This is the first in a series of posts in which we discuss various business entity types. In the first of this series, we discuss general partnerships. The general partnership represents the most basic multi-owner business entity type. Despite its flexibility and tax appeals, the general partnership also fails to protect its owners in the way many other entities do.
Ease of Formation: A Risk and a Benefit
The general partnership’s informal nature is its most appealing quality but also perhaps its greatest risk. A general partnership is formed when two or more individuals, called partners, begin conducting business together. The general partnership does not require any filings with the Texas Secretary of State and does not require any business governance documents. The partners may draft a partnership agreement, but this is optional. Although these qualities may appeal at first glance, they also present a serious danger. Because the Secretary of State does not require any partnership filings, unless the partners draft a partnership agreement or other document memorializing the relationship of the parties, the partners’ very possible lack of understanding regarding their relationship and regarding details of their joint business frequently lead to partnership disputes and litigation. For example, if two individuals agree to begin “doing business together” and in fact begin transacting business without clarifying the nature of their relationship, their division of revenue, their division of labor, their capital contributions, and numerous other contentious factors, disputes may occur regarding not only these details but also regarding whether they are even partners. This presents an especially complex dispute when each individual also owns his own business outside the joint endeavor.
Texas courts and the Texas Business Organizations Code, the body of law governing Texas businesses and many disputes surrounding them, designate several factors to resolve disputes regarding whether a partnership exists. Because the factors are holistic and complex, we cannot efficiently discuss them here. Numerous other disputes may also arise concerning partnership details, such as division of labor and revenue, capital contributions, and many others, but these are best left to a separate discussion dedicated exclusively to partnership, shareholder, and member disputes.
No Limited Liability Protection
Another major weakness of the general partnership lies in its lack of limited liability protections. In exchange for their formation filings and filing fees, the State of Texas grants most business entity types some degree of liability protection. Because the general partnership avoids all formation fees and forgoes any State filings, however, the general partnership does not benefit from liability protections. As a result, the Texas Business Organizations Code holds general partners jointly and severally liable. If one partner incurs a liability or is sued, the other partners may also be liable for the full extent of the damages. In other words, general partners are liable for one another’s faults and may designate one another as responsible parties during litigation. In addition, the partnership’s liabilities may access the partners’ personal assets. The risk of personal asset loss alone represents sufficient grounds for most prospective business owners to avoid the general partnership structure.
Flexibility and Taxation
Despite its significant weaknesses, the general partnership features a few limited strengths. First, the general partnership presents a flexible management structure. The partners may memorialize their division of labor and job duties in an agreement or other document. Although prospective businesses should memorialize operations and duties in writing as a precautionary measure and in defense of potential conflicts, the law does not set forth of general partnerships specific recordkeeping or contract requirements. Subject to any self-imposed restrictions in a written partnership agreement, partners may also appoint officers and managers in their discretion. This ease of management constitutes one of the most desirable facets of general partnerships, though some other business entity types also offer similarly flexible management.
General partnerships also offer favorable taxation treatment. Tax law treats partnerships as pass-through entities. This means the business entity does not pay tax at the entity level. Instead, the partnership’s profits and losses pass through to the partners, and each partner includes his or her share of the partnership’s profits and losses in the partner’s income tax returns. Again, although favorable tax treatment entices many prospective business owners, some other business entity structures also offer pass-through taxation.
Despite the general partnership’s ease of management and the lack of need to incur filing fees and to file formation documents, rarely can I recommend this business structure to my clients. The danger of the entity type’s joint and several liability and the exposure of personal assets simply outweighs the convenient lack of filing requirements and tax benefits, especially because other entity types offer comparably flexible management and tax treatment. Business owner hopefuls who lack the minimal funds to file formation documents with the Texas Secretary of State may consider the general partnership structure, but such businesses should consider converting to other structures for the sake of liability protection when funds allow.
Note: Do not conflate the general partnership with other partnership structures, such as limited partnerships. We will cover other partnership structures in future discussions.
Samy Diab, Attorney
Diab Law Firm