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There are several types of business partnerships, but the most common is a general partnership.
What is a general partnership?
A general partnership is an unincorporated business with two or more owners who share business responsibilities. Each general partner has unlimited personal liability for the debts and obligations of the business. Each partner reports their share of business profits and losses on their personal tax return.
General partnerships are common among the different types of business entities because they're simple, both in terms of getting started and filing taxes.
Understanding general partnerships
A general partnership is an unincorporated business, which means you don’t need to register your business with the state in order to legally operate. In fact, when two or more people go into business together with the goal of earning a profit, a general partnership exists by default.
To have a general partnership, two conditions must be true:
The company must have two or more owners.
All partners must agree to have unlimited personal responsibility for any debts or legal liabilities the partnership might incur.
In a general partnership, every partner can enter into contracts or business deals that are binding on every other partner. While this can be convenient, it also means that you should really trust the person or persons with whom you launch your company. It might be fun to start a business with a friend or family member, but they might not necessarily make the best fit as a business partner. Your partner’s actions or mistakes can affect you legally and financially.
To prevent and resolve disagreements, owners in most general partnerships create a founders’ agreement or partnership agreement. The agreement outlines the governing structure of the business and each owner’s rights and responsibilities. The agreement also typically addresses partner voting rights and the division of profits.
In the absence of a partnership agreement, general partnerships dissolve when one of the partners passes away, becomes disabled or leaves the partnership. An agreement can specify what should happen in these circumstances. For example, if one partner dies, the surviving partner or partners might get the first opportunity to buy out that individual’s share.
General partnership features
It doesn’t take much to create a general partnership, but once a partnership is established, the consequences can be very impactful, particularly in terms of shared liability among partners. Here are more details on what you can expect from a general partnership.
Joint liability in a general partnership
The hallmark of a general partnership is shared liability for partnership debts and obligations. Every partner in a general partnership faces unlimited personal liability for three different things:
Their own actions.
The actions of other partners that bind the partnership.
The actions of company employees.
If someone sues a general partnership, the partners have shared responsibility for any damages a judge or jury awards. This is called joint liability.
Some states take this a step further with something called joint and several liability. In that case, a debtor or legal claimant can sue any partner for actions taken by other partners. It’s then the partners' responsibility to sort out who owes what. Shared liability in a general partnership can be particularly harmful if one partner is negligent or involved in criminal activity.
Let’s say Partners A, B and C own a landscaping company together. Partner A accidentally injures a client with a lawnmower while out on a job one day. The client sues all three partners and receives a large damages award of $1 million. In court, Partner A discloses having very few personal assets. In states that follow joint and several liability, the client can then recover the damages from the personal assets of Partner B and Partner C even though they had nothing to do with the lawnmower injury.
Later, Partners B and C can sue Partner A to recover money, but it might not be worth their time if Partner A doesn’t have any assets.
Fiduciary duties in a general partnership
Fiduciary duties can help protect owners in a general partnership. There are four types of fiduciary duties among general partners:
Duty of Good Faith and Fairness: Partners must act honestly and fairly in all activities that affect the business.
Duty of Loyalty: Partners should place the best interests of the partnership above their own interests and avoid any conflicts of interest that could hurt the partnership.
Duty of Disclosure: Partners should disclose the potential benefits and risks known to them of a prospective business decision so that the partners can make an informed choice about whether to pursue it. Partners might have to disclose information about business activities, finances, contracts, etc.
Duty of Care: Partners must use reasonable care when managing the partnership. For example, partners should document important business matters in writing and maintain books for financial transactions.
These fiduciary duties arise from the moment the partnership starts, and they continue until the partnership is dissolved. State law might specify additional fiduciary duties, but business owners can add to or modify certain fiduciary duties with a partnership agreement. If a partner breaches a fiduciary duty, the other partners can sue.
Management and control in a general partnership
A partnership agreement can specify different areas of responsibility and different privileges for each owner.
You can distribute voting rights and profit share however you see fit.
Some partnerships specify a few managing partners to take the lead on business matters.
One thing you can’t change with a partnership agreement is your state’s rules on joint liability or joint and several liability.
In the absence of a partnership agreement, the majority of states follow the Revised Uniform Partnership Act, also known as RUPA or UPA. This is a model statute that provides standard rules about how a partnership should be governed and the rights and duties of each partner. Under RUPA, all partners have equal voting rights and profit shares, even if one partner contributes more resources or money to the company.
Compensation in a general partnership
General partners are entitled to compensation for their participation in the partnership.
Partners aren’t considered employees, so compensation isn’t in the form of a salary. Instead, partners receive distributions from the partnership’s profits, in line with their share of profits as outlined in the partnership agreement (profits are equally distributed if there’s no agreement).
The IRS considers distributions as self-employment income, which is subject to self-employment taxes for Social Security and Medicare.
The partnership can retain any money that’s not distributed and reinvest it in the company, but partners still have to pay taxes on retained earnings.
Taxes in a general partnership
General partnerships don’t pay business income taxes, because they are pass-through entities. This means each owner reports their share of the partnership's income and losses on their personal tax return and pays the taxes accordingly.
The partnership must complete and provide a Schedule K-1 to each owner no later than March 15 each year. Schedule K-1 summarizes each owner’s share of business income, losses, credits and deductions. Each partner uses the information in the Schedule K-1 to complete their Form 1040 tax return.
Income for general partners is usually treated as self-employment income, so the partner should attach Schedule SE to their 1040.
In addition, the partnership must file Form 1065 as an informational return with the IRS no later than April 15.
In most states, partners must pay federal, state and local income taxes. There might also be other small-business tax obligations, such as payroll taxes and sales tax collection, depending on the specific circumstances of your company.
Filing business taxes can be a multi-step process, so we recommend using a tax professional to complete your taxes.
Pros and cons of a general partnership
Here are some of the pros and cons to consider for a general partnership.
Easy to start (no registration or incorporation required).
The partnership doesn’t pay taxes (income and losses pass through to the owners’ personal tax returns).
Compliance is relatively easy (e.g., no annual reports).
Partners can customize management and control to some extent via a partnership agreement.
Partners have unlimited personal liability for the actions of other partners and employees.
Disputes among partners can cause the business to fail, particularly in the absence of a partnership agreement.
This is not an appropriate business structure for raising investor money.
Is a general partnership right for you? Other types of partnerships
A general partnership might be a practical way to start your business venture because it’s easy and inexpensive.
Eventually though, your business may become too large or complex for a general partnership structure. When your business is involved in several different activities, deals and contracts, the likelihood that a mistake or oversight will occur is much larger. And if it does, joint liability can be very harmful to the business.
As a business grows, consider a business structure that limits liability for owners, such as a limited partnership, limited liability company or corporation.
LLCs and corporations limit personal liability for all owners of the business.
In a limited partnership, there are two types of partners — general partners and limited partners. General partners have unlimited personal liability for business debts and obligations, but limited partners are only responsible up to the amount of their investments.
Limited partnerships can be a good option when pooling the resources of multiple people or when a few partners bring capital to the table.
Whenever you start a business with multiple people, regardless of the type of business structure, it’s important to have a founders’ agreement that delineates the rights and responsibilities of each owner. This is the a good way to prevent disagreements among partners and provide clarity in uncertain situations.
This article originally appeared on JustBusiness, a subsidiary of NerdWallet.