Incorporator The Journal of U.S. Formation
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Editorial 6 MIN READ

The general partnership, and why you might already be in one

No filing, no fee, no paperwork — and that is exactly the problem

The Editors
Staff, Incorporator.org
6 min read Updated
Contents 5 sections
  1. How a general partnership is formed
  2. The liability rule is the point
  3. Federal tax treatment
  4. Failure modes
  5. Sources

general partnership is the only business entity you can form by accident. Two people agreeing to sell something together, splitting whatever comes in, is a partnership the moment they start, whether or not either of them has ever said the word.

Nothing is filed. Nothing is paid. The state does not know. The IRS does not know. But the law knows, and so does a plaintiff's lawyer the first time one of the two signs a contract the other cannot cover.

How a general partnership is formed

Under the Revised Uniform Partnership Act (1997) — the framework roughly 37 states and the District of Columbia have adopted in some form — a partnership is "the association of two or more persons to carry on as co-owners a business for profit," and it exists "whether or not the persons intend to form a partnership." That is RUPA § 202(a), and the second half of the sentence is the half that matters. Subjective intent to be partners is not required. Louisiana, the only state that never adopted UPA or RUPA, reaches a similar result through its Civil Code; states that still operate under the original 1914 UPA — a shrinking group that includes, in various partial forms, New York, Massachusetts, and Georgia — share the same core rule.

The courts have had almost a century of practice applying it. In Martin v. Peyton, 246 N.Y. 213, 158 N.E. 77 (N.Y. 1927), the New York Court of Appeals examined a set of financiers who had "loaned" $2.5 million in securities to a floundering brokerage in exchange for a share of profits, veto rights over certain decisions, and the right to inspect the books. The creditor argued they were partners and therefore liable for the brokerage's debts. The court, in an opinion by Judge Andrews, held they were not — the controls were protective of the loan, not participatory in the business — but the analysis had to work through every term of the deal to get there. The case is taught in law school because it is the cleanest example of how thin the line is.

Seventy-five years later the Michigan Supreme Court drew it sharper. In Byker v. Mannes, 465 Mich. 637, 641 N.W.2d 210 (Mich. 2002), two men had worked together for two decades on a long series of real estate and business ventures, splitting profits and losses. When one turned out to owe the other money after the ventures soured, the defendant argued there had never been a partnership because the two had never agreed in so many words to be partners. The court rejected that flatly: the question is whether the parties intended to carry on as co-owners of a business for profit, not whether they intended the label "partner" to attach. Conduct controls. If you are in, you are in.

RUPA § 202(c) gives some structure to the conduct test. Sharing gross returns does not by itself make a partnership; joint ownership of property does not either. Sharing profits, however, is presumptive evidence of partnership unless the share can be explained as repayment of a debt, wages, rent, an annuity, interest on a loan, or a handful of other named categories. Everything else — everything that looks like two people splitting the upside — is presumed in.

The liability rule is the point

The reason this matters is RUPA § 306(a): "all partners are liable jointly and severally for all obligations of the partnership." Joint and several means a plaintiff with a judgment against the partnership can collect the whole amount from any one partner whose wallet is nearest. The partner with resources subsidizes the partner without them. A new partner admitted to an existing firm is not personally liable for pre-admission obligations — § 306(b) carves that out — but picks up full exposure for everything after.

Under the older 1914 UPA, which still governs in jurisdictions that have not moved, contract liability was joint-only, meaning partners had to be sued together. RUPA's shift to joint-and-several for all obligations is the single most consequential change between the two acts. In either regime, every partner's personal assets — house, savings, car — are on the hook for partnership debts, unlike in an LLC or a corporation, where the entity's separate legal existence absorbs the hit.

There is one partial off-ramp. Every state now authorizes a variant called the limited liability partnership (LLP), in which partners file a short statement with the state and, in exchange, lose the vicarious liability for other partners' misconduct. The LLP is dominant in law firms and some accounting firms and requires a deliberate filing to elect. A garden-variety general partnership does not file anything, and gets none of the protection.

Federal tax treatment

A general partnership is a pass-through entity under Subchapter K of the Internal Revenue Code (IRC §§ 701–777). The partnership itself pays no federal income tax. It files Form 1065, U.S. Return of Partnership Income, as an information return, and issues a Schedule K-1 to each partner reflecting that partner's distributive share of income, deductions, credits, and other items. The partners report those amounts on their individual returns, whether or not cash was actually distributed.

The deadline moved. For tax years beginning after December 31, 2015, Form 1065 is due on the 15th day of the third month after year-end — March 15 for calendar-year partnerships, a month earlier than the old April 15 date. The change came in the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 (Pub. L. 114-41), enacted July 31, 2015, and it was aimed at making K-1s reach partners before their own individual returns came due. A six-month extension to September 15 is available. The penalty for a late-filed partnership return, before any reasonable-cause relief, runs in the low hundreds of dollars per partner per month under IRC § 6698.

The pass-through itself is not optional for general partners: their share of the partnership's income is subject to self-employment tax under IRC § 1402, not just income tax. A partner who has never written herself a paycheck and has never seen a W-2 will still owe the full combined employer-and-employee portion of Social Security and Medicare on her share of the profits — something accidental partners routinely discover the first April after their first good year.

Failure modes

The accidental partnership is the classic failure. Two friends build a website together, split revenue, never incorporate. One signs a server contract in his own name and stops paying. The vendor sues. The friend who did not sign discovers that a court applying RUPA § 202 can find partnership from the conduct, and that § 306 puts his savings on the table for a debt he never agreed to.

The second failure is the sophisticated one: a lender, a licensor, or an early investor takes a profit share and enough governance rights to feel like an owner. Martin v. Peyton survives because the controls were framed as protections for a loan. Re-papered less carefully, the same facts produce a partnership, and the lender's balance sheet is exposed to every downstream liability of the operating company.

The third failure is complacency. Two partners who have operated happily for ten years have, between them, no written agreement, no buy-sell provision, and no default rule they have even read. When one dies or wants out, RUPA's default dissolution and wind-up rules apply automatically, and those defaults are rarely what either partner would have chosen. A written partnership agreement — which, like an LLC operating agreement, is not filed anywhere — is cheap insurance.

A general partnership is the correct form for almost nobody who has a choice. It exists mostly as a legal category into which people fall when they have not chosen anything else. If two people are doing something together that earns money, the right answer in January 2017 is almost always an LLC formed at home: a filing fee in the low hundreds, a short operating agreement, the same pass-through taxation, and a liability shield between the business and the house.

Sources

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