Disadvantages of Partnership: Everything You Need to Know
The disadvantages of partnership include the fact that each owner or member is exposed to unlimited liability for their activities within the business.12 min read
Disadvantages of Partnership
The disadvantages of partnership include the fact that each owner or member is exposed to unlimited liability for their activities within the business, transferability can be difficult to achieve, and a partnership is unstable as it can automatically dissolve when just one partner no longer wants to participate in the business or can no longer do so.
Partnerships can have many drawbacks. For example, partners are still liable for the profits of the business and will have to report the partnership's income on their tax returns. Profits and losses are a part of each partner's personal responsibility. Furthermore, in most of the partnership models, the partners will have unlimited personal liability for the company's debts. Additional disadvantages include:
- Having more people in a business can also complicate decision-making and decrease profits.
- Liability may be less for limited partners but general partners retain full liability among the owners for their own actions as well as all other general partners.
- Disagreement between equally sharing partners is one of the biggest reasons that companies dissolve.
- Losing a partner will be costly as you will have to value that person's assets plus replace an essential person who has taken on a lot of liability/responsibility
Partnerships also can easily collapse. If a general partnership has no provision regarding what happens if a partner leaves, then the partnership collapses if any partner leaves or dies. Even though partnerships are easy to form, it is helpful to have more formal documents and procedures to ensure that the business will run smoothly. Having an agreement is also important if partners end up having disagreements. Because partners are each personally liable for the company's obligations, the business partners need to be selected carefully and with care. The duties and rights of each partner also should be clearly defined.
Partnerships allow decision-making to be smooth and to avoid complicated bureaucracy when all the partners agree. However, if partners disagree, decisions may become difficult to make. If partners have very different visions of what the partnership will do, these differences may be unable to be resolved.
Partners will have to decide among themselves what skills and how much money each of them will bring to the partnership. This should be set out in the original partnership agreement. It is important to set out what each partner's duties are, because since each partner shares in the partnership's profits equally, the partnership may face trouble if some partners do less than others.
Partnerships Defined and Explained
A partnership is defined as a legal entity between at least two people who contribute capital and operate a company. Unlike with a sole proprietorship, a partnership is separate from the partners as individuals. For a general partnership, there is a flow-through structure by which profits and losses flow to the individual tax return of each partner. The partners have equal responsibility and control in the business, as well as being involved in daily operations of the organization and making decisions as managers.
Should a partner sign a contract on behalf of the partnership, the contract then applies to all partners in the partnership. Creating a partnership is fairly straightforward, although significant time ought to be put into organizing the details of the agreement. A partnership agreement sets forth details of its structure, including:
- How to finance the company.
- Who is responsible for which tasks.
- What occurs if a partner dies.
- What occurs if one or all partners desire dissolution of the partnership.
- That all partners must agree with the addition of other partners.
- That an individual partner can assign shares of profits and losses, as well as rights to distributions.
- That a partner's judgment creditor can get an order to change a partner's transferable interest to collect on a judgment.
Aside from sole proprietorships, business partnerships are the most popular type of business entity. A general partnership always includes three things:
- Profit and loss sharing
- Joint business ownership
- Equal right as company managers
As for a limited partnership, it has a general partnership and at least one limited partner. The limited partner is often an investor. This person only provides assets to the business and has no management role. On the other hand, a general partner is liable for any debts or legal judgments against the company.
Some disadvantages of companies are worth considering before creating one, including the informal structure that means fewer protections against partners in the agreement than in other types of business entities. For example, there are no liability limits, the transfer of ownership can be complex, and the duties and authority of parties can be muddled. Below is more about each of the disadvantages of partnership.
Within a partnership, members are vulnerable to unlimited liability for their overall actions. Every partner is personally liable for any company debts and responsibilities. If the company lacks the assets to cover an organizational debt, then creditors can seize the partners' personal assets to cover that debt. One way to cover this disadvantage is to form a partnership between two corporations. In a general partnership, each partner is liable for the activities of the other partners, while only the general partner (who runs the business) is liable in a limited partnership.
Unless there is an agreement saying the opposite, the default rule in a partnership is that one person's stake is not transferable without the consent of every remaining partner. This lack of flexibility can make it difficult to achieve transferability. For example, there may be existing disagreements that hold up a smooth process.
The unstable overall nature of partnerships is another drawback. This type of business entity can automatically dissolve when just one of the partners does not want to participate in the organization any longer or can no longer do so. An automatic dissolution happens when a member dies, resigns, retires, files for bankruptcy, or quits for another reason. The result can be a fast and perhaps surprising end to a company that has been achieving profit. A partner may also sell his or her interest as part of a divorce settlement.
