Three key reasons that general partnerships are liability nightmares

Key Points

Editor's note: The information in this article is general in nature and should not be construed as comprehensive financial, tax, or legal advice. As with any financial or legal matter, consult your qualified securities, tax, or legal representative before taking action.

Simply put, never operate a practice as a general partnership. A general partnership is a creditor or plaintiff's dream and a partner's liability nightmare.

Consider three costly hidden dangers of a general partnership.

A general partnership does not require a formal written agreement, as does a limited partnership. You verbally can agree to start a venture with another person and create a general partnership-with all of its liabilities. Think about that when you plan a new business venture with someone.

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 as partners. You already may be part of a liability-ridden general partnership and not even know it.

Case Study #1: Roger inadvertently has partners.

Roger was one of four ophthalmologists who used a common office arrangement. They each had their own patients, whom they did not share. They did, however, share a common waiting area, support staff, and accounting service. Each ophthalmologist set individual practice methods, set individual office hours, and was not otherwise accountable to the other partners.

When a client sued one of the ophthalmologists for professional misconduct, Roger and the other two doctors had a rude awakening. Although only the client's ophthalmologist allegedly was negligent, all four partners were named defendants in the lawsuit. The court found that the patient reasonably could 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 ophthalmologists as a general partnership, with each partner "jointly and severally" liable for the plaintiff's losses.

2. Partners have unlimited liability for the partnership

That tragic fact goes unrealized by many ophthalmologists 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 consider that their liability as a partner is joint and several with the other partners. Remember, a plaintiff that successfully sues the partnership can collect the full judgment from any one partner.

Case study #2: Jane and Ted's real estate venture.

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

3. Partners have unlimited liability for their partners

As a partner in a general partnership, you assume all the risk that the partner(s) may cause with a lawsuit. When a complaint arises from one partner's act or omission in the ordinary course of business, every other partner is personally liable. The dreaded joint and several liability then applies: If one of your partners gets into trouble, then 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 or she commits malpractice, gets in a car accident while on partnership business, defrauds someone through the business, sexually harasses an employee, wrongfully fires an employee, and so on. Multiply that risk times the number of partners in your partnership and you have a lawsuit liability nightmare.

Case Study #3: Michael gets burned by his partner.

Michael was the founding partner in a successful three-partner software development firm near Portland, OR. One of firm's customers sued the firm when a program malfunctioned, causing a loss of valuable data. The lawsuit alleged breach of contract, product liability, and punitive damages.