Being part of a business partnership isn’t always easy, but forming one is. Maybe you’ve heard the term general partnership, or a GP, to describe a business structure, but you aren’t really sure what one is, or what the benefits of choosing a general partnership over another type of business entity are.
This short guide can help you get up to speed on general partnerships and determine whether forming one for your business is the right call.
What is a general partnership?
Do you want to start a business that’s owned by two or more people? Then maybe a general partnership is the way to go. But then again, it might not be exactly what you’re looking for at all.
A general partnership is probably the easiest and quickest way for more than one person to legally go into business together. Since it’s considered an unincorporated structure, there is no required paperwork to file in most states. However, in reality, many GPs choose to file a DBA, since it allows partners to choose a fictitious business name instead of being stuck with their legal names as the company name.
While a general partnership may seem like a great way to quickly and easily start a business, it comes with a few significant downsides. While all partners share in the profits and management responsibilities equally, they also assume all business debts and obligations. And because personal assets are not shielded in a general partnership, creditors can come after them.
For that reason, it is essential to understand how general partnerships work before deciding if it is right for you.
How general partnerships work
Here is a high-level overview of how a GP typically operates in terms of management, liability, and fiduciary duties to partners.
Management
General partnerships are democratic, with each partner having equal authority unless the management structures are specifically spelled out in the partnership agreement. That means that any partner can make any business decision, such as enter into a contract on behalf of the entire partnership, without the permission or consent of any of the other partners.
Liability
Any debt owed by the general partnership is typically subject to joint and several liability. This is a legal term that describes who is responsible for a debt. Under joint and several liability, each partner assumes full responsibility for the entire amount of any money owed by the GP, not just a share. That means if you have two partners, and your business owes $30,000 to a creditor, the creditor can come after you for the full $30,000, and not just a third.
And that debt? The court can seize your personal assets, like your family home or cars, to pay it off.
Fiduciary duties
Partners in a general partnership have legal and ethical requirements to act in the best interest of the business. These are called fiduciary duties, and include:
- Duty of loyalty – Partners must prioritize the partnership’s financial health over individual gain, such as by avoiding conflicts of interest or competing against the company.
- Duty of care – Partners must conduct themselves in a way that a reasonable person would not consider grossly negligent or reckless.
- Duty of good faith – Partners are required to be honest in all matters relating to the partnership.
There are specific legal actions that partners may take if one partner violates these duties. Although a partnership agreement is not required, most general partnerships create one to help prevent and resolve disputes without resorting to legal action.
The downsides of general partnerships have led many companies to wonder whether a limited liability corporation (LLC) is a better option.
What is a general partnership vs an LLC?
Between general partnerships and LLCs, more people are familiar with LLCs. But that doesn’t mean they’re always the better option. General partnerships are often perfectly fine for low-risk professionals, but LLCs are usually better suited to businesses with bigger and more frequent exposure.
A few of the ways the two structures differ include:
Liability
A general partnership does not protect the partners’ personal assets from damages or debt. On the other hand, the personal assets of an LLC’s owners are not at risk.
Formation
No paperwork is required for establishing a general partnership. It is created as soon as two or more people start to work together. To form an LLC, you must fill out paperwork, pay a fee, and register with the state.
Taxation
Both LLCs and general partnerships are pass-through entities by default, meaning income is reported on the partners’ personal tax returns. However, an LLC can elect to be taxed as an S Corp or a C Corp.
Credibility & structure
Although there is no legal justification, some potential customers and businesses believe LLCs have greater credibility than general partnerships.
What is the difference between a general and a limited partnership?
Maybe you have heard of limited partnerships and wonder if they are the same as general partnerships. The simple answer is no, there are distinct differences between the two types.
Perhaps the largest difference is that limited partners do not have unlimited liability for the company’s debt, but only up to the amount they invested. That’s why limited partnerships are common in investment and real estate companies.
Another major difference between the two categories of partnerships is who manages them. The partners in a general partnership often share day-to-day management responsibilities, while limited partners typically do not.
What are the advantages and disadvantages of a general partnership?
Below is a short summary of some of the advantages a general partnership may have over other business structures:
Advantages of a general partnership
- Easy and inexpensive to form – No state filing fees, so you can start working almost immediately.
- Minimal paperwork – Many general partnerships choose to file an optional DBA form, and a partnership agreement, while not required, is a very smart idea.
- No corporate formalities – No need to hold meetings, keep minutes, file annual reports, or hire a registered agent.
- Pass-through taxation – Partners pay their own taxes.
