By Austin Fahnestock
BC Law EIC Student
April 2023
Before you take another step, consider: is your startup a partnership?
Imagine that you and several of your friends have been life-long cowboy hat enthusiasts. Together, you’ve traveled the American West and amassed not only a collection of hats but a working knowledge of the basics of how they are made. You’ve long been interested in the design of hats, particularly when it comes to adapting them to modern contexts, and your friend, “Larry” has developed a line of proprietary leathers using techniques he adapted from old family trade secrets. Several years ago, you and Larry got together and created a prototype “Urban Bullrider Hat” which you designed and he helped craft using his leathers. After a positive reception from your friends, you suggest selling the hat online, and Larry agrees. You sell informally on social media with some success, and soon find that there is a market not only for the hats themselves but for the patterns and tutorials on how to make them. Excitedly, you begin exploring sales avenues and licensing regimes for the patterns, and, at the end of a conversation with a friend, informally agree to take them on as an investor with a share in a new entity you plan to form. Several days later, Larry approaches you, clearly upset. He says you should not have agreed to an investor without asking him and that you either need to buy him out or start passing along half of the profits.
While it may seem strange that someone else could possess an interest in your designs or the profit you derive from them, it can happen if your business is a general partnership. But how do you know if you have a general partnership?
Business Entities
A general partnership is one of a number of common forms that a profit-making effort may take.[1] Other well-known forms include sole-proprietorships, Limited Liability Companies (“LLC”), S-Corporations (“S-Corp”), and C-Corporations (“C-Corp”).[2] Each of these has their own body of law and unique characteristics, but one of the most defining differences is that LLCs, S-Corps, and C-Corps require filing with a secretary of state to form, while sole-proprietorships and general partnerships may arise by implication simply through engaging in business for profit.[3] The main difference between a sole-proprietorship and a general partnership is that a sole-proprietorship involves only one person while a partnership has two owners.[4]
Legal Features of a General Partnership
Here in Massachusetts, a partnership involves two people co-owning a business for profit that is not already another form of association.[5] In fact, the sharing of profits is one of the defining features indicating the existence of a partnership.[6] Other features include pass-through taxation, in which profits and losses are realized on the individual partners’ tax returns, joint and several liability, and the option, but not requirement, of a governing partnership agreement.[7]
Formation of a Partnership
A partnership forms on the intent of two or more parties to conduct business together, but that intent may be implied by actions.[8] Where parties disagree about the existence of a partnership, Massachusetts courts look to both statutes and case law for criteria.[9] Three of the most significant facts are an agreement by the parties showing their intention to be in a partnership, sharing of profits and losses, and participation in control or management.[10] Other factors may include a limitation to a single undertaking and the contribution of money, property, skill, knowledge, or effort.[11]
Rights and Obligations of a Partner
Once a partnership exists, each partner is subject to a series of rights and obligations which may come either from an oral or written agreement between the parties or from state law.[12] Obligations include joint liability, as already discussed.[13] Rights include a share of the profits and surplus, rights in the property of the partnership, and fiduciary duties from the other partners [14]. Partnership agreements, especially those that are written, may supply sophisticated terms for dividing profits or property [15]. Where a partnership agreement does not supply terms, state default law applies, which, in the case of shares of profit, mandates a split of equal shares [16].
Riding Alone… Or Not
As a business develops, a founder may receive assistance and input from many different people. For solo founders who do not want a business partner, it is important to clarify the relationship between the business and any others involved as something other than a partnership, such as an employment or contractual relationship. Similarly, for those who are working with one or several cofounders, defining the relationship early on with a written partnership agreement will reduce the possibility of unwanted legal defaults applying later on.
Conclusion
Unlike LLCs, S-Corps, C-Corps, and other entities formed by registration, a general partnership is formed by the agreement of the partners, which may be implied from series of factors. The rights of those partners are then either derived from the partnership agreement or supplied by law if there are none. This has important implications for the rights of partners to partnership property and profits. For founders working with others on a startup, like Urban Bullrider, it is important to recognize that their shared effort may be a partnership. For founders who know they are in a partnership, there may be some ambiguity as to the rights and liabilities of the partners. In both cases, founders will benefit from implementing an explicit, written agreement before proceeding further with their enterprise.
