Your Money: Steer Clear of General Partnerships

You should never operate any business or practice as a general partnership. Why? Because a general partnership is a creditor’s or plaintiff’s dream and a partner’s liability nightmare.

Consider three hidden dangers of a general partnership:

Partners have unlimited liability for partnership debts. This tragic fact goes unrecognized by many business people, professionals, and other entrepreneurs when they’re involved in general partnerships. They, in effect, personally guarantee every partnership debt and personally assume the risk for malpractice, accidents, and other liability sources of the entire partnership. They fail to realize that their liability as partners is seen as “joint and several” by the other partners. This is legalese for “my problem is your problem.” You may think it protects you as much as it exposes you, since your partners are liable for your debts as much as you are for theirs, but under the joint-and-several principle, a plaintiff who successfully sues the partnership can collect the full judgment from any one partner.

Take this illustration: Jane and Ted were friends who decided to go into a real estate venture together to refurbish old three-family homes and sell them as condominiums. Events went well for a while, but the real estate market went sour, and they defaulted on a $650,000 bank loan. Jane was much wealthier than Ted, so the bank pursued Jane for the full amount, ignoring Ted.

Partners have unlimited liability for one another’s actions. As a participant in a general partnership, you assume all the risk that any of your partners may incur in a lawsuit. When a lawsuit arises from one partner’s act or omission in the ordinary course of business, every other partner is also personally liable. The dreaded joint-and-several principle applies - if one of your partners gets into trouble, you can be personally liable for the entire amount, even if you were neither involved in the alleged incident nor aware of it.

Think of the many ways a partner could get you into trouble: He commits malpractice, gets into a car accident while on partnership business, defrauds someone through the business, sexually harasses an employee, wrongfully fires an employee, etc. Multiply this risk by the number of partners in your group and you have a lawsuit liability nightmare.

A real-world example: Michael was the founding partner in a successful three-partner software development company near Portland, Ore. One of the firm’s customers sued when a program malfunctioned, causing a loss of valuable data. The lawsuit alleged breach of contract as well as product liability, and it sought punitive damages. Settlement negotiations were unsuccessful, and the trial jury awarded an extremely large verdict against the partnership, exceeding the limits of its liability insurance by $250,000. Because Michael was the wealthiest of the partners, the plaintiff’s lawyer pursued him first, forcing him to pay the entire amount from his personal savings, even though he had less contact with this customer than his partners did. Michael now understands the risks of a general partnership.

You may be an “unaware” general partner. A general partnership does not require a formal written agreement, as a limited partnership does. You can create a general partnership - with all of its liability problems - simply by verbally agreeing to start a venture with another person.

Even if you make no agreement to partner with another person, the law may impose general partnership liability on you if the general public reasonably perceives you and a business associate as partners. You may already be part of a liability-ridden general partnership and not even know it.

Here’s a case in point: Roger was one of four physicians who used a common office arrangement. Each physician had his own discrete set of patients. The group did, however, share a common waiting area, support staff, and accounting team. Each physician had his own practice methods, set his own hours, and was not otherwise accountable to the others.

When one of the doctors was sued by a patient for professional misconduct, Roger and the two other physicians associated with him had a rude awakening. Although only the patient’s physician was negligent, all four were defendants in the lawsuit. The court found that the patient could reasonably conclude that the four professionals were partners together because of their office setup and common support staff. Therefore, the court allowed the plaintiff to proceed with the suit against all four - as a general partnership, with each jointly and severally liable for the plaintiff’s losses.

What business form should you use, if not a general partnership? Consider a limited partnership, a C or S corporation, or a limited liability company. These entities have limited liability provisions for their owners.

If you do form a general partnership, each partner should set up his own corporation, and the corporations should become the partners in the general partnership. This advice guides many medical professionals and attorneys using professional corporations (PCs).

Each doctor or lawyer establishes a PC, and the PC is the official partner in the partnership - not the individual professional. Structuring the partnership this way, the underlying corporate owner’s personal assets remain protected from claims against the partnership. However, as with any corporation, corporate formalities must be followed to ensure asset protection.

David B. Mandell, JD, MBA, is an attorney, lecturer, and author of “Wealth Protection, MD.” He is also a cofounder of The Wealth Protection Alliance, a nationwide network of independent financial advisory firms whose goal is to help clients build and preserve their wealth. Louis W. Pierro, Esq. is the founder and principal of Pierro & Associates, LLC. He concentrates his practice in the areas of estate planning, estate and trust administration, business succession planning, and elder law. David and Louis can both be reached at 800 554 7233 or via editor@physicianspractice.com.

This article originally appeared in the March 2007 issue of Physicians Practice.