If a general partner leaves in a limited partnership, a new general manager must be appointed for the partnership to keep going. For a general partnership, the majority of partners still in the business must agree to continue the business. Those partners may have to collect enough money to buy out the partner who wants to leave.
Management and Disputes
The disadvantages of partnership also come from the informal nature of this type of business entity. Each member's duties may not be clear to those who are in the partnership or to people outside of the arrangement. As a traditional partnership involves each member having an equal responsibility in the structure without an authority hierarchy, a third party can see this as all partners behaving on behalf of the partnership. As a result, the business can end up in agreements that not all partners agree with.
Furthermore, if a written agreement for the partnership is unclear, then arguments can easily result about which partner bears the responsibility for each part of the business. This problem does not affect limited partnerships, where only a general manager has control over company operations, but it does affect general partnerships where a lack of clarity can create a chaotic atmosphere that gives rise to a partnership dispute.
Types of Partnership
A partnership is a formal arrangement in which two or more parties cooperate in managing and operating a business. There are three types of partnerships:
- General partnership: All the partners or owners are on equal ground because they have the same responsibilities and rights. Therefore, each owner may act on behalf of the business as a whole. All owners share in the losses and profits of the business. Joint and several liability can occur when each individual owner is personally responsible for any actions taken by other partners.
- Limited partnership: A limited partnership is similar to a general partnership, except that while a general partnership must have at least two general partners, a limited partnership must have at least one general partner and at least one limited partner. The general partner(s) are responsible for managing the company and have the same responsibilities and rights as the partners in a general partnership, which includes joint and several liability. The limited partner contributes capital toward the equity of the company but is not involved in the daily operations of the business. This person can be thought of as playing the role of a silent partner. A limited partner benefits from not being personally liable for the actions taken by the general partner(s) or partnership.
- Limited liability partnership (LLP): An LLP is considered a blend of a corporation and a partnership. Beyond the assets that were invested in the partnership, none of the partners may be held personally responsible for the actions of other parties. Each partner may decide on how much they'd like to be involved in the daily operations of the business and also how much capital they'd like to contribute. LLPs are usually formed by registering with the state and through a written agreement between the partners. LLPs may be reserved in some states for professional partnerships, such as for accountants and lawyers.
Advantages of a General Partnership
- Partnerships need not pay income tax:
- Instead, every partner files a personal tax return that declares the profits and losses of the company.
- There is no separate tax for the business to pay.
- Raising funds is easier because there's more than a single partner.
- Different partners draw on different skills, contacts, experience, and knowledge.
- Stronger management arises from having more than one owner.
- Potential employees may join the business if they see the opportunity to become a partner.
- Good use of money:
- Different owners focus on various parts of the business.
- Moral support:
- Supportive relationships can enhance brainstorming sessions.
- When partners have skills that complement each other, there's bound to be progress made.
Advantages of a Limited Partnership
In a limited partnership, the limited partner has limitations on liability regarding money and possible lawsuits. Thus, this partner is only liable for the assets this person contributes to the partnership. A creditor cannot seize a limited partner's personal assets. On a related note, this limited liability can attract investors to a limited partnership because their personal assets are safe.
Also, in a limited liability, profits and losses “pass through” the company to its partners. They are taxed on their individual tax returns. For limited partners, even though they are not involved in managing the business, they still get to share in the profits and losses.
Disadvantages of a General Partnership
One of the largest disadvantages of developing a general partnership is the fact that all individuals are liable together for the decisions, debts, and obligations of the partnership. This includes legal problems such as breach of contracts and torts. Also, a single partner can be sued in relation to the business by another person or a business, and in effect, all of the partners are liable for the outcome of the lawsuit.
In terms of liability, the fact that personal assets can be seized to settle the debts of the partnership is seen as a major drawback. Basically, each member is personally liable for the failure of the business. The inability to transfer the partnership without the express knowledge and permissions of all partners is a negative as well.
Partnerships are not completely stable business entities since the business can completely dissolve based on a retirement or death of one member. When this type of business is formed, each member may not have specific duties and responsibilities. This can create a fairly vague business structure within the business itself and as seen by the public. Even if one member is not as involved in the business, profits are shared evenly, regardless. Disagreements are common among the partners since all individuals have an equal say in decisions. If disagreements, situations, or expectations change within the partnership, then this can create a complete split-up of the business itself.
The partners have general and several liabilities for the behaviors of other partner obligations in the company, such as torts, breaches of trust, and contracts. These liabilities mean that if an outside party wants to sue the partners, it can sue one of the partners rather than all of them. That said, if the third party sues a partner and this person cannot come up with the necessary cash, the third party can get the money from the other members.
