Terms of Engagement

Partnerships
 

While partnerships were once governed by common law, they are now governed solely by statute, the (i) Texas Revised Partnership Act for partnerships formed before January 1, 2006, and (ii) the Partnership Law of the new Business Organizations Code. Both laws have liberal allowance for variation by contract among partners. The Texas Uniform Partnership Act, adopted in Texas in 1961 but by other states as early as 1915, is no longer effective, having ended its existence on December 31, 1998. The Code does not change much law from the Revised Partnership Act, but that act, effective for all partnerships only as late as 1999, made a number of dramatic changes.

Franchise Tax to Pay, or Not

Some partnerships must pay pay the Texas franchise tax of 1% of a computed "gross margin" starting as of January 1, 2007. A general partnership made up only of individuals will not pay the tax, as will some other partnerships.

How Formed

A general partnership is formed without any filing with the Secretary of State. A partnership may be formed by an oral understanding. No writing whatsoever is required. In fact, it is unlikely but possible that a court would find a partnership is created without a meeting of the minds into an agreement. What is required is simply that there be "an association [not a term of art here, but a generic term like ‘group’] of two or more persons to carry on a business for profit" and which is not an entity created under another law, unless the other law is a partnership law. Among other things, the requirement under the old law that there be agreement to share losses is not necessary now in order to have a partnership.

Governance

Each general partner is entitled to one vote; i.e., the control is per capita, not by percentage of ownership interest. This may be, and usually is, varied by agreement. Each general partner has full authority, individually, to speak for and bind the partnership. This is in contrast to corporations, where only officers (not owners) have the power to bind the entity by an agreement made with another.

Earnings and Losses

Each partner has added to his or her capital account the percentage of earnings determined by one as the numerator and the number of partners as the denominator. This may be varied by agreement. Each partner starts with a capital account equal in value to the contribution the partner made, whether in money or in kind, but not for future labor; to the capital account is added earnings and subtracted losses and actual distributions in cash or in kind.

No Liability Shield for General Partners

All the general partners in a general or limited partnership are exposed to unlimited liability for the debts of the partnership. Each general partner is exposed to claims based upon the promises, actions, or omissions of the other general partners, and well as of all the agents, including employees, of the partnership. A substantial liability shield may be obtained through the partnership filing and adhering to the requirements to be a registered limited liability partnership (an LLP).

No Double Taxation

As with S corporations, a significant advantage of the partnership form of doing business is the freedom from the double taxation that applies to C corporations. But multi-member LLCs, limited partnerships, and limited liability partnerships can also be taxed under the partnership rules.

Great Flexibility in Terms of Ownership and Capital Structure

Unlike corporations, and especially S corporations, partnerships offer great flexibility in terms of ownership and capital structure due to both state law and partnership taxation rules. Unlike corporations, there can be disparity among owners of the rights to profits, losses, breakup capital and control. There are no partnership counterparts to the S corporation limitations on number and type of shareholders and the one class of stock rule. Thus, when the advantage of pass-through taxation is critical, and the entity cannot qualify for S corporation status, the remaining options are an entity taxed under the partnership provisions. But, again, multi-member LLCs, limited partnerships, and limited liability partnerships can also be taxed under the partnership taxation rules.

Tax Advantages Not Available to S Corporation Shareholders

Compared to S corporations, partnerships offer the additional tax advantages of:

1. partner basis includes partnership debt (including non-recourse debt),
2. the ability to step up the basis of partnership assets upon the sale or exchange of a partnership interest,
3. greater opportunities for partners to make tax-free contributions of appreciated property or property burdened with debt and to receive tax-free distributions of appreciated property, and
4. the ability to make special allocations of tax items to the partners.

Lack of Tax-Advantaged Fringe Benefits

Partnerships do not compare favorably to C corporations regarding fringe benefits. For small businesses, the inability to offer tax-advantaged accident and health insurance benefits to partners can be a significant negative factor (This is a disadvantage of S corporation status as well because the same fringe benefit tax rules apply to both partners and employee-owners of S corporations.)

This memorandum contains general information and while the information presented is accurate as of the date of its publication, it cannot be relied upon as legal advice, as that can only be obtained through personal consultation with an attorney with whom you share your specific facts.

 Copyright © 2005-06 by Sterling A. Minor. All Rights Reserved.

Last Updated: July 25, 2006