Two of the most common issues that we discuss in the Entrepreneur Assistance Clinic are whether two or more founders should form an entity and, if so, what kind. We will save for another day a detailed comparison of the various entity choices, and focus in this post on one of the most common types, the general partnership. The general partnership is common not because knowledgeable lawyers or accountants steer their clients towards this choice, but because the general partnership just arises from the parties’ conduct—a so-called de facto general partnership. It is safe to say that two or more founders should choose an entity other than a general partnership for their business and should likewise take steps to make sure that they are not deemed to have an unintended general partnership.
In contrast to the other common entities, such as corporations and limited liability companies, two or more founders can create a general partnership without filing a formation document with a governmental agency or having any formal agreement between the parties. If at least two persons engage in a business activity together as co-owners and share the profits, they will likely be considered to have a general partnership even though no one has uttered the words partner or partnership.
Having a general partnership, whether accidental or intentional, is usually not a wise choice because each partner has personal liability for the obligations of the partnership. This sharply contrasts with corporations and LLCs where the owners do not have analogous personal liability.
Let’s return to the Italian Delites restaurant hypo that we have been using in this blog and assume that Mary and Marty, two recent graduates of Penn State, started the restaurant in State College, PA, with the intention of splitting the profits but without any other discussion of their relationship. The restaurant started off as a roaring success with long waiting lines down Calder Alley (in a pre-COVID world). However, after several successful months, the restaurant had a serious food-poisoning problem when it is discovered that it was using defective olive oil in its recipes for several weeks. The defective olive oil caused many restaurant patrons to get sick, most of whom had to hospitalized, which overwhelmed the small hospital in State College. A local lawyer filed a class-action lawsuit seeking damages on behalf of all restaurant patrons who got sick.
Mary and Marty met with their lawyer, Bernice, to discuss how to respond to the complaint that was filed. Bernice and also Mary were shocked when Marty admitted that he never mailed the check to buy liability insurance for the restaurant because he thought it was a waste of money. Bernice was likewise surprised when Mary and Marty responded “I don’t know” when Bernice asked if they had formed an entity to own and operate the restaurant. Bernice informed Mary and Marty that they likely have a general partnership and that each of them, therefore, could be liable for all of the damages related to the food poisoning.
To skip ahead, the class-action case was eventually settled for $2.5 million. The restaurant’s assets were liquidated for $500,000, which left $2 million of the judgment to be satisfied. The plaintiffs sought to recover the balance from the two general partners, Mary and Marty. Marty, as a recent graduate, had virtually no assets that could be tapped for the judgment, but Mary was sitting on $3 million of securities, which she had inherited from her rich uncle. The plaintiffs were entitled to recover the remaining $2 million from Mary, which they did. Mary was entitled to require Marty to contribute to the liability but he had no assets.
Mary and Marty could have avoided much of this catastrophe by forming a simple LLC for a mere $125 filing fee in PA (or a corporation for slightly more). The LLC’s assets would have still been subject to attachment to satisfy the $2.5 million judgment, but the important difference is that Mary and Marty would not have been held personally liable for the $2 million portion that could not be satisfied with the business’ assets.
People or entities that engage in business activities should be careful to create a de facto partnership when they do not intend to do so. The PA statute follows the general rule that “the association of two or more persons to carry on as co-owners a business for profit forms a partnership, whether or not the persons intend to form a partnership [emphasis added].” However, the PA statute excludes from partnership status certain common relationships, such as a joint tenancy’s sharing of profits from jointly owned property or an independent contractor or employee’s receipt of profit-sharing payments.
A limited partnership differs from a general partnership primarily with respect to the potential personal liability of the owners. A limited partnership must have at least one general partner, who is then personally liability for the obligations of the partnership. However, the limited partners in a limited partnership generally are not personally liable for the obligations of the partnership. As with a corporation and an LLC, the formation of a limited partnership requires the filing of a formation document with a government agency.
In order to avoid the foregoing issues with a general partnership, we generally recommend that founders start an LLC for their business. Many of the do-it-yourself websites lead entrepreneurs towards forming corporations in Delaware as their initial entities. We will explain in a subsequent post why it usually makes more sense to first form an LLC in PA if the business is based in PA.
This post was written by Tom Sharbaugh, Director of the Entrepreneur Assistance Clinic at Penn State Law.