- Shared decision-making – Partners usually have a say in the management of the business.
Disadvantages of a general partnership
- Unlimited personal liability – Each partner is personally liable for any company debt.
- Each partner legally binds the others – One partner’s actions can legally and financially affect the other partners.
- Disputes can disrupt operations – Unresolved disagreements can negatively affect the business.
- Harder to raise capital – Some investors are more hesitant to invest in a general partnership.
- Business dissolves automatically – If a partner leaves (unless agreement states otherwise).
At the end of the day, the biggest reason people choose not to form a general partnership is the high personal financial exposure it entails.
General partnership taxation
As a pass-through entity, taxes for general partnerships are pretty simple. Just like a sole proprietorship, the taxes are paid at the personal level. However, a partnership must still file an informational return (IRS Form 1065) with profit-and-loss information.
Each partner will receive a Schedule K-1 from the partnership and include it with their federal personal income tax return. Taxes are due on the partner’s share of both distributed and undistributed profits, as well as self-employment taxes. Many partners involved in a general partnership prefer to pay estimated quarterly taxes instead of a large tax bill all at once along with possible penalties.
Taxes at the state level differ, so make sure to speak with your accountant to remain compliant.
When does a general partnership make sense?
So, is a general partnership for you? Only you can make that decision, but successful companies that are run as general partnerships are usually:
- Small, low-risk service businesses with limited financial exposure
- Short-term collaborations, like a pop-up shop
- Generational and family-run operations
- Businesses with partners who trust each other strongly
If your business carries significant financial liability, such as if you’re starting a construction business or going into manufacturing, an alternative business structure, such as an LLC, is a much better option.
Should you create a partnership agreement?
Although there is no requirement to draft a partnership agreement, most experts suggest that general partnerships should have one. A written agreement you can refer back to is useful when dealing with the inevitable disagreements that will crop up.
A good partnership agreement that covers both management and money issues, such as;
- Define how profits and losses will be distributed amongst the partners.
- Decide who can make management decisions, how responsibilities are divided, and whether any actions require all partners to vote.
- Establish how disagreements will be settled, such as through voting.
- Determine the procedure if one partner wants to sell their interest in the business to another partner.
- Develop a succession plan if a partner leaves the company.
Converting a general partnership to an LLC
All businesses evolve, and you may find that your general partnership just doesn’t work anymore. The good news is that you can convert your general partnership to an LLC with minimal interruption.
While there is no simple form to fill out, the process is pretty straightforward:
Formally dissolve the general partnership
Although creating a general partnership doesn’t require much paperwork, dissolving one is a little more complex.
First, all partners must agree to dissolve the partnership in accordance with the partnership agreement, if one exists. A formal written dissolution document is then written up. After there’s an agreement to dissolve the partnership, any outstanding debts and obligations must be settled. It is important to note that dissolving a partnership does not eliminate any debts. After all the debts are discharged, there is a final distribution of profits and closing of any bank, merchant, and other financial accounts.
Some states require additional paperwork.
Form the new LLC with the state
Once the general partnership is dissolved, the partners may form an LLC in the usual manner. None of the former agreements automatically carries over to the new business structure.
Just as with any new LLC, the partners will need to file Articles of Organization, select a business name, draft an Operating Agreement, and file all required paperwork with the state.
Since forming an LLC is more complicated, even experienced business owners like to use a platform like Tailor Brands to ensure everything goes as smoothly as possible.
Transfer assets, contracts, and operations
Once you make the change to an LLC, don’t forget to open new bank and merchant accounts in the name of the new LLC. You will also have to update client contracts, vendor agreements, business licenses, and permits before you can legally do business.
Address tax filings and EIN requirements
When you change from a general partnership to an LLC, taxes may be particularly complicated. If you don’t usually use an accountant, it is probably a good idea to hire one during the transition to fully understand your new tax burden and ensure you remain compliant.
In addition to filing the final Form 1065 and sending out the Schedule K-1s to the partners of your dissolved general partnership, you will need to update your federal and state tax registrations.
Understand liability timing
Remember, converting an old general partnership to an LLC will only protect the owners from the time the LLC was registered. It has no effect on past liabilities.
Conclusion
A general partnership is a low-cost and simple way to start a business with multiple partners. The downside to this type of business structure is that partners’ personal assets are not protected against financial obligations, and one partner can create lasting legal issues for all partners. Despite the drawbacks, creating a general partnership is a good option when working with trusted partners in low-risk industries, and there is always the option to convert to an LLC if liability protection becomes important later.