Starting a business is exciting. But in the whirlwind that surrounds getting started, it is easy to make a huge mistake that can lead to a host of legal problems.
In this post we’ll explain how accidental partnerships are created, what that means, and how to avoid that mistake.
In most states, when two or more people operate a for-profit business and they don’t file anything with their secretary of state, they will be deemed a “general partnership.”
It sounds simple but it isn’t that clear cut in the real world.
For example, you and a friend might start talking about an idea, you both do some research, work on a rough business plan, and maybe even get a few clients to hire you. Then one of two scenarios play out: (i) the business is successful and one partner doesn’t think the other should be a co-owner or doesn’t think the other should get 50%; or (ii) the business fails and no one is sure who is liable for the debts and liabilities of the company.
In those scenarios, a startup lawyer will probably explain to you that you are equal partners in a general partnership.
That means (A) you have equal voting rights; (B) you are both entitled to 50% of the income and deductions from the company; and (C) you are both personally liable for the debts and liabilities of the company.
That’s not good.
Here’s what that means:
In an accidental partnership, there is a strong argument that each partner will have equal voting rights. This means you are likely to end up in deadlock on a major decision like adding a new partner or when one partner wants to withdraw. Depending on the scenario, one partner might have more voting power by virtue of contributing more capital, but sometimes it is hard to establish the exact value of each partner’s capital contribution when you factor in the fair market value of assets and services contributed.
Sharing of Income & Deductions
If the partnership is 50/50, then each partner is entitled to 50% of the income from the partnership. Even if one partner does more work than the other, each partner can make a claim to 50% of the income. And if there are losses or other financial allocations available, those will similarly be passed through to each partner’s personal tax return, most likely at 50/50.
Worst of all, every partner in the general partnership will be liable for the debts and liabilities of the partnership. So if you borrowed money from your partner’s rich uncle, and your partner runs off, you will be on the hook for the full amount owed. Further, the uncle can sue you and garnish your wages and place liens on your property!
How to Avoid an Accidental Partnership
While you can use a written partnership agreement to avoid some of the problems described above, you are almost always going to be better served by forming a LLC or Corporation and drafting an Operating Agreement (for an LLC) or Bylaws (for a corporation).
By doing so, you can clearly establish the voting and economic rights of the parties and you can benefit from the limited liability these businesses entities provide.
And keep in mind, it is almost always best to talk with an experienced startup lawyer or small business attorney when forming your business to make sure you don’t make mistakes in the process. A small investment up front can help you avoid huge legal bills and headaches down the road.