A partnership is an association of two or more persons to carry on as co-owners a business for profit. The liability protection provided by a partnership depends on the type of partnership that is formed, the status of the partners, and the laws of the state where it is created. Because limited liability companies offer the flow-through taxation of partnership and provide equal or better protection against liability, limited liability companies are often preferred over partnerships.
A partnership is recognized as a legal entity separate from its owner for state law purposes. There are several different types of partnerships, including:
- General Partnership – A partnership with only general partners. Each general partner takes part in the management of the partnership and is personally liable for obligations of the partnership
- Limited Partnership – A partnership with both general and limited partners. General partners manage the partnership and are personally liable for partnership obligations. Limited partners do not participate in the day-to-day management of the partnership and are not personally liable for partnership obligations.
- Limited Liability Partnership – A limited liability partnership is a hybrid form of partnership in which each partner can participate in the day-to-day management of the partnership, but without personal liability. It is similar to a limited liability company.
Partnerships are formed by agreement between the partners. General partnerships can often be formed without any need to file documents with the state. Limited partnerships and limited liability partnerships usually require a certificate of partnership to be filed with the state.
Unlike C corporations, the income of partnerships is subject to a single level of tax at the partner level. The partnership functions as a conduit to pass income and deductions through to the partners. The partnership is required to file Form 1065 to report income and deductions. This return shows each partner’s distributive share of the partnership’s income and deductions. Each partner must include that partner’s share of the partnership income and deductions on his personal tax return. For more information on taxation of partnerships, see Taxation of LLCs and Partnerships, Tax Consequences of Contributions to LLCs and Partnerships, and Tax Consequences of Distributions from LLCs and Partnerships.
Capitalization and Contributions
A partnership is initially capitalized by transferring property to the partnership in exchange for a partnership interest in the partnership. A partnership can have different classes of partnership interests, each with their own right to voting and distributions and level of liability for obligations of the partnership.
Owner Liability for Entity Obligations
The liability of partners for obligations of the partnership depends on the type of partnership.
- General Partnership – The general partners are personally liable for the debts and obligations of the partnership, including debts incurred by their partners. Because of this broad liability, general partnerships are usually a poor choice of business entity.
- Limited Partnership – The general partners are personally liable for the debts and obligations of the partnership, but the limited partners are not.
- Limited Liability Partnership – No partners are personally liable for the debts and obligations of the partnership (similar to a limited liability company).
Important Note: By using a corporation or limited liability company to serve as general partner, a limited partnership can approximate the liability protection offered by a limited liability partnership or limited liability company. As with other forms of business entities, limited partners are personally liable for any loans or other obligations that they personally guarantee.
Protection of Entity Assets from Owner’s Personal Creditors
State law permits creditors of a partner to obtain a charging order against that partner’s partnership interest. A charging order, which is issued by the court, directs that distributions of income or profits that would otherwise be paid to the debtor-partner should instead be paid to the creditor.
In most states, a charging order confers only the right to receive distributions. It does not give the creditor the right to vote or otherwise participate in the management of the partnership. As a result, the creditor cannot force the company to make distributions. If the company makes no distributions, the creditor receives no payments. This makes the charging order an unattractive remedy for creditors. In many states, the charging order is the only remedy to creditors of the partnership.
Control of a partnership depends on the partnership agreement, the type of partnership involved, and state law. Control of a general or limited partnership is vested in the general partners, and each has the right to act on behalf of the partnership. Control of a limited liability partnership is determined by the partnership agreement. While the laws of most states have similar provisions regarding control of the partnership, there are some state-by-state variations that should be considered.
Continuity, Transferability, and Dissolution
General partnerships are usually dissolved by the death or withdrawal of one of the partners unless the parties have agreed to continue the partnership business. The continuity of a limited partnership or limited liability partnership depends on the provisions of the partnership agreement.
Most states allow a limited partner to transfer a limited partnership interest without triggering dissolution. But the withdrawal of a general partner from a limited partnership will cause dissolution unless there is a continuing general partner or the remaining partners agree in writing to continue the business and, if necessary, elect a new general partner.
Partners are generally free to transfer their partnership interests unless restricted by the partnership agreement or other agreement between the partners. Transfer of a partnership interest usually requires consent of the remaining partners. State law may prohibit an absolute restriction on transferability.
A partnership’s partnership agreement, books, and records are not publicly accessible, but a certificate of formation and other reports filed with the state can generally be viewed by third parties.
Transition to Other Entity Form
In some circumstances, a partnership may be converted to another form of entity. This could involve a distribution of assets to the partners followed by a contribution of those assets to the new form of entity, or through some other form of cross-entity merger or reorganization.