5. Business Organization – Business Structures
Partnerships are another common form of business structure enabling partners with different skills and resources to leverage the unique elements they possess to achieve market success. Partnerships are the default business organization when two or more people work together who are not legally married. People do not need to call themselves partners for a partnership to exist, so it is important for business professionals to understand what constitutes a partnership to avoid forming a business entity that they did not intend. If there is an intention to form a partnership, each partner should understand their rights and duties towards each other. A partnership is a voluntary association of two or more people who jointly own and carry on a business for profit. There are only two required elements to form a partnership:
- A common interest to conduct business together; and
- An understanding to share profits and losses.
There are two main types of partnerships: general partnership and limited partnership.
A general partnership is in place when all partners participate fully in running the business and share in the profits or losses. Legal documents are not required to form a partnership. If two or more people do business together, share management of the business and profits and losses, they have a partnership. If a partnership is formally established, then the written agreement is called the articles of partnership. The articles can set forth anything the partners wish to include about how the partnership will be run.
Any profit or loss from the general partnership business is shared amongst the partners and is reported as employment income. General partnerships are exposed to unlimited liability. Every partner in the partnership is jointly and severally liable for the partnership’s debts and obligations. This is a feature of general partnerships which should be carefully considered. One partner may be innocent of any wrongdoing and still be liable for another partner’s malpractice or bad acts. More importantly, they may have to pay damages for other partner’s actions.
General partnerships are dissolved as easily as they are formed. Since the central feature of a general partnership is an agreement to share profits and losses, once that agreement ends, the general partnership ends with it. In a general partnership with more than two persons, the remaining partners can reconstitute the partnership if they wish, without the old partner.
An issue that often arises is how to value a withdrawing partner’s share of the business. Articles of partnership typically include a buy/sell agreement, including terms on valuing and compensating a withdrawing partner’s share.
A limited partnership has two types of partners: a general partner who runs the business and is responsible for its liabilities, and any number of limited partners who have limited involvement in the business operations and whose losses are limited to the amount of their investment. The main purpose of a limited partnership is to allow people to invest in a business without having to manage the business, and without risking more than the sum invested.
A partnership is implied when one or more people represent themselves as partners to a third party who relies on that representation. A person who is deemed a partner by a third party through implied partnership becomes liable for any credit extended to the partnership by the third party.
Each potential partner should understand, research, and develop the business agreement or proposal ahead of proceeding and, at the very least, investigate their potential partners prior to making any commitments.
All general partners have an equal right to manage the partnership’s business. This does not mean that partners cannot divide up responsibility for the day-to-day management of the business. Rather, partners have the right to enter into contracts on behalf of the partnership, hire employees, and engage in business transactions.
Partners also have a right to compensation for services on behalf of the partnership if they have an agreement for compensation beyond profit sharing. Compensation provisions are particularly common in limited partnerships where some partners are active in the management of business and others are not.
Partners also have the right to receive interest on cash advances made to the partnership. An advance is not automatically considered a capital contribution unless determined to be so under the partnership agreement.
Every partner is entitled to full and complete access to inspect the business records of the partnership and each partner has the right to receive notices and information from all other partners regarding the business. Therefore, partners must notify other partners about material information related to the business and business interests.
Similarly, partners are entitled to an accounting when another partner has withheld profits from the partnership, when there are legal proceedings against the partnership, or upon dissolution. Partners also have the right to indemnification from the partnership for actions of other partners. For example, if the partnership is sued because a partner commits a tort, the other partners may lose their monetary investment in the partnership, but their personal assets are not at risk.
Partners are co-owners of partnership property. Unless altered by a partnership agreement, partners have an equal right to possess partnership property for business purposes.
Duties Partners Owe Each Other
A partnership is a fiduciary relationship, and each partner has duties to the other partners. Partners owe each other duties as a result of their relationship of trust, good faith and confidence. Typically, this requires partners to put the firm’s interests ahead of their own. Breach of fiduciary duty may result in claims for compensatory, consequential, and incidental damages; recoupment of compensation; and, in some situations, punitive damages. The following is a list of important duties partners owe to one another:
- have an obligation of good faith and fair dealing with each other and the partnership.
- are liable to the partnership for gross negligence or intentional misconduct. Partners are not liable for ordinary negligence.
- cannot compete with the partnership.
- cannot take opportunities away from the partnership unless the other partner’s consent.
- cannot engage in conflicts of interest.
- may not make a secret profit while doing partnership business,
- must maintain the confidentiality of partnership information.
These are some key points and not intended to represent a comprehensive list. Courts will determine on a case-by-case basis whether a duty has been breached. Extending from its roots in agency law, partnership law also imposes a duty of care on partners. Partners are to faithfully serve to the best of their ability.
Easy to create
Flow-through tax entity (owner pays personal income tax on all business profits)
Easy to dissolve
Allows for investment by limited partners to raise capital
May be hard to value individual partner’s share of business
Flexibility in sharing management decisions
Dissolution occurs any time a new partner is added or old partner leaves
No formal documents or governmental filings required to start business
A business partnership is often analogized to a marriage partnership. In both instances there is a relationship of trust and confidence between (or among) the parties and poor judgment, negligence, or dishonesty within the relationship can lead to negative outcomes.
Regardless of whether the partnership is formal or informal, all partners have important duties in a partnership, including:
- the duty to serve—that is, to devote to the work of the partnership;
- the duty of loyalty, which is informed by the fiduciary standard: the obligation to act always in the best interest of the partnership and not in one’s own best interest;
- the duty of care—that is, to act as a reasonably prudent partner would;
- the duty of obedience not to breach any aspect of the agreement or act without authority;
- the duty to inform other partners; and
- the duty to account to the partnership.
