fact that it may only have one owner. If your business grows and you bring in another owner, you are no longer a Sole Proprietorship. Once you start splitting the profits with another individual, your business becomes a General Partnership. And with that you are using an even less desirable entity for doing business than a Sole Proprietorship.
General Partnership
Whenever two or more persons agree to share profits and losses a partnership has been formed. Even if you never sign a Partnership Agreement, state law provides that under such circumstances you have formed a General Partnership.
A written Partnership Agreement is not required by law. A handshake is acceptable for formation. In the event you do not sign a formal document, you will be subject to your state’s applicable partnership laws. This may not be to your advantage in that such general rules rarely satisfy specific situations. As an example, most states provide that profits and losses are to be divided equally among the partners. If your oral understanding is that you are to receive 75 percent of the profits, state law and your handshake will not help you. You are better advised to prepare a written agreement addressing your rights and rewards.
Unlike a Sole Proprietorship, in which only one individual may participate, by definition, a General Partnership must consist of two or more people. You cannot have a one-person partnership. On the other hand, you may have as many partners as you want in a General Partnership. This may sound like a blessing, but it can actually be a curse.
The greatest drawback of a General Partnership is that each partner is liable for the debts and obligations incurred by all the other general partners. While you may trust the one general partner you have not to improperly obligate the partnership, the more general partners you bring aboard the greater risk you run that someone will mess up.
And remember, just as with Sole Proprietorships, your personal assets are at risk in a General Partnership. Your house and your life savings can be lost through the actions of your partner. While you may have had nothing to do with the decision that was made and you may have been five thousand miles away when it was made and you may have voiced your opposition to it when you found out it was made, as a general partner you are still personally responsible for that decision.
As such, a General Partnership is much riskier than a Sole Proprietorship. In a Sole Proprietorship, only the proprietor can bind the business. In a General Partnership, any general partner – no matter how wise or, unfortunately, how ignorant – may obligate the business. By contrast, LLCs and LPs and Corporations offer much greater protection. All of them offer owners limited personal liability for business debts and the acts of others.
It should be noted that because of these unlimited risks, the last thing you want to do is become a general partner of an enterprise in which you do not have day-to-day management control. If you do not thoroughly know what is going on in the company you should not put your future on the line as a general partner.
This issue occasionally arises when investment scam artists are trying to raise money through the sale of General Partnership interests. Because the sales of securities are so heavily regulated, and therefore costly to promote, certain unscrupulous types have promoted General Partnerships as an exception to the securities laws. Their slick rationale is that a General Partnership interest is not defined as a security since all general partners are manager/participants and thus not the type of passive investors for which the securities laws apply. Federal and state securities regulators do not agree with this definition. The interest you purchase allows you and several hundred other people to become general partners in, for example, “the most significant silver mining property in Bolivian history.” The promoters raise the money and obligate the partnership to purchase several million dollars worth of mining equipment. Of course, the promoters then retire to Bolivia, leaving the remaining general partners liable for the partnership’s debts.
In oil and gas investment scenarios, the only way to receive the very favorable tax incentives is to be a general partner in the limited partnership syndication. You must be a general partner as an individual (not through an entity) to get the tax breaks. In that event be certain the syndicator has plenty of insurance (which never completely reduces risk) and once all the tax benefits are received that you are converted to a limited partner, a position of much greater protection.
Certain advisors will, as with Sole Proprietorships, suggest that a General Partnership be used because it is easy to set up. Most states do not require organizational paperwork for a General Partnership to be filed with the secretary of state. Some advisors will comment that there is no requirement for a General Partnership to hold regular meetings or keep records of meetings, despite the fact that the better practice is to do so, and thus argue that General Partnerships are, again, easy.
As discussed with Sole Proprietorships, when it comes to General Partnerships, easier is not better. The specter of unlimited personal liability in this day and age is too overwhelming even for the lowliest aspiring start-up to take on. Furthermore, nothing about operating a business successfully is easy. Why then should one of the most important legal decisions you make about your business be “easy”?
There are two further arguments that certain advisors will make as to the easiness of General Partnerships. Both are fallacious and wrong.
In discussing the issue of unlimited personal liability for the acts of general partners, some will suggest that insurance can overcome such risks. This ignores the fact that many affordable commercial insurance policies contain:
• high deductibles for which the partners are responsible; and
• innumerable exclusions designed to limit coverage
Furthermore, most people involved in small businesses cannot foresee all the possible risks, and even if they could, would not be able to afford full coverage. No policy will cover the mismanagement of the partnership, much less the wrongful acts of one general partner. And no insurance is going to cover the inability of the partnership to pay its normal debts and obligations. Again, such acts become the personal responsibility of the general partners. On the other hand, LLCs and Corporations, as a matter of law, shield their owners from such liability.
A second argument made as to the easiness of the General Partnership is that all it takes is a simple General Partnership Agreement. As discussed, the need for a written document to reflect the partners’ intent is prudent. However, the problem arises in that no General Partnership Agreement is simple. Each one must be tailored to reflect the specifics of the understanding and the transaction. The cost to have an attorney draft a General Partnership Agreement will run between $1,500 and $5,000. And with that, you are paying a significant amount of money for a document and an entity that will not protect you.
In my practice, I will not prepare a General Partnership Agreement for a client. It is simply not the right entity for any of my clients. Our company, Corporate Direct, Inc., prepares a complete and fully ready LLC, LP or Corporation for $695 or less, plus state filing fees. In doing so, we can better protect our clients and save them money in the process. Why should our clients pay more money to be put at greater risk?
I trust this initial discussion of Sole Proprietorships and General Partnerships has dissuaded you from considering the use of such entities. They will be noted in the entity chart and in the section on taxation for purposes of comparison, but not seriously discussed hereafter.
Corporations
Forming a Corporation involves creating an independent legal entity with a life of its own. It has its own name, business purpose and tax identity with the IRS. As such, it – the Corporation – is responsible for the activities of the business. In this way, the owners, or shareholders, are protected. The owners’ liability is limited to the monies they used to start the Corporation, not all of their other personal assets. If an entity is to be sued it is the Corporation, not the individuals behind this legal entity.
The history of Corporations can be traced to western civilization’s rise from the stagnation of the Dark Ages. In the early 1500s it became apparent that a new form of business was needed in order to advance economic activity. Previously, an investor/entrepreneur who engaged in a business that was not successful would not only lose all of his personal assets, he also could