Monday, May 2, 2011

Lesson #7: Establishing the Legal Entity for Our Business; Part 2

A partnership is a legal relationship existing between two or more persons (the law does not have an upper limit) who join to carry on a profit-motivated business. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business.
Unlike a sole proprietorship, a partnership is a separate legal entity with the power to sign agreements, borrow money and represent those who make up the business. However, a partnership files its annual tax return only as an “informational” report showing its income, deductions, expenses and losses from its operations. The actual income tax responsibility is placed on each partner based on his percentage of ownership in the partnership. Each partner is required to include his share of the partnership's income or loss on his personal tax returns.
General Partnerships
Like a sole proprietorship, a general partnership in California has no formal registration procedure. It only requires two or more people to formalize a verbal agreement to start a business. It would be well advised, however, to establish a written agreement using the federal “Uniform Partnership Act” as your opening template. This document will describe the rights and responsibilities of each partner.
  • Use the same formation process as for the sole proprietorship beginning with the search for a fictitious business name. You could also search through the recorded names of corporations and LLCs listed with the California Secretary of State if you’re considering statewide use.
  • Determine the initial contribution each partner will make to the partnership based on a solid estimate of the money and resources you’ll need to launch the business. Contributions may be in the form of cash, property or services, but the contributions must provide the business enough capital to operate reasonably from the outset. Your agreement needs to show each partner's initial contribution.
  • Within your agreement, create a procedure on how the business will dispense the profits and losses among the partners. The Uniform Partnership Act will presume that each partner is “jointly and severally” liable for the partnership debts -- that is, each partner is individually liable for the entire partnership debt -- but you may outline in your partnership agreement how profits and losses will be distributed.
  • Divide authority among each partner. While each partner must have access to the partnership fiscal and operating records, the scope of each partner's authority can be defined and limited in the partnership agreement.
  • Develop a process for conflict resolution between partners. Disputes can result in an ugly partnership dissolution unless specific guidelines are described in the partnership agreement.
  • Outline the steps for adding a new partner or for allowing an existing partner to resign.
  • Optional: you can register your new business in a Statement of General Partnership with the California Secretary of State for a fee of $70.

Operation of a General Partnership
  • Because a partnership is a group endeavor, you have the advantage of working with others toward a common objective. However, any time you’re dealing with people, conflicts are most likely going to arise. How you are set up to settle these conflicts is critical to your success:
Ø  Make sure you have the same vision. Talk it all out before entering into the partnership
Ø  Define your roles by considering each of your strengths and skills
Ø  Hold periodic meetings – at least once a month – and create an open communicative culture
Ø  Establish the decision-making process especially as it pertains to resolving conflicts
Ø  Write up a partnership agreement (see below)
  • In a general partnership, each partner is “jointly and severally” liable for the actions of the partnership. This means that each general partner is deemed an agent of the partnership and is empowered to make decisions on behalf of the company including borrowing money and signing agreements. It also means that if one partner misuses funds and personally cannot pay back a debt, all the partners become liable for that debt. Furthermore, if one partner is caught in a wrongful act or represents the company without the knowledge of the other partners, all the partners are held liable. While a written agreement is not required by law, having one drafted and signed by all the partners is essential to curbing any impropriates or misunderstandings.
  • According to the US Small Business Administration, a partnership agreement should include:
Ø  Amount of equity invested by each partner
Ø  Defining the type of business and being clear as to what you’re selling
Ø  How profits and loss will be shared
Ø  Partners pay and compensation
Ø  Distribution of assets on dissolution
Ø  Provisions for changes or dissolving the partnership
Ø  Dispute settlement clause
Ø  Settlement in case of death or incapacitation
Ø  Restrictions of authority and expenditures
Ø  Length of partnership
  • By law, a general partnership can terminate upon the death, disability, or even withdrawal of any partner. However, you can avoid this by spelling out the provisions to address these occurrences. In most cases, the shares of a departing partner are purchased by the remaining partners.
  • By law, each general partner has an equal right to participate in the management and control of the business. Disagreements in the ordinary course of business are decided by a majority of the partners. More serious disagreements or amendments to the partnership agreement require the consent of all partners. However, in a partnership of any size the partnership agreement may include language allowing certain partners to manage the partnership such as a company board.
  • Unless otherwise provided in the partnership agreement, no one can become a member of the partnership without the consent of all partners, though a partner may assign his share of the profits and losses and right to receive distributions ("transferable interest").
·       Each partner is responsible for reporting their percentage of the partnership’s revenues and losses directly on their personal tax returns. While the partnership entity is required to report its financial activities to the IRS, it is not required to pay any taxes owed or given credits for losses.
Liability Potential
·       A general partnership is considered open for liability to the partners and not to the partnership as a separate entity as would be the advantage of an LLC and corporation. This places the burden of financial responsibility onto each partner whether for financial or legal mishaps.
·       As with a sole proprietorship, it is mandatory for the business to carry liability insurance and for each partner to carry a personal umbrella coverage to cover any negative legal rulings.

Limited Partnerships
A limited partnership is a business entity consisting of one or more general partners and one or more limited partners. The general partners are responsible for the operation of the company and thus, are also held liable for any legal action. Limited partners are only liable for the amount they invest into the company, and they have no management or decision-making powers.  The limited partnership was developed to address the liability flaw inherent in the general partnership law. In addition, you can only create a limited partnership by registering with the state. Given its more complex formation and protection for its limited partners, a more complete registration process is necessary.
Note: a Limited Partnership is not the same as a Limited Liability Partnership.
Limited partnerships are formed when an individual or individuals have a business idea they want to pursue but lack the necessary finances to get it started. Thus, they solicit investors as their “silent partners” with the intentions of sharing any future financial gains. Much of the same rules that are listed above for general partnerships can also be applied for the limited partnership.
Limited Partnerships are required to register with the state:
Ø (worker’s comp insurance)
  • If you will be selling products, a reseller certificate will also be mandatory:

Operation of a Limited Partnership
  • Write up a partnership agreement using the guidelines set forth in the General Partnership section above. However, you’ll need to specify the different rules between the general partners and the limited partners.
  • In some instances, individuals forming the limited partnership have designated a corporation as the general partnership. In this case, it would be wise to seek the assistance of a business attorney to help you set this up assuming that you are also the founder of the corporation.
  • A limited partnership must maintain certain records and must follow specific requirements for registering the business name.
  • A limited partnership is not permitted to engage in the banking, insurance, or trust business.
  • When a limited partnership wishes to dissolve, it must file a certificate of cancellation with the Secretary of State in order to cancel its certificate of limited partnership.
  • A limited partnership can continue after the death or departure of a partner assuming it is written as such in the partnership agreement. The departing partner (or his or her beneficiaries) may be entitled to the fair market value of the partnership interest. The beneficiaries also may have the option of becoming limited partners.

·       Partners are not employees and are not issued a Form W-2. The partnership must furnish copies of Schedule K-1 (Form 1065) to the partners.
·       Each partner is responsible for reporting their percentage of the partnership’s revenues and losses directly on their personal tax returns. While the partnership entity is required to report its financial activities to the IRS, it is not required to pay any taxes owed or given credits for losses.
Liability Potential
·       As its name states, the limited partners are limited in their liability only for their share of the investments. The general partners are liable for the entirety of their company even when it goes beyond their own investments. In the case of a legal action against the company, the court can order the general partner to pay whatever amount deemed to satisfy the court’s decision.

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