Small Business Structure Drives Debt Responsibility in Partnerships

Businesses are usually joint ventures. Rarely does one person conceptualize, create and build a business to success without help. Starting a business usually means partnering with friends, family or other industry professionals. It’s a big job, and if you partner with someone, it’s important to make sure you properly establish your business to protect yourself financially.

If you set up a general partnership and leave the business, you could be on the hook for any debt the business has taken on and failed to pay. By understanding the different types of businesses, personal guarantees, and what to do as partners come and go from your business, you can protect both your personal assets and your business from potential financial issues.

Business structure, personal guarantees, ownership stake

There are two main types of partnerships among small businesses: general partnerships and limited partnerships. General partnerships are exactly what they sound like. Two or more individuals enter into an agreement to start and run a business. This type of business can be set up without any legal entities.

“Me and you can have a handshake today, and we’re a general partnership going forward,” said Walter Gumersell, partner with Rivkin Radler. “You don’t have to register with the state.”

Unless there is a predetermined partnership agreement that all parties have signed, the general partnership means each partner is equally liable for debt and other outstanding payments, according to Gumersell. The general partnership is also a type of business that does not protect partners’ personal assets from business liability. Only limited liability companies (LLC) and corporations can offer this type of protection.

A limited partnership is between a general partner and a limited partner, who usually serves as an investor or supplemental supporter. The general partner, like in a general partnership, is exposed to the lion’s share of the liability. The limited partner is only accountable for their stake in the company, according to Gumersell. Unlike a general partnership, limited partnerships are registered with the state and require formal documentation detailing an agreement between parties.

The key takeaway is that if you are involved in a general partnership and leave the business, unless otherwise agreed upon in a legal document, you’ll be on the hook for business debt when the lender comes to collect.

In a general partnership, “each partner is 100 percent liable for anything done in the partnership name,” said Jim Wilson, founder and principal attorney of Wilson Law Group.  

If you and your partners set up an LLC or corporation, your personal assets will be separate from your business assets. If the proper agreement is reached before someone leaves the company, a former partner cannot be found liable unless the business is insolvent or the former partner signed a personal guarantee, Gumersell said.

Personal guarantees are agreements with a lender that say an individual will personally pay the remainder of a debt if the business cannot make payments. Whether you’re part of a corporation, LLC or general partnership, you can end up on the hook for a partner’s personal guarantee if the lender decides to sue the partnership to cover the debt, according to Wilson.

This distinction is important, and, as with any financial document, it’s crucial to understand what you’re signing before doing so.

“I’ve seen things where people sign, [and] they think they’re doing it for their business – you know, the corporation,” Gumersell said. “But the document in front of them that they sign, they sign personally. That’s a tough one to win in court, because there’s no mention of the corporation.”

What to do when leaving a business

If you’re leaving a business, whether it’s a general partnership, LLC, limited partnership or corporation, there are some important steps to take to protect yourself financially from future transactions by your former business.

Gumersell recommends establishing a written agreement of termination. This agreement should say that the company will not hold you financially accountable for any acts that occur after your termination. It should also detail the financial compensation for exiting. You should try to get out of any personal guarantees you signed on behalf of the business or other partners, but this could be very difficult. By ironing out these issues, you can protect yourself from your company’s future financial dealings and ensure you receive the value of your original stake in the business.

What to do when your partner leaves the business

If you own a business and a partner is leaving, you should include a section in the termination agreement that says the person leaving has no further claims against you or the company, according to Gumersell. Wilson said remaining partners should also look to keep the exiting partner financially committed to the debt incurred before a certain date within the company. This will vary based on each business’s specific situation.

The agreement of termination serves to protect both the individual leaving and the business from future financial gray areas.

Bottom line

When you set up a business, it’s crucial to pick the right type of legal entity to protect your personal and business assets. Partnerships can be complicated, so make sure you work with a lawyer to set up the right legal documentation between all parties. If you have a handshake deal with someone, that’s considered a general partnership, which is a type of company that will leave you personally exposed to your company’s financial issues. By working with your business partners and legal representation, you can set up a situation that works best for everyone.  

The advice in this article should be received as general information on partnerships and business debt, and not specific legal advice, which only a certified legal professional is qualified to provide. If you’re worried about your specific situation, it’s important to seek legal services.

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