“The only ship that doesn’t float is a partnership”. This is common when consulting entrepreneurs who are considering bringing on a business partner. While a general partnership is the oldest business organization, it is the worst choice possible. This is because general partnerships are laden with traps that could easily end in financial ruin for all involved. A Limited Partnership is a better form of organization for protecting investors.
So, why was the limited partnership law developed to protect investors, and how do you avoid being considered a general partnership?
What Is a General Partnership?
A general partnership is formed through implied conduct. This is when two or more individuals agree, either orally or in writing, to engage in business towards a common goal. A general partnership commences upon performance of even preliminary tasks to create the business. This is the default applied anytime two or more people choose not to file a limited liability business entity before they operate together. Liability during this pre-incorporation stage is referred to as “promoter liability”.
A general partnership is a bottomless pit of liability. Partners are married at the hip in every action. Partners are liable for their own actions plus their partners’ actions. This is true even if every partner did not approve or was not aware. Each partner has the authority to make legally binding decisions on behalf of the general partnership. Partners share all profits and losses equally by default unless otherwise agreed upon.
Liabilities against partners in a general partnership remain “joint and several”, regardless of agreement. This means a 1% partner can be personally subject to liens and asset attachments for 100% of the general partnership liability. Only after the creditor is paid, would it be up to that 1% partner to collect proportionate shares of liability from his or her other partners to recoup his losses of 99%.
What Is a Limited Partnership?
A limited partnership does what its name suggests. It limits the responsibilities of one or more of the silent investment partners, called limited partners. A limited partner is not involved in the day-to-day activities. Their liability is also limited to their investment in the company. This differs from the rule of the general partner in the limited partnership, who is the manager and retains unlimited personal liability beyond their own investments within the company.
Many of today’s limited partnerships use a separate corporation or LLC as the general partner to address a general partner’s unlimited liability. This two-layer entity structure limits the liability for the general partner. Limited partnerships are often used in real estate investments and private equity. The term “master limited partnership” is used when the limited partnership is sufficiently large in size and solicits institutional investors.
Why Form a Limited Partnership?
Entrepreneurs should never use a general partnership. Even for “small investment” businesses where risks are remote or investments are small, the potential downside of unlimited personal liability may result in personal bankruptcy. Therefore, a better structure would be to form a limited partnership with an LLC setup to serve as its general partner, simply by forming a Delaware LLC instead. An LLC affords liability protection for everyone included by default, including a natural person as manager, without having to form a separate entity for the manager as would be needed in a limited partnership.