A written partnership agreement is not required to form a partnership, but it is a best business practice. Given the variety of different types of partnerships, it is understandable that no formal requirements for a partnership agreement exist. When developing a formal partnership agreement, it should be clearly understood that the agreement itself is a contract and should follow the principles and rules of contract law. Because it is intended to govern the relations of the partners toward themselves and their business, every partnership contract should include the following terms:
- Name of partnership – partnerships may choose almost any name they would like. However, partnerships may not use the word “company” or any other word that would imply the business is a corporation. If partners choose a name that does not include their names, the fictitious name requires that they must give public notice as to the identities of the partners.
- Purpose and duration – is the partnership for a limited time or for a specific purpose? Is it a joint venture between businesses that grants partners only limited authority and property rights? Is it a general partnership with the flexibility to grow the business as the market allows?
- Capital contributions – partners may contribute cash, intellectual property rights, real and personal property, and goodwill to the partnership. Capital contributions do not include the partners’ business experience. An individual may also become a partner without making a capital contribution if the other partners agree to it.
- Methods of sharing profits and losses – the default rule is that each partner shares equally in the profits and losses of the partnership. Such provisions often include any credit for capital contributions partners may receive in the event of dissolution.
- Effects of advances – if the partnership is short of cash and a partner agrees to advance money to the partnership, that cash advance could be considered either a personal loan or a capital contribution to the partnership. Determining in advance how that money will be spent, repaid, and/or credited within the partnership helps facilitate these types of transactions.
- Compensation – if general partners receive any salary or additional compensation for their management of the business, the terms of compensation should be clearly defined. In addition, the procedure for setting the amount and type of compensation should also be addressed.
- Fiscal year and accounting methods – processes for accounting and tax liabilities are important to clearly define, especially as partnerships are flow-through tax entities.
- Property – partnerships often use personal property of partners as well as property of the business. The default rule is that all property brought into the partnership or acquired by it becomes partnership property. If a partner does not want to lose property rights to the partnership or its creditors, this should be clearly specified.
- Dispute resolution – if partners are unable to agree on how to manage the business, how will the deadlock be resolved? These provisions are especially helpful when there are an even number of partners to avoid dissolution when deadlock occurs.
- Modification – how may the partners modify the partnership agreement? Is unanimous consent required to add new partners or add new terms to the contract?
- Rights and obligations at dissolution – partners should think about what will happen if a partner chooses to leave the partnership or dies. Can the remaining partner(s) buy out that partner’s share of the business? If so, under what terms or process?
It is important to remember that partnership agreements exist between partners in a business, not between the partners and third parties. Partnership agreements are contracts between individuals who want to work together.
Termination of a Partnership
The legal end of a partnership is called dissolution. Dissolution may occur when partners mutually agree to stop working together, a partner dies or withdraws from the partnership, or a new partner is added. A new partnership is formed when there is a change in partners, whether an existing partner leaves or a new partner is added. Often, these types of changes do not significantly impact on the day-to-day operations of the business.
However, a new partnership agreement, and sometimes a new partnership name, is necessary.
If the partnership ceases to operate, then winding up occurs. Winding up is the process in which a partnership is liquidated. Partnership assets are reduced to cash, creditors are paid off, and any remaining profit and assets are distributed to the partners. During winding up, there is a priority of distributing the partnership assets. In general, all creditors other than partners are entitled to be paid before the partners divide up the partnership’s assets.
If the partnership does not have enough assets to cover its debts, then the priority of paying creditors is governed by the provincial law where the partnership exists. Provincial laws vary regarding the priority of distributing assets, so it is important to consult a professional for guidance or advice.
Other Forms of Partnerships
Franchises – A franchise is an arrangement in which a business, in return for compensation, grants another entity the right to engage in a certain business or in a business using a particular trademark in a certain area. Franchises are not a separate form of business organization – they are a form of contract between businesses. Most franchises involve corporations, but they may include sole proprietorships and partnerships.
The advantage of a franchise is that under a franchise agreement, an entrepreneur can open and run a business under a proven business model. The local owner, the franchisee, uses the franchisor’s trademark, intellectual property, and business model under a license agreement. The franchisee offers goods or services to the public and keeps any income earned. In exchange for the right to sell goods or services developed by the franchisor, the franchisee pays a fee to the franchisor.
Franchise agreements can be very detailed and often require the franchisee to use specific vendors, ingredients, store layouts, colors, or meet other conditions. Franchises are common in some industries such as quick service restaurants, hotels, and tax preparation services.
Joint Venture – A joint venture is when two or more individuals or businesses combine their efforts in a particular business enterprise and agree to share the profits and losses jointly or in proportion to their contributions. Unlike a partnership, which operates as a general business for as long as the partner’s desire, a joint venture is for a single transaction or a limited activity. The businesses remain separate entities and they do not share financial or confidential information unless they decide to. Joint ventures automatically terminate at the conclusion of an event or project.
Joint ventures are often formed to address a common need or to reach a mutual goal. They may also be enacted to share the costs of major research or infrastructure projects within an industry. This occurs frequently when industries are impacted by advances in technology. For example, BMW and Toyota created a joint venture to research hydrogen fuel cells, electric vehicles, and ultra-lightweight materials needed in next generation vehicles. By sharing the cost of research and development, the companies can be on the forefront of technological advancements in their industry.
Partnerships are very common because of their flexibility and ease of creation. However, if individuals want to create a partnership, a best practice would be to create a partnership agreement that identifies the rights and obligations of the partners. Partnerships are fiduciary relationships in which the law assigns certain rights and obligations even if there is not a formalized partnership agreement.