Starting a business is exciting, but it’s not always a simple process for one person to complete on their own, which is why many people choose to work as a team and form businesses with other entrepreneurs.
Doing so without officially registering with the state automatically forms a general partnership, but is this the right entity for your company?
A general partnership is a cheap and easy entity to form and maintain, but it does have its drawbacks. One important factor when choosing between the general partnership and more formal business entities is to consider whether your business requires any legal protections.
In this guide, we’ll cover the role legal protection plays in a general partnership.
Before we dig into whether or not legal protection exists for a general partnership, we first need to clarify what we mean by “legal protection.”
This protection is often referred to as personal asset protection, or limited liability, and is a privilege offered to formal business entities. Essentially, this means that there is a legal division between the business itself and its owners, which separates the company’s assets from the personal assets of each owner.
With this protection, the home, car, or other valuables of an owner cannot be taken to pay for a legal settlement or debt against the business. For example, if the business is sued, or defaults on a debt, the personal assets of its owners cannot be seized, unless the business was improperly maintained, or if the owners committed fraud.
Unfortunately, a general partnership does not have this legal separation, which is one of the biggest disadvantages of this business type compared to the LLC. In the eyes of the law, the owners and the business entity are one and the same, so there is no personal asset protection available for general partnership owners.
Since a partnership does not have personal asset protection, then each partner can be held personally responsible for any and all business debts. But here’s what’s worse: in a general partnership, your personal liability isn’t necessarily a 50/50 split, with you taking half the debt and your partner taking the other. Your liability could actually be as high as 100%.
This means that you can be legally required to pay up for the mistakes your partner makes. For example, let’s say your partner signs a contract and doesn’t fulfill it.
When your creditors decide to pursue the debt accrued by this failed contract, if they discover that your business does not have enough assets to cover the debt, and neither does your partner, a court can then order you to personally pay all of the damages. Even if you only have a 10% share of the profits, you can be held 100% responsible for the debts. This is one of the big risks associated with general partnerships, and also the reason that we typically advise against using this business model.
In fact, because of this issue, many people consider the general partnership to be the most risky entity type to form — even moreso than a sole proprietorship. At least with a sole proprietorship, you have no one to blame but yourself if your business goes belly-up.
If you stay as a general partnership, you cannot protect your personal liability ― we consider this to be the fatal flaw of the general partnership as a business structure. There are a few other options to protect yourself, however.
For one thing, you could consider forming a multi-member limited liability company, or an LLC. This entity type is more expensive to form and has more formality than a partnership, but it provides personal liability protection. If you’re interested in this route, you might want to read through our “General Partnership vs. LLC” article to get all the relevant details on how these two different entity types compare.
For the vast majority of our readers, we strongly suggest forming an LLC rather than sticking with the informalities of the general partnership. Not only does the LLC provide personal asset protection, but it so lends an air of credibility to your business that a general partnership can’t match.
This is due in part to the fact that an LLC has a unique business name that is registered with the state, whereas a general partnership is simply referred to using the personal names of its owners — for instance, if your name is Susan Smith and you form a general partnership with Jane Johnson, your general partnership would simply be known as “Susan Smith and Jane Johnson,” not by a formal business name.
Do you still want to stay as a general partnership instead? If so, you should look into obtaining a general liability insurance policy for your business. A general liability policy helps you to cover expenses caused by mistakes made in the course of operating your business.
Of course, it won’t necessarily cover the entire expense, but it will help reduce the personal impact of a lawsuit or debt for your general partnership.
Finally, you should ensure that your partnership agreement includes a clause about decision-making. A lot of partnership disputes occur when one partner makes a decision without consulting anyone, and then that decision ends up hurting the business. You can avoid situations like these by defining an internal policy for making business decisions together.
There are a few advantages to the general partnership, mostly based around how incredibly simple and basic this business type is. It would be nearly impossible to get confused about the process for forming and maintaining one, because there are essentially zero legal requirements involved with doing so.
On the other hand, the general partnership offers no legal protections whatsoever for its owners, which puts this business type at a huge disadvantage compared to formal business entities like the limited liability company.
If you want your personal assets to be protected from lawsuits against your business, forming a general partnership is absolutely not advised under any circumstances. In that case, creating an LLC would be your best bet and can be done quickly through an LLC formation website.
Disclaimer: The content on this page is for information purposes only and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.
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