Just like marriages, there are a LOT of things that can go wrong with business partnerships! I’ve been working on these for almost 15 years and I still don’t think I’ve seen it all. But, despite all the risks, there’s still ways in which we can structure partnerships so that they work. Let’s dive right in!
You’d be surprised by how quickly a business partnership can be created. If you and a friend take money for a service or selling something together, technically, that small move automatically creates a partnership. Yes, out of thin air, even by accident! Of course, that can be a dangerous thing–if not done intentionally!
This creates a “General Partnership,” which makes you legally at risk for (arguably) everything your business partner does that’s in-any-way-related to the business. Importantly, you do NOT have “limited liability,” either, so whatever your partner does, even if it’s fraudulent or criminal, you’re at risk of taking the consequences for your partner’s actions.
How do we avoid all of that? Read on!
Obviously, the “General Partnership” structure that we talked about, above, is not an attractive option. So, what are the alternatives? We’ve got LLCs, which are probably the most common, Corporations, S Corps, LLPs, LLLPs, Professional Corporations (PC), etc. We could write multiple articles on the pros and cons of each one, but for efficiency, let’s just discuss the most common:
Like we said, above, many partnerships are created by accident, and of course those are volatile and risky. Getting your partnership set up correctly needs to be done intentionally and by an attorney.
Legally, the attorney will have to register your new company with the State’s Secretary of State’s Office. You will need to link the entity (your business) to a living, breathing professional that can handle things like service of process if/when it gets sued (because the company is considered a “fictitious entity,” and not an actual human being). This lawyer is called your “Registered Agent.”
Depending on the county you’re doing business in, you will likely need a business license, as well.
Perhaps most importantly, you will need to workout some details of your partnership agreement, which we’ll get into below.
Nearly every provision in a partnership agreement is essential, but I’ll list out the top 3 here:
While oral agreements and handshake deals are technically binding, in my experience they are not binding in a practical sense. For any contract to actually be enforceable (binding) you really have to have it written down and signed by everyone.
I know, I know, you’re probably thinking that this guy is such a great friend, and attended your wedding, and is Godfather to your daughter or something, but trust me when I say that partnerships fall through all the time. Things change and people make other plans. Maybe your partner becomes addicted to something or has to move to another state to help out a loved one, or has a bad car accident and needs money quickly to pay medical bills – there’s a million things that can happen, and when they do, you have to have a contract to know how to deal with it.
A good partnership agreement covers things like this, so that the outcome (for the business and the remaining business partners) is as smooth as possible.
Fiduciary duties (or in plain English, what you have to do for your business partners) largely depend on the entity type you’ve got (General Partnership, LLC, Corporation, etc.) and, of course, your partnership agreement itself. By default, General Partnerships (which are bad bad bad – see above) give you a huge amount of duties towards your partner(s). These rules are based in very old, archaic laws left on the books, such as the duty of loyalty and duty of care. The duty of loyalty requires that you take every business opportunity to your general partner and give them the right of first refusal before doing it. You also have to include your partner in basically all other business endeavors, which sort of makes sense for the 1500s when the laws were made, but not really in our modern society!
To contrast the rules of a general partnership, LLCs don’t obligate partners to these types of things, absent a specific provision in the agreement. There are pros and cons to this. Most new LLCs don’t have any restriction on partners competing against each other. That would certainly make for bad blood among partners, but the going rule is that “it’s a free country” and partners are allowed to partake in whatever business activities they want to, even if it’s (arguably) harmful to the LLC partnership! To offset this, a lot of the partnership agreements we draft will include a non-compete and non-solicitation agreement. There are additional provisions that we like to use in the agreements we write, but going over all of them would make this article too lengthy–feel free to call us though and we can walk you through it!
As you can see, above, for general partnerships there can be a LOT of liability. The archaic laws still (arguably) make YOU liable for your partner’s actions, even if those actions were against your advice, and even if they were criminal!
For most modern partnerships, though, with LLCs or Corporations, you are not liable for actions taken by your business partner, so long as those actions are not for the partnership itself.
If, instead, the activity is on behalf of your partnership, then the company will be liable for those actions (for example, the your partner can bind your company to, say, a lease agreement, and your company will still have to pay the landlord even if you didn’t sign anything). There are, of course, ways to write a good partnership agreement that limits each partner’s “authority to bind” the company, but that has to be done intentionally in order for it to work the way you want it.
In case you were wondering, for modern partnerships (LLCs and Corporations) you are not generally held liable for criminal actions your partner takes that are not for the company.
Yes! In fact, this is more common than you might think. This solves a common issue between partners – who gets to use company funds for personal expenses? Often, business owners will use company funds for things that would otherwise be personal expenses (things like car payments, health insurance, cell phone and home wifi). This is all well and good, but when one partner’s personal expenses are paid for by the company and the other partner does not HAVE those expenses (or their expenses are much lower) then the result is a windfall for the partner with “more expenses.”
This is easily solved by making each partner own their own LLC or Corporation (where they can pay for personal expenses just fine) that owns their actual shares in the Partnership LLC or Corporation. That way, each partner gets to use their own company to pay for these expenses, and take tax deductions and so forth as needed, without allowing for the disparity between the partners!
I’m no CPA, so take this with a grain of salt (ask your actual CPA, please!). That said, my experience is that taxes don’t change a lot when adding business partners. Each partner will get what’s called a “K-1” that shows the amount of income/profits they are being taxed on for the relevant tax period. If you have more than 100 owners, you can’t have it taxed “as an S Corp,” but of course that’s very rare, these days.
The right way is to hire an attorney to help negotiate the deal for you, and draft a contract that adds or removes the partner with the least amount of friction or leftover threads that could make for problems in the future (there are many). Please, please, please don’t write something yourself! I’ve been able to blow those up hundreds of times, and it’s really not worth it.
And there’s so many! Let me just brainstorm:
At Sparks Law, we’ve worked with thousands of business owners and their partnerships (yes, actual thousands). We’ve got the experience and the know-how to help you to get a great partnership agreement in place that protects your business from all of the nightmares we’ve seen, throughout the years! We pride ourselves on our responsiveness! When you pick up the phone, you get to speak with a real person – our firm is small enough to care. Reach out online or give us a call today at 470.268.5234!