Another disadvantage of partnership is that a partner cannot transfer their interest in the business without getting the consent of every one of the remaining partners. If it is a general partnership, it can be hard to raise capital from third-party investors because they would have to be members and take on the liability vulnerabilities of the partnership if they were to join the company. This liability issue is solved if the organization becomes a limited partnership, as the investors would become limited partners. So, obviously, a general partnership has a big stumbling block to overcome if it wants to grow.
Disadvantages of a Limited Partnership
- If a limited partner takes on an active role in the partnership, this person may have general-partner personal liability.
- The business must file a Certificate of Limited Partnership with the state, and pay an accompanying state filing fee before a partnership exists.
If You Decide on a Business Partnership
In case a partner leaves, have a prewritten “business prenuptial agreement” in place to help safeguard the business. This document ought to spell out what will occur if a co-owner wants to leave the business or retire, goes through personal bankruptcy, wants to sell his interests, goes through a divorce, or dies. This document can either be written by a business lawyer or the partners can write it themselves.
If you and the other partners plan to create a business prenuptial agreement yourself, then it is wise to refer to business buyout agreement templates and samples available online. They explain the steps for creating a lawful contract that is like a premarital agreement for the business that protects the interests of all involved.
A sole proprietorship is among the simplest business entities for beginning a business. In essence, the owner IS the business.
Advantages of a Sole Proprietorship
- The owner gets all profits.
- Easier, lower-cost startup process:
- No filing fees.
- Minimal documents needed.
- The owner makes all decisions about how to operate the business.
- There is only personal income tax to pay on profits.
Disadvantages of a Sole Proprietorship
One drawback is that the owner alone is responsible for company liabilities. If the business lacks the assets to pay a business debt, then creditors can come after the owner to seize personal assets. Raising capital can be challenging, too, because the owner has only his own funds to draw from, aside from any loans. The result can be that the business is difficult to grow.
The business can also end suddenly if the owner dies. The company won't exist unless it transfers to heirs. However, if the business does transfer to heirs or family, then it becomes a new sole proprietorship.
A C corporation, or C-corp, is created by individuals, called shareholders, who provide money, property, or both for the organization's capital stock. It is any kind of corporation taxed separately from its owners. In other words, the legal entity is separate from the tax entity.
Advantages of a C Corporation
- Several investors pool capital, so it is easier to start and run the business.
- Shareholders hold no personal liability for the corporation's debts.
- Should the corporation fail, shareholders can lose their investments but aren't personally on the hook for the corporation's debts.
Disadvantages of a C Corporation
A C corporation must file articles of incorporation as per state law with the secretary of state and pay a necessary filing fee. Another disadvantage is that the corporation's profits are taxed because the corporation earned at a corporate level. The profit also is taxed to the shareholders when it goes out to them as dividends.
Also, consider that certain shareholders have more voting power. If they form a majority of the corporation's voting stock, then they have more pull in how the company is managed, as compared to shareholders who have fewer shares of stock.
A business can choose to be an S corporation, which is also known as an S-corp, to avoid the corporate tax that a C-corp has to pay. An S-corp still keeps the benefit of limited liability as a corporation.
Advantages of an S Corporation
For an S-corp, filing taxes occurs only at the shareholder level. There is no tax at the corporate level, so the S-corp avoids paying taxes twice, as a C-corp has to do. Another benefit is that shareholders are not liable personally for any debts the corporation might accrue. While shareholders stand to lose the investments they made in the corporation if it fails later, they are not personally responsible for the corporate debts.
Disadvantages of an S Corporation
- You must file articles of incorporation with the secretary of state, along with a filing fee.
- Shareholders with most of the voting stock hold the most power when it comes to management decisions, while those with less stock have little power.
Limited Liability Companies
LLC is an acronym for Limited Liability Company. It is a mix of a partnership and a corporation, as it has the limited liability aspect of a corporation and the tax perks of a partnership.
Advantages of an LLC
In a limited liability company, profits are distributed through the LLC, and each business member or owner pays taxes individually. Another perk is that the personal liability is limited to the individual's investments in the company. Also, members are eligible for participating fully in managing the company. As for who LLC members can be, they can include partnerships and corporations, and no maximum limit exists on the number of LLC members. An LLC can even just consist of a single member.
Another big benefit of an LLC is its high flexibility. Owners typically create an operating agreement that outlines how they will operate different parts of their business. Thus, it can adapt based on the members' needs.
Disadvantages of an LLC
Just as there are disadvantages of partnership, there are also drawbacks of an LLC. For example, most members must pay a self-employment tax. Also, an LLC can be quite complex to form, and if an LLC decides to change its classification, this comes with a whole host of pros and cons, depending on how it is reclassified. A limited liability company can file as a
- Sole proprietorship
If you are pondering the advantages and disadvantages of a partnership or other business entities, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Stripe, and Twilio.