Understanding Business Accounting For Dummies, 2nd Edition (85 page)

To keep this limited liability, a limited partner may not participate in the management of the business, with very few exceptions. A limited partner who does get actively involved in the management of the business risks losing immunity from personal liability and having the same legal exposure as a general partner.

Caution:
We would advise you as a member of a partnership, either as a general or limited partner, to get up to speed on the special accounting practices of the business regarding how salaries and other payments for services to owners and partners are accounted for in the entity's financial statements and how they are treated in determining annual taxable income. Don't take anything for granted; investigate first. Call a tax professional if you have questions or need advice in this area.

Going into partnership:
Partnerships are effectively collections of sole traders or proprietors. It is a common structure used by people who started out on their own, but want to expand. There are very few restrictions to setting up in business with another person (or persons) in partnership, and several definite advantages. By pooling resources you may have more capital; you will be bringing, hopefully, several sets of skills to the business; and if you are ill, the business can still carry on.

The legal regulations governing partnerships in essence assume that competent businesspeople should know what they are doing. The law merely provides a framework of agreement, which applies ‘in the absence of agreement to the contrary'. It follows from this that many partnerships are entered into without legal formalities and sometimes without the parties themselves being aware that they have entered a partnership! Just giving the impression that you are partners may be enough to create an ‘implied partnership'.

In the absence of an agreement to the contrary, these rules apply to partnerships:

All partners contribute capital equally.

All partners share profits and losses equally.

No partner shall have interest paid on their capital.

No partner shall be paid a salary.

All partners have an equal say in the management of the business.

It is unlikely that all these provisions will suit you, so you would be well advised to get a partnership agreement drawn up in writing before trading.

Partnerships have three serious financial drawbacks that merit particular attention.

1. If your partner makes a business mistake, perhaps by signing a disastrous contract without your knowledge or consent, every member of the partnership must shoulder the consequences. Under these circumstances, your personal assets could be taken to pay the creditors, even though the mistake was no fault of your own.

2. If your partner goes bankrupt in their personal capacity, for whatever reason, his or her creditors can seize their share of the partnership. As a private individual you are not liable for your partner's private debts, but having to buy them out of the partnership at short notice could put you and the business in financial jeopardy.

3. If your partnership breaks up for any reason, those continuing with it will want to recover control of the business; those who remain shareholders will want to buy back shares; the leaver wants a realistic price. The agreement you have on setting up the business should specify the procedures, and how to value the leaver's share, otherwise resolving the situation will be costly. The traditional route to value the leaver's share is to ask an independent accountant. This is rarely cost-effective. The valuation costs money and worst of all it is not definite and consequently there is room for argument. Another way is to establish a formula, an agreed eight times the last audited pre-tax profits, for example. This approach is simple but difficult to get right. A fast-growing business is undervalued by a formula using historic data unless the multiple is high; a high multiple may overvalue ‘hope' or goodwill, thus unreasonably profiting the leaver. Under a third option, one partner offers to buy out the others at a price he specifies. If they do not accept his offer, the continuing partners must buy the leaver out at that price. In theory, such a price should be acceptable to all.

Even death may not release you from partnership obligations and in some circumstances your estate can remain liable. Unless you take public leave of your partnership by notifying your business contacts, and legally bringing your partnership to an end, you will remain liable indefinitely.

The partnership agreement specifies how to divide profit among the owners. Whereas owners of a company receive a portion of profit that's directly proportional to the number of shares they own and, therefore, how much they invested, a partnership does not have to divide profit according to how much each owner invested. Invested capital is only one of three factors that generally play into profit allocation in partnerships:

Treasure:
Owners may be rewarded according to how much of the ‘treasure' - invested capital - they contributed; they get back a certain percentage (return) on their investment. So if Joe invested twice as much as Jane did, his cut of the profit may be set at twice as much as Jane's.

Time:
Owners who invest more time in the business may receive more of the profit. In some businesses, a partner may not contribute much more than capital and his or her name, whereas other partners work long hours. This way of allocating profit works like a salary.