There are several types of business partnerships, but the most common is a general partnership. When two or more people agree to run a business together, without registering or incorporating the business, it is a general partnership. General partnerships are quite common among the different types of business entities because they are simple, both in terms of getting started and filing taxes.
If you’re going into business with partners, it’s important to understand how a general partnership compares to other types of partnerships and to other business structures.
General partnership definition
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.
How a general partnership works
A general partnership is an unincorporated business, which means that 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.
More specifically, in order to have a general partnership, there are two conditions that must be true:
The company must have two or more owners.
All partners must agree to have unlimited personal responsibility for any debt or legal liability that the partnership might incur.
In a general partnership, every partner has the authority to 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 impact you legally and financially, which we’ll explain more about in the next section.
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. Provisions for partner voting rights and the division of profits are also typically written into the agreement.
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.
Features of a general partnership
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 that 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 responsibility of the partners 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.
An example is the best way to illustrate shared liability among partners. Let’s say that Partners A, B and C own a landscaping company together. Partner A accidentally injures Client with a lawnmower while out on a job one day. Client sues all three partners and receives a large damages award of $1 million. At court, it’s shown that Partner A has very few personal assets. In states that follow joint and several liability, Client can recover full 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 file a lawsuit to recover money from Partner A, but it might not be worth their time if Partner A doesn’t have any money.
Thomas Simeone, a CPA and attorney with Simeone & Miller, LLP, says that the purpose behind joint and several liability is to help the person bringing the lawsuit: “All partners may be responsible for payment. The debtor will usually pursue and sue the wealthiest or most accessible partner for the full debt. That partner can then seek to have other partners contribute their share of the payment [according to the division of liabilities that they’ve agreed to]. But, for the debtor, it is a great advantage to be able to recover all your funds from the partner who is the wealthiest and most reachable.”
Fiduciary duties in a general partnership
You might be surprised that partners can be held liable for acts they didn’t commit, but 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 impact the business.
Duty of Loyalty: Partners should place the best interest 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 very moment that the partnership starts and 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
Partners have flexibility in deciding how to manage and run the business on a day-to-day basis. 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 of the few things you can’t change with a partnership agreement is your state’s rules on joint liability or joint and several liability. Simeone says, “Partners can split ownership interests and profit any way they like, but all general partners are equally liable for debts.”
In the absence of a partnership agreement, the majority of states follow the Revised Uniform Partnership Act (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 receive compensation for their participation in the partnership. Partners aren’t considered employees, so the 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).
Distributions are considered self-employment income and are subject to self-employment taxes for social security and Medicare. Any money that’s not distributed can be retained by the partnership for reinvestment 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 that the income and losses of the partnership are reflected on the personal tax return of each owner. Each owner pays their personal income tax rate on their share of the business profits.
Even though partnerships aren’t taxed, the partnership must complete and give a Schedule K-1 to each owner no later than March 15. 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 personal 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
General partnerships are the simplest kind of partnership. You don’t need to register your business to have a general partnership, and a partnership agreement isn’t required. Despite the ease of a general partnership, more and more small business owners are looking to other business structures that offer greater legal protections. General partnerships leave partners completely open to liability, which is probably the biggest disadvantage of this business type.
Here are some of the pros and cons to consider for a general partnership:
Easy to start up (no registration or incorporation required).
The partnership itself doesn’t pay taxes (income and losses pass through to the owners’ personal tax returns).
Compliance is easy (e.g. no annual reports).
Partners can customize management and control to some extent with 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?
Many small business owners find themselves with a general partnership on their hands before they even start thinking about whether to change business structures. After all, there’s no formal document that you have to file with the state in order to create a general partnership. When two or more people run a business together to make a profit, a general partnership exists.
Oftentimes, a general partnership might be a practical way to start your business venture because it’s easy and inexpensive.
According to Stephanie Jones, a partner at Gordon Rees Scully Mansukhani LLP: “A general partnership is a great way for business owners to save money at the outset. Typically, applicable laws require fewer formalities for formation and operation of a general partnership than other kinds of business organizations. In addition, the business itself likely does not have to pay income tax. At first glance, this may appear to be the simple, cost effective option for an emerging business.” Eventually, it’s possible that your business will grow into an operation that’s 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, it’s a good idea to consider a business structure that limits liability for owners, such as a limited partnership, limited liability company (LLC) or corporation. LLCs and corporations limit personal liability for all owners of the business. In a limited partnership, there are two different 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 best way to prevent disagreements among partners and provide clarity in uncertain situations.
The good news is that there are very few formal steps you need to take to set up a general partnership. As with any time you start a business, you might need to get a business permit or get permission to use a trade name. But there’s no need to register or incorporate your business with the state. Tax filing is easy too, since business income and losses pass through to the owners’ personal tax returns.
Just make sure you consider the biggest downside of a general partnership — unlimited personal liability for all partners. As your business grows, consider other business structures. Business entities that offer limited liability for owners include limited partnerships, LLCs and corporations.
This article originally appeared on JustBusiness, a subsidiary of NerdWallet.