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 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 passes away

  • What occurs if one or all partners desire dissolution of the partnership

  • All partners must agree with each member being a part of it

  • Individual partners can assign shares of profits and losses, as well as rights to distributions

  • A partner’s judgment creditor can get an order charging this partner’s transferable interest when doing so because a judgment demands it

Aside from sole proprietorships, business partnerships are the most popular type of business entity. A general partnership always includes three things: (1) profit and loss sharing; (2) joint business ownership; (3) 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 provides only 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 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.

Liability

Within a partnership, members are vulnerable to unlimited liability for their overall actions within the partnership. Every partner is personally liable for any company debts and responsibilities, and 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.

Transferability

Unless there is an agreement saying the opposite, the default rule in a partnership is that one person’s stake is not transferable without getting consent from 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.

Instability

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 passes away, 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 interest as part of a divorce settlement.

If a general partner is no longer participating in a limited partnership, a new general manager must be an appointment for the partnership to keep going. If it is a general partnership, the majority of partners still in the business must agree to continue the business and partners may have to collect enough money to buy out the partner leaving if the others want to continue to operate.

Management and Disputes

The disadvantages of partnership also come from the informal nature of this type of business entity. When it comes to each member’s duties, not all may be clear to those who are in the partnership and those 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 sees this as all partners behaving on behalf of the partnership. As a result, the business can get entered into agreements that not all members agree with.

Furthermore, if a written agreement for the partnership is unclear, then arguments can easily result about which partner bears the responsibility for which 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.

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

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, they 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 of the disadvantages 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, a drawback is also that it can be hard to raise capital from third party investors because they would have to be members and take on liability vulnerabilities of the partnership if they were to join the company. This liability issue is solved though 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 pre-written “business prenuptial agreement” in place to help safeguard the business. This document ought to spell out what will occur to the company 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 partners can draft it up themselves.

If you and the other partners plan to create the business prenup 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.

Sole Proprietorship

A sole proprietorship is amongst 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 start up process

    • No filing fees

    • Minimal documents needed

  • Owner makes all decisions about how to operate business

  • 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 back 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 their own funds to draw from, aside from any loans given to the owner. The result can be that the business is difficult to grow.

The business can also end suddenly and if the owner dies. The company won’t exist anymore unless it transfers to heirs, but if the business does transfer to heirs or family, then it becomes a new sole proprietorship.

C Corporation

A C Corporation or C Corp is created by individuals called shareholders that provide money, property, or both of these 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 in it 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. There is a filing fee to pay with it. Another of the disadvantages is that the corporation’s profits are taxed because the corporation earned at a corporate level. The profit also gets taxed to the shareholders when the profit goes out to them as dividends. Also, 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 less stock.

S Corporation

A business can choose to be a S Corporation, which is also known as a 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 a S Corporation

For a 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 like 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 a 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 a 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. A LLC can even just consist of a single member.

Another big benefit of a 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 a LLC

Just as there are disadvantages of partnership, there are also drawbacks of a LLC. For example, most members must pay a self-employment tax. Also, a LLC can be quite complex to form, and if a LLC decides to change its classification, this comes with a whole host of pros and cons, depending on how it is re-classed. A limited liability company can file as a:

  • Partnership

  • Sole proprietorship

  • Corporation

If you are pondering the advantages and disadvantages of 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.