Business Formation: Forming a Partnership
June 18, 2014
Forming a partnership is the focus of this installment of our series on business formation and choosing the right business structure. This article follows the one about forming a sole proprietorship. So, track back and read that one if you missed it.
Kinds of Partnerships
In most jurisdictions, there are generally three major kinds of partnerships: General Partnerships (GPs), Limited Partnerships (LPs), and Limited-Liability Partnerships (LLPs). In a GP, each partner usually participates in the management of the business and has unlimited liability for the debts and obligations of the business. If one partner is sued, all partners are held jointly and severally liable. Unlike a GP, an LP limits the liability of holders of minority interests in the partnership–often referred to as “limited partners” or “limited liability partners”–but there still must always be at least one general partner who has unlimited liability for the debts and obligations of the business. In an LLP, the liability of all partners is limited to some extent. LLPs operate similar to limited-liability companies (LLCs), which will be discussed in a subsequent article on this blog.
When forming a partnership, one should have a clear reason for structuring it one way as opposed to another. For example, if three potential partners come together to form a partnership, and two are not going to participate in the management of the business, but are going to provide start-up capital and ongoing credit to the business while the other manages the day-to-day operations of the business, a limited partnership is likely to be the best structure for that partnership. If two or more partners are all going to be involved in the management of the business, a general partnership or LLP may be preferable, depending on the nature of the business. The choice of the kind of partnership you form should be based on the incentives and concerns of the various partners. If you are uncertain about which form of partnership would be best for your venture, you should consult a business attorney.
Forming a Partnership: What Not to Do
In the case of Summers v. Dooley, 481 P.2d 318 (Idaho 1971), a man named Summers entered into a partnership agreement with another named Dooley to operate a trash collection business. The two men operated the business together, and each supplied a temporary replacement if the other was unable to work. About eight years into the partnership, Summers approached his partner, Dooley, about hiring an additional employee, but Dooley refused. Nevertheless, on his own initiative, Summers hired the man and paid him out of his own pocket. Dooley, upon discovering Summers had hired an additional man, objected, stating he did not feel additional labor was necessary. Dooley refused to pay for the new employee out of the partnership’s funds. Summers continued to operate the business using the third man, and, the next year, filed a lawsuit against his partner for $6,000.00.
The issue in Summers v. Dooley was whether an equal partner in a two-man partnership has the authority to hire a new employee in disregard of the objection of the other partner and then attempt to charge the dissenting partner with the costs incurred as a result of his unilateral decision. The court held that, if partners are equally divided, those who forbid a change must have their way, citing Walter B. Lindley’s A Treatise on the Law of Partnership, Ch. II, § III, ¶ 24-8, p. 403 (1924).
The court noted that Dooley continually voiced objection to the hiring of the third man. He did not sit idly by and acquiesce in the actions of his partner. Under such circumstances, the court found, it would have been manifestly unjust to permit Summers to recover an expense which was incurred individually and not for the benefit of the partnership, per se, but rather for the benefit of one partner.
Summers v. Dooley is my favorite partnership law case, because it illustrates not just the principle for which it is generally cited–that if partners are equally divided, those who forbid a change must have their way–but, more broadly, the potentially complex dynamics of even a two-man “50/50” partnership. A well-drafted Partnership Agreement is essential to a smoothly-run partnership, because it will specify under what circumstances each partner has authority to act on behalf of the partnership. Partnerships can exist without a Partnership Agreement, but operating a partnership without a written Partnership is foolish.
What a Partnership Agreement Actually Does
A partner relationship is generally the result of a contract either express or implied with no formal requirements (such as a signed document). To determine whether a partnership exists courts look at: (1) intention of the parties, (2) sharing of profits and losses (3) joint administration and control of business operation, (4) capital investment by each partner, and (5) common ownership of property. Ask yourself whether you trust a court to accurately interpret the intentions potential partners and to correctly determine each and every one of those 5 elements.
Now, ask yourself whether you would prefer to have a contract that clearly and comprehensively discusses each of those elements with respect to a potential partnership. That is what a partnership agreement does. The benefits are obvious, and practically universally outweigh the costs of having a Partnership Agreement drafted by a business attorney.
Other Considerations When Forming a Partnership
Every partnership will have an interest in establishing a strong trade name, often the most visible part of a business’s brand aside from its logo. For some partnerships, the name is just the names of the senior partners all together. Partnerships, however, like other organized businesses, can use trade names that do not include the names of the partners. Registering your partnership’s trade name with the Secretary of State in the state in which you do business may be necessary. In some states, like Tennessee, it is not necessary to register your partnership’s trade name with the Secretary of State, but it may still be desirable to do so. You should consult a business attorney to help you make this decision.
There are a few things you can do to add the more formal trappings to a business when forming a partnership. Getting an Employer Identification Number (EIN) from the Internal Revenue Service (I.R.S.) is a good way to increase your business’s “footprint” on paper. A partnership will want to use the EIN to open bank accounts and other accounts in the name of the business. Of course, like any business, a partnership should maintain separate business accounts for operations, payroll, etc.
Having both an accountant and a business lawyer as part of your team are essential, even if you cannot afford to put either on your payroll. An attorney who serves as “general counsel” is the chief lawyer for a business; if that lawyer is independently contracted, and not on the business’s payroll, he is said to be “outside general counsel” for the business. Outside general counsel services are crucial to a business’s success, because legal services are necessary for every business, and are one area where cutting corners will usually result in expensive problems later. Taking a proactive, preventive approach to your legal issues can seem costly, but the preventive approach is often far less expensive than the alternative—litigation. Obviously, unless you’re a CPA, you also need an accountant for similar reasons. It’s better to pay a little for bookkeeping services in advance than pay a lot when you get audited, later.
In addition to reiterating the need for having both outside general counsel and a CPA on your team, is the necessity of a written business plan. A business without a written business plan is like an ancient sailing ship on the high seas without a map. It might be a sunny day with wind in your sails when you start out, but a storm is coming, and you’re going to get tossed around a bit. You better have a way to figure out where you are when that happens. A well-written, thorough business plan will keep you oriented on your priorities and help you stay on track, come what may.
The Series Continues
Please bookmark www.ExecutiveLP.com and return over the next couple weeks as we continue the discussion on our blog about choosing the proper form or structure a business can take. If you need legal counsel—and we believe every business does—please contact Executive Legal Professionals and let us know what concerns you have. We will quickly follow-up with you and do all we can to see your legal needs are efficiently and effectively addressed by a qualified legal professional. If your need is urgent, please call Executive Legal Professionals at +1.615.669.6566.
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