General Partnerships in California
The California general partnership is the default entity formed when two individuals carry on a business activity for intended commercial gains and with the intent to share profits and losses.
California general partnerships are one of the several common forms of business ownership and have a lot in common with sole-proprietorship with one main difference––whereas a sole-proprietorship involves one person in charge and making decisions for the business, a general partnership involves at least two owners who share responsibility for completing business tasks, contributing financial resources, generating profits and mitigating losses.
Keep in Mind: It should be noted that a general partnership is different from a limited partnership, which shares some characteristics of a corporation and provides liability protection to certain partners. The information contained in this article pertains to general partnerships only.
Advantages of a California General Partnership
Starting a business can be easier when you do it with a partner (or partners) with whom you can share responsibilities and split the start-up costs. Companies like Apple, Microsoft, Google, and Ben and Jerry’s all started with good partnerships. Having more input also contributes to a general partnership have a greater chance of succeeding than a solo practice. In fact, most high-growth businesses start with two or more individuals combining their resources to achieve a shared goal.
4 key advantages to operating as a general partnership:
- Ease of startup – you can literally just find a location, bring your partners, and start doing business together.
- A larger pool of capital – if you have little or no money, a partnership can allow you to easily join up with those who do.
- Shared decision making and specialization – if you are having trouble making decisions, or if there are certain areas where your skills are lacking, you have partners who can advise you and who may have expertise in the areas where you do not.
- No special taxation – unlike a corporation that has to pay extra money to the government, a general partnership does not.
Disadvantages of a California General Partnership
There are many issues that can arise from a business partnership, whether it is between two individuals or more, and those who have been involved in a partnership that has failed will tell you that it is probably worse than going through a divorce. Here is a list of some the main disadvantages of operating your practice as general partnerships:
- Unlimited liability – There is no liability protection. The personal assets of the partners or owners are completely vulnerable to the debts and liabilities of the practice.
- Joint liability – partners are jointly and individually liable for each other’s actions.
- Potential for conflict – more input means a greater possibility for disagreement and conflict.
- Limited continuity – by default, a partnership ends when a partner dies, retires or leaves the partnership.
- Shared profits – profits must be shared amongst the partners.
Important Things You Need To Know About General Partnerships
Here are some of the more important things you need to know about operating a business as a general partnership:
Creating a California General Partnership
A California general partnership, as stated above, is simply created by two or more people engaging in a commercial venture with the intent to share profits and losses. There are no maintenance requirements for a general partnership and no meetings or minute are required to be recorded.
In terms of ownership, a general partnership can be split into whatever percentages the partners want pursuant to a partnership agreement. If there is no partnership agreement in place that divides ownership in some specific manner, then ownership will be divided equally amongst the partners, i.e. 50/50, 33/33/33 etc.
A general partnership is pretty easy and inexpensive to form. But, while there are no formal requirements for forming a general partnership, certain steps must be taken to register a business name, and to comply with local requirements with regards to business registration and state taxes.
The California Partnership Agreement
Everyone involved in a partnership has to fully understand the terms of the partnership and agree to them up front. Otherwise, legal disputes may develop, which can be a drain on resources and from which many startups do not recover. For this reason, most general partnerships are governed by what is referred to as a partnership agreement.
You can clearly define the terms of your partnership and avoid costly legal problems by addressing the following issues in a partnership agreement:
- The names of the partners
- The duration of the partnership
- Each partner’s individual contributions to the practice in terms of money, real estate or equipment.
- The division of labor authority and duties
- How new partners can be added, when the desire or need arises
- What happens to the business when a partner dies, retires or decides to leave the partnership
By default, a general partnership dissolves whenever there is a change in partners. Because of this, there is no interest in the partnership that can be passed on to a partners heirs and assignees unless the practice is liquidated. This means having to wind up any outstanding business obligations and distribute the remaining assets among the partners and or their heirs and assignees.
You can prevent this, however, with a partnership agreement that contains a buy/sell clause specifying what happens to the practice when a partner retires, dies or simply decides to leave the partnership. For example, your buy/sell clause can allow a partner’s share of interest in the practice to be sold or transferred to the remaining partners, or to someone else, when he or she leaves the practice, thereby allowing the partnership to continue on.
Without such an agreement in place, the default continuity aspect of a general partnership cannot be modified and the partnership will have no continuity all.
Unless there is an agreement stating otherwise, any partner in a general partnership has complete authority to act on behalf of the practice. Even though the intent of the partners may be to limit the extent to which any single partner can act on its behalf, by default they will have complete authority to do so.
Even if there is a partnership agreement limiting the authority of a partner to act on behalf of the partnership, third-parties are still justified in believing that any partner has the complete authority to act on behalf of the partnership and is thereby justified in doing business with that partner.
This can obviously create issues of liability that are undesirable. As we will see below, each partner is held personally liable for the action of the other partners. Therefore, partnership agreements normally place limits on the ability of any individual partner to unilaterally act on behalf of the partnership.
Personal Liability for All Owners
One of the significant disadvantages of a general partnership is the idea of unlimited liability. The partners enjoy no personal liability protection. Their personal assets (bank accounts, homes, cars, etc.) are exposed to any debts or liabilities arising out of the practice. In fact, unlimited liability is generally more of an issue in general partnership than any other business entity. This is because not only are you liable to creditors for debts and liabilities incurred due to your own decisions, you are liable to those that arise from decisions made by your partners as well.
This can create a very dangerous scenario when partners that have the authority to unilaterally act on behalf of the partnership. When a partner creates liability for the business (i.e. a debt via contract, or a lawsuit), then the personal assets of each partner can be attached to satisfy this liability.
Because of this, general partnerships are considered by some to be a dangerous structure under which to operate a business. Moreover, the California general partnership often has difficulty attracting investment. Most investors don’t want to open themselves up to the liability inherent in this business structure.
Generally, partners of a general partnership are not entitled to draw a salary. Any profits generated by the partnership are distributed to the partner in accordance with their percentage of ownership unless a special allocation of profits is specified in a partnership agreement. For example, a partnership that is split 50/50 can split profits 60/40 as long as it is specified in it’s a partnership agreement.
The IRS, however, has an economic reality test that requires any disparity in the allocation of profits to be based on some economic reality. In other words, it has to be based on some disparity in the level of investment (time, money, materials, etc.) that partners put into the practice.
Each partner will then be taxed individually on his or her share of the profits from the practice, regardless of how profits are split and whether or not the profits are taken out of the practice.
In addition to allowing a practice to leverage the skills and resource of multiple partners, a general partnership also offers certain tax advantages. Similar to a solo practitioner, there is no legal separation between the partners and the practice in the eyes of the IRS. In other words, a partner and his or her share of interest in the practice are considered to be one entity.
Because of this, the partners are allowed to claim any type of profits generated by the practice as income on their own personal tax returns. While corporate tax rates are around 35 – 40%, individual income tax rates are typically much lower than that. So, the partners in a California general partnership can claim profits from the practice at a much lower tax rate.
Operating a business as a California general partnership has its pros and cons. Before choosing a general partnership as your business structure, you need to first determine if the structure suits the needs of your business. Then you need to think very carefully about what you need in a partner and what kind of partner(s) will best suit you and your business.
For more information regarding the pros and cons of a California general partnerships, or for help with choosing a business structure for your California business, contact an experienced California business attorney who can answer all of your questions and provide you with the guidance you need.