It’s obvious that before you form a partnership with somebody, you should make sure that he or she is a person you can trust and have confidence in. What’s not necessarily as obvious is exactly how much you must trust this person before forming a partnership actually becomes a good idea.
Unlimited Liability—Even for Each Other!
Generally speaking, every partner in a partnership has unlimited liability for all of the partnership’s debts. [Note: Limited Partnerships, which we’ll be discussing momentarily, work somewhat differently.] It’s very much like a sole proprietor’s unlimited liability but with one crucial difference: You’re now personally responsible for debts of the business, even if you had nothing to do with creating them.
EXAMPLE: Tom and Jennifer run a local newspaper, and their business is organized as a partnership. One week while Jennifer is on vacation, Tom reprints—without permission—an article from another newspaper. The other paper decides to sue for copyright infringement. Even though Jennifer had nothing to do with the legal infraction, the other newspaper can sue her for the entire amount of the debt, should it decide to. Such is the risk of being a partner in a partnership.
Of course, Jennifer would likely be successful if she took Tom to court to sue for the amount that she ended up paying. But she’d still be out the cost of the legal fees, not to mention the hassle involved.
Partners as Agents of the Partnership
Each partner can be held responsible not only for liabilities resulting from a lawsuit, but also for liabilities stemming from a contract signed by only one of the partners. Such a situation is the result of the fact that each partner is what is referred to legally as an agent of the partnership. Each partner (agent) has the legal power to bind the partnership—and thus each of the partners—to a contract.
Fortunately, there are some limitations to a partner’s power as an agent of the partnership. Most importantly, each partner can only act as an agent in affairs that are within the scope of the partnership’s business. For example, if you run a retail store that sells locally grown produce, you don’t have to worry about your partner buying a house under the name of the partnership. Given that the purchase of a house is clearly outside the scope of the business, your partner would have no power as an agent to bind the partnership to the contract.
So far, our discussion of partnerships has been about what are known more precisely as “general partnerships.” In addition to general partnerships, there is another form of partnership known as the “limited partnership.” Generally speaking though, whenever somebody simply uses the term “partnership,” he’s referring to a general partnership.
Limited partnership taxation works the same way as general partnership taxation. The difference between the two structures is that, in a limited partnership, there are two types of partners: General partners and limited partners.
General partners have unlimited liability for the debts of the partnership while limited partners do not. Limited partners (much like shareholders of a corporation) cannot lose an amount greater than their initial investment in the partnership. A limited partnership can have as many or as few of each type of partner as it wants, with the one notable exception that there must be at least one general partner.
One important rule about limited partnerships is that the limited partners cannot participate in managerial decisions or the day-to-day operation of the partnership. If they do, they’ll lose their limited liability. As such, in many limited partnerships, the general partners are the original founders, and the limited partners are outside investors.
- In a general partnership (commonly referred to as simply a “partnership”), each partner has unlimited liability for all of the partnership’s debts.
- Each partner, as an agent of the partnership, has the power to bind the partnership to a contract.
- Partners do not, however, have the power to bind the partnership to contracts that are clearly outside the scope of the business.
- In a limited partnership, limited partners have limited liability. They can only lose the amount that they initially invested. General partners in a limited partnership have unlimited liability.
- Limited partnerships can have as many or as few limited partners as they choose, but they must have at least one general partner.