Last month, I started a four-part series of columns to help you understand the various entities under which you can do business and their advantages and disadvantages. The primary advantage is to protect your assets. In part two, I present General Partnership and Limited Partnership.
General Partnership
A general partnership is formed when two or more individuals or entities agree to do business together, for a profit. No written partnership agreement is required, although one can be created. A general partnership can be created, even if you did not intend it (i.e., a judge will let you know when you are sued for something someone else did on your behalf – this is sometimes known as “partnership by estoppel”).The partnership itself does not pay taxes; it files an informational tax return with the IRS. This return (IRS form 1065) simply summarizes the income, expenses, profits and losses of the partnership. The bottom-line profit or loss “flows through” to the partners who report their share of income or loss on schedule “E” of their personal income tax returns (the partnership will send each of the partners an IRS form K-1, which states the partner’s share of profit or loss).
A general partnership does not protect its partners from liability protection. Partners are jointly and severally liable for each other’s tortuous (wrongful) acts. “Jointly” means that if one partner causes the partnership to be sued, all partners are liable; “severally” means that all partners are liable for 100% of the judgment. If you are the “silent” partner who invests the most money and has more assets than your partner, then you have the most to lose.
Limited Partnership
A limited partnership has at least one limited partner and one general partner. Most states require the filing of a certificate with the state to be recognized as a limited partnership.
The limited partners generally have no liability beyond their contribution to the partnership. If the limited partnership business fails, then creditors cannot go after the limited partners for debts (there are a few minor exceptions to this rule that are rather easy to avoid).
Furthermore, limited partners are not personally liable for wrongful acts committed by the other partners. In exchange for this limited liability, the limited partners give up their right to participate in the control and management of the partnership. The general partners run the management of the partnership. The general partners control the cash distributions to the partners. The general partners also have unlimited liability, as in a general partnership.
Creditors of the partnership can look to the general partners’ personal assets, if the limited partnership’s assets are insufficient. Furthermore, the general partners are liable to third parties for wrongful conduct within the partnership business (e.g., a “slip and fall lawsuit”). Thus, a corporation is usually better for pure liability protection for its owners.
The limited partnership does not pay federal income taxes. It files a partnership return of income (IRS form 1065) and issues a form K-1 to the partners. The partners report the partnership income or loss on their personal tax returns. The partners must pay income tax on all gains whether or not the profit is distributed.
Creditors of individual partners cannot take a partner’s place in the partnership. A creditor may garnish the partner’s share of income, but has no right to participate in the management or utilize partnership property. The creditor is only entitled to attach the income that the partner is current receiving. Thus, if a creditor attaches a limited partner’s income, then the general partner can frustrate the creditor by not distributing income to the partners. Obviously, the general partner should be someone under the limited partner’s control.
