and others can impose different taxes on the business.
Are LLPs and LLCs the same thing?
Nope! Although their structure is quite similar, LLPs and LLCs (Limited Liability Companies) have a few key differences in partnership liability protection and operational procedures. Keep in mind that states can also determine taxes and other legal differences for LLPs and LLCs. According to the Massachusetts state website, members of an LLC are typically not personally liable for an LLC’s debts, obligations, or liabilities; whereas members of an LLP have limited personal liability for these things. Wondering how to form an LLC? The process is actually pretty similar, but just make sure to do your due diligence or get help from a business consultant to help you find the best partnership organization for you.
Forming a Business Partnership
No matter how much you trust your business partner(s), establishing a legal contract can protect both primary and secondary business owners. Afterall, not all business partnerships end up with huge profits and tales of everlasting friendship. One of the most famous cases of a business partnership gone bad was the feud between Microsoft’s Bill Gates and Paul Allen. Gates insisted on a 60/40 ownership agreement with Allen— the 60% benefitting Gates, of course— and continued throughout the partnership to request more ownership (profit) of the business. While we hope this never becomes the case between you and your partners, forming a proper partnership can help protect yourself from unfair or complicated business agreements down the line.
Is forming a business partnership required?
Forming a business partnership is not legally required, but it is highly recommended in case any changes or issues come up between owners. For example, if one partner wishes to dissolve from the partnership or bring on an additional partner, having an outline of how these matters will be handled could help owners work out the issues without having to take it to court.
How to choose the right business partnership
Figuring out which business partnership is right for you can be a bit of an overwhelming process. Between weighing the pros and cons of each and understanding the legal aspects, there’s a lot to consider before jumping into business with your partner.
The most important thing to remember when forming a business entity is to be honest and clear about your expectations and agreements. Establishing an open dialogue from the start can help you and your partners avoid disagreements about management, money, and changes later.
How To Form a Business Entity
Now that you know the importance of forming a legal business partnership, you’re probably ready to get your business up and running with your fellow owners. But how exactly do you form a proper business partnership?
What you’ll need to start a partnership business
- Both partners should understand the partnership liabilities of their business partnership agreement
- An outline of the rights and responsibilities of your company’s owners, business contract agreement
- Registration with state and local agencies
- An Employee Identification Number (EIN)
- A business bank account
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Forming a proper business partnership involves a lot more than just an investment and a simple handshake to seal the deal. And the way you structure your business could contribute to huge growth for your company, or end up costing you depending on which partnership you choose— and who you’re partnering with. If you’re unsure how to navigate the process but want to ensure you choose the right partnership for everyone involved in your company, work with a professional business consultant to help you form your business entity.
Finance Pal offers one-on-one business consultations and business formation services to help you form an initial business partnership, or make changes to your current entity agreement. Our business experts are happy to walk you through the different types of partnerships, and their applicable partnership liabilities so you can choose the option that fosters the most growth for your business.