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In my humble opinion, it's a poor decision to go into business as a general partnership. One of my reasons is that in a general partnership all partners are jointly (together) and severally (individually) liable for all actions of the partnership.
For instance, let's assume John and Joe go into business together. John has good credit, money, a good standing in the community and is better looking than Mel Gibson. Joe, on the other hand, is hard up for cash, has no credit and has the business attitude of a snake. As fate has it, Joe has a great idea and convinces John to buy in on it. So John and Joe form a general partnership.
One day Joe goes to John's bank, and on John's credit borrows $ 1,000,000 in the name of the partnership and takes off to Tahiti and devotes his life to wine, women and song. John is STUCK. He owes the money to the bank and has to pay the debt even though he never agreed to it or never even knew about it. (Now we all know this could never happen since the bank wouldn't allow Joe to borrow from them without informing John first, don't we?)
The general partnership, therefore, more than any other type of entity calls for a great deal of trust in your partners. While it is true that you probably shouldn't go into business with someone you can't trust, people do it all the time and end up regretting it. My point is that if someone is going to rob you, you don't have to give him the gun with which to do it. It gets worse.
In a general partnership, all partners are individually liable for any wrongs committed by the partnership. If a creditor comes after the partnership, or if a court judgment is recorded against the partnership, a creditor may go after not just the partnership assets, but also the personal assets (houses, savings, cars, etc.) of the individual partners, even if all but one of the partners were totally innocent.
Now you are saying to yourself that this makes partnerships look really unattractive. There is no legal protection from creditors and you are open to being taken to the cleaners by your own partners. Why would anyone want to use a partnership? Well, pat yourself on the back for learning at least one thing today.
However, there are some reasons to operate as a partnership. Partnerships (unless they have employees) don't have to pay wages to their partners or pay payroll taxes. This translates to less paperwork and less expense. Flexibility is another reason to consider a general partnership. Partnerships can better handle contributions of assets to and distributions from assets of the partnership. Basis in partnership property can be adjusted for the death of a partner (or other reasons other reasons
for adjustment).
Now let's see if we can take steps to reduce some of the liabilities of being a partnership while retaining the benefits.
One way is to organize a limited partnership. A limited partnership has one or more general partners and a number of limited partners. The general partners are usually the main players in the partnership and the limited partners are nothing more than investors. General partners still have unlimited liability but the limited partners are liable only to the extent of their investment. These kinds of partnerships are usually set up for rental real estate or other investment properties.
The problem is that there is still unlimited liability for someone (the general partners) and generally no one wants that.
In the old days you could get around personal liability by incorporating, and electing to be taxed as an S corporation. This gave you the pass-through of income and expenses (like partnerships) and liability protection (unlike partnerships). But as usual in tax law, there was a problem. Prior to 1996, you could only have 35 shareholders in an S corporation and the type of people that could own shares was limited. In 1996 the number of allowable shareholders was increased to 75 and the type
of allowable shareholder was expanded.
There are a couple of problems with the S corporation, however. First, even 75 shareholders may not be enough. Large partnerships frequently have more than 75 investors. Also, when you have appreciating assets inside a corporation, you have a problem getting them back out without getting taxed to the hilt.
LIMITED LIABILITY CORPORATION (LLC) (back to top)
Thus was created the Limited Liability Company, or the LLC. With a limited liability company, you can have an unlimited number of members. Members are protected from personal liability. The LLC can file tax returns as either a C corporation or a partnership, although most choose to file as a partnership (DUH! Otherwise, why not just become a corporation?) .
Since there are no general partners in a LLC, no one faces personal liability and you get to pass through the income or losses to the members just like a general partnership.
LIMITED LIABILITY PARTNERSHIP (back to top)
The Limited Liability Partnership, or the LLP, falls somewhere between the general partnership and the LLC. The LLP does not protect assets from general liability but does give protection from liability that arises from wrongful acts of other partners in the partnership. This is important because in a general partnership, if one partner creates a wrongful act, all partners can be held liable for his or her action, even to the extent of their personal assets. (Good luck trying to hide all
your assets in your spouse's name.) Let us presume a partnership made up of doctors. One doctor commits malpractice and is sued. In a general partnership, all partners would be jointly and severally liable. But in an LLP only the partner committing the act would be liable.
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Accountant & Management, Inc. 30 Years And Counting
