Hey everyone, hope your day is going/went well.
Today’s post will be a continuation of the topic introduced in the last one, namely how to structure your business from a legal standpoint. In that last post (if you haven’t read through it yet; do so now - it will help this one makes more sense/be more useful to you), we learned that the default option for how the legal system in North America views your business is called a sole proprietorship - unless you take further action to pursue another option.
Today, we discuss one of those options, specifically, the Partnership.
You may not realize it, but partnerships are all around us, especially in the professional service industry - there’s a good chance your local law and accounting firms are structured as partnerships. But not all partnerships are created equal, and as each has their pros and cons, some types fit certain situations better than others.
Here’s what you need to know about partnerships, in our traditionally concise, ‘no B.S.’ format:
- A partnership is a business arrangement consisting of two or more individuals.
- Rules: A partnership is formed when those individuals enter into a contract known as a partnership agreement. This agreement outlines how the business will be run -- the ‘rules of the game’, in other words.
- Function: In nearly every way, a partnership will function as a ‘flow through entity’ - meaning that whatever happens to the partnership itself will flow through to the partners themselves, based primarily on whatever ‘rules’ are documented in the partnership agreement. We’ll come back to this soon.
- Different flavours: Partnerships come in 3 main forms. These are the General Partnership (GP), Limited Partnership (LP), and the Limited Liability Partnership (LLP). We’ll explore each below.
- Profits, Taxes, and Legal Liability:
- In a GP, legal, financial, and tax events flow through the partnership to all of the partners (based on their percentage of ownership, in whatever way that is calculated per the partnership agreement). This means that a general partner faces the exact same risks as a sole proprietor (personal legal liability, no tax benefits, etc.). While those risks are all reduced by that partner’s ownership percentage, so are the rewards (profits) - so the risk/reward ratio remains proportional.
- An LP introduces the idea of limited partners. Note that every LP requires at least one general partner within it. The GP must be involved in the day-to-day operations and faces the same risk/reward scenario as described for GPs above. For the LPs, the partnership agreement specifically outlines the rewards (profits) they’re entitled to, what responsibilities they have (which should not include day-to-day operations to avoid the courts treating you as a GP), what they must contribute, and what types of risks they face. Generally, the risk exposure for an LP is limited by the amount that they’ve contributed to the partnership.
- An LLP is typically only available to certain professions that offer services to the public and face considerable financial risk. Examples include doctors, lawyers, accountants, and engineers. In an LLP, all of the partners are limited (there is no general partner), and each partner is only responsible/faces risks from the activities they were directly involved with. However, they share in the profits generated from the LLP as a whole (allocated based on their proportional ownership, of course).
- Transfer of Ownership: This can be extremely easy or simply not allowed - it all comes down to how that process was defined in the partnership agreement.
As you can see, the partnership option really kicks things up in terms of flexibility and complexities when you’re deciding on how your business should be structured. When you’re considering what’s best for you, the key to remember is the concept of the flow-through entity - how you operating through a partnership will look depends on your specific circumstances, since the partnership’s results will flow through it directly to you.
In general, I recommend partnerships when you’re faced with a situation where you have some of the ‘puzzle pieces’ (knowledge, reputation, financing, capital, etc.) and another individual has the others. Meaning that it’s far easier to achieve a given goal/solve the puzzle (successfully enter a new industry/market/country/etc.) together than it would be alone. When you’re considering expansion while managing the inherent risks, using a partnership can often be a solid strategic move.
But what if that’s not your immediate goal, and you’re more excited by the idea of reducing personal liability and getting tax benefits to help you grow/scale faster? Sit tight - we’ll be getting to that next time.
1 In this context, an individual can be a person or other entity recognized in the eyes of the law. This may include, but is not limited to: sole proprietors, corporations, other partnerships, non-profit organizations/charities, governments, etc.