Partnerships: Pros and cons

The most important decision an entrepreneur can make is how to form his or her company. If a business owner has a partner or partners, frequently the most obvious choice is to form a partnership.

But, like everything, partnerships come with their own pros and cons. In fact, forming a partnership should be based on what is best for the company, not simply because there is more than one person involved in the business.

There are three types of partnerships—a general partnership, limited partnership, and limited liability partnership.

General partnership

General partnerships consist of two or more partners responsible for the business. They share the assets and profits, as well as the liabilities and management responsibilities for running the business.

Each of the individual general partners is taxed on his or her personal income tax return, which means they must include the business' income on their income tax returns.

Each partner can also deduct losses from the business on his or her own individual tax return. This pass-through tax treatment is one of the most beneficial advantages of forming a partnership. With pass-through tax treatment, filing is relatively easy. There is no taxation to the business itself. All income, deductions, and credits, "pass-through" to the individual partners and are reported on their individual tax returns.

Another benefit of general partnerships is their simplicity and flexibility. General partnerships are usually less expensive to form and require less paperwork and formalities than corporations, limited partnerships, or limited liability partnerships. General partnerships can choose a centralized management structure, like a corporation, or a completely decentralized structure, where every partner is actively involved in the management of the business. Other advantages of a general partnership are that the partners can combine resources and share the financial commitment.

There are disadvantages to general partnerships, principally liability. General partners are personally liable for the business debts and liabilities. Each partner is also liable for the debts incurred by the actions of other partners. Because of this potential personal liability, general partnerships are limited in their ability to raise money and attract investors.

Limited partnership

If 100 percent liability is too much of a risk, a business owner may opt for either a limited partnership or a limited liability partnership. In a limited partnership, there are one or more general partners and one or more limited partners. The general partners participate in management and have 100 percent of the liability for partnership obligations.

Limited partners cannot participate in the management and have no liability for partnership obligations beyond their capital contributions, protecting them against personal liability for the partnership's debts and other obligations. They do, however, receive a share of the profits for their involvement as limited partners.

Many partnerships are formed as limited partnerships because the limited liability is attractive to passive investors. Many people find it easier to market limited partner interests, and general partners can raise money without involving outside investors in the management of the business.

Assets are also protected in a limited partnership. Unlike corporate law, which allows a shareholder's stock to be confiscated in a personal lawsuit, there are provisions that protect a partner's interest in a limited partnership from being taken away if the other partner gets sued. A limited partnership also enjoys the advantages of pass-through tax treatment, as it is taxed like a general partnership in that it is the profits and losses pass through to the partners, who then include their allocated income on their personal tax returns.

Besides the obvious advantages of limited liability for limited partners, a limited partnership can also allow the general partners to use their expertise to make important decisions in managing the business.

However, having general partners can also be a disadvantage, in that they still assume 100% personal liability. Limited partnerships also have more filing formalities than a typical general partnership. In addition, limited partners lose all of their limited liability if they participate in any management functions within the company.

Limited liability partnership (LLP)

For the business owners who do not want to assume any liability whatsoever, there are limited liability partnerships (LLPs).

An LLP allows limited liability for all of the partners. Like general and limited partnerships, LLPs pass the profits and losses through to the partners, and LLPs have the flexibility of choosing either a centralized management structure or a completely decentralized structure like a general partnership.

Unlike a general partnership, partners in an LLP have limited liability and, unlike limited partners in a limited partnership, they do not lose their limited liability if they actively participate in management.

Probably the biggest disadvantage to forming an LLP is that it is available only for certain occupations, such as attorneys or physicians. This significantly limits the number of businesses that have LLP formation as an option.

In addition, a partner in an LLP is personally liable for his or her own negligence, or the negligence of an employee working under the partner's direct supervision. The partner is also personally liable for many types of obligations owed to business creditors, lenders, and landlords. The partner is not personally liable for the negligence of the other partners.

Before deciding on a business formation strategy, it's always smart to talk to your legal and tax professionals.