[1] Andrew Bloomenthal, General Partnerships: Definition, Features, and Example, Investopedia https://www.investopedia.com/terms/g/generalpartnership.asp (last visited February 24, 2023).
[2] Types of Corporations, Investopedia https://www.investopedia.com/types-of-corporations-5270647 (last visited February 24, 2023).
[3] Andrew Bloomenthal, General Partnerships: Definition, Features, and Example, Investopedia https://www.investopedia.com/terms/g/generalpartnership.asp (last visited February 24, 2023) (“General partnerships are unincorporated businesses”).
[4] Id. (“A general partnership is a business arrangement by which two or more individuals agree to share responsibilities, assets, profits, and financial and legal liabilities of a jointly-owned business.”)
[5] ALM GL ch. 108A, § 6 (“A partnership is an association of two or more persons to carry on as co-owners a business for profit and includes, for all purposes of the laws of the commonwealth, a registered limited liability partnership.”)
[6] ALM GL ch. 108A, § 7(4) (“The receipt by a person of a share of the profits of a business is prima facie evidence that he is a partner in the business. . . .”)
[7] 26 U.S.C.S. § 701 (“A partnership as such shall not be subject to the income tax imposed by this chapter [26 USCS §§ 1 et seq.]. Persons carrying on business as partners shall be liable for income tax only in their separate or individual capacities.”); ALM GL ch. 108A, § 15(1) (“[A]ll partners are liable . . . . jointly and severally for everything chargeable to the partnership. . . .”); Kansallis Fin. v. Fern, 40 F.3d 476, 479 (1st Cir. 1994) (“While a partnership undoubtedly requires an agreement among the partners, that agreement need not be in writing. Rather, intent to carry on business as partners may be inferred from the partners' words and acts.”)
[8] Kansallis Fin. v. Fern, 40 F.3d 476, 479 (1st Cir. 1994) (“Rather, intent to carry on business as partners may be inferred from the partners' words and acts.”)
[9] Id.
[10] Fenton v. Bryan, 33 Mass. App. Ct. 688, 691 (1992) (“Those factors include, among others, (1) an agreement by the parties manifesting their intention to associate in a partnership (2) a sharing by the parties of profits and losses, and (3) participation by the parties in the control or management of the enterprise.”)
[11] Shain Inv. Co. v. Cohen, 15 Mass. App. Ct. 4, 8-9 (1982) (“Nevertheless, the following pragmatic check list suggests considerations which, if present or absent, may bear upon the recognition of one: (1) an agreement by the parties manifesting their intention to associate for joint profit not amounting to a partnership or a corporation; (2) a contribution of money, property, effort, knowledge, skill, or other assets to a common undertaking; (3) a joint property interest in all or parts of the subject matter of the venture; (4) a right to participate in the control or management of the enterprise; (5) an expectation of profit; (6) a right to share in profits; (7) an express or implied duty to share in losses; and (8) a limitation to a single undertaking (or possibly a small number of enterprises).”)
[12] See e.g. ALM GL ch. 108A, §1-49; Whitcomb v. Converse, 119 Mass. 38, 42-43 (1875) (“In the absence of controlling agreement, partners must bear the losses in the same proportion as the profits of the partnership, even if one contributes the whole capital, and the other nothing but his labor or services. Whether a loss of capital is a partnership loss, to be borne by all the partners, depends upon the nature and extent of the contract of partnership.”)
[13] ALM GL ch. 108A, § 15(1) (“[A]ll partners are liable . . . . jointly and severally for everything chargeable to the partnership. . . .”)
[14] ALM GL ch. 108A, § 18, 25, 26.
[15] See, e.g., Adams v. Adams, 459 Mass. 361, 366 (2011) (discussing a relatively complex partnership agreement in the context of determining marital property).
[16] Whitcomb v. Converse, 119 Mass. 38, 42-43 (1875) (“In the absence of controlling agreement, partners must bear the losses in the same proportion as the profits of the partnership, even if one contributes the whole capital, and the other nothing but his labor or services. Whether a loss of capital is a partnership loss, to be borne by all the partners, depends upon the nature and extent of the contract of partnership.”)