In California, not every business is required to form a business entity with the state of California. Individuals, or multiple people working together in partnership who conduct business for profit, are automatically subject to certain laws and legal classifications.
These default laws apply even when those business people have not taken any affirmative steps to register or formalize their business structure or rules of operation.
An individual conducting business without creating a business entity is classified as a sole proprietor; multiple people conducting business together as partners without creating a business entity are classified as general partners.
If one person paints houses for money, and has not filed any business organization documents with the state, that person is a sole proprietor. If two people paint houses together for money, and intend to work as partners, that business is legally classified as a general partnership.
Sole proprietors and general partnerships receive similar default treatment under the law. The individual proprietor or partners are subject to personal liability for activities of the business. For tax purposes, business income is allocated directly to the individuals and so are business losses.
This is called being a “pass-through” entity because money passes right through the business entity directly to the individual business owners; the business itself does not pay taxes but the owners pay taxes on the business’s income.
Sole proprietors do not register their business with the secretary of state. General partnerships may register with the secretary of state, but it is optional. If general partners elect to register with the secretary of state, they file a document called a Statement of Partnership Authority.
General partners are “jointly and severally” responsible for the obligations of this business. This means that all of the partners are equally responsible for the business’s obligations, or any of them individually could be responsible for the entirety of those obligations. The partners also share business income equally, unless they make an agreement to change the allocations.
Unlike other business entity types such as corporations and LLCs, sole proprietors and general partnerships do not pay an annual $800 franchise tax to the state of California. Sole proprietors and partners in general partnerships also do not receive the same protections under the law as corporate shareholders or LLC members. The personal assets of a sole proprietor or a general partner can be subjected to the liabilities of the business’s activities.
General partnerships can operate with or without contracts governing the rules of operation of the business. If the partners of a general partnership wanted to memorialize the terms of their arrangement in writing, they would do so with a partnership agreement. Although partners are not required to enter into a partnership agreement, they should. Relying on assumptions or verbal discussions can lead to uncertainties, misunderstandings, and disputes between partners.
Keeping a written record of the agreement of the partners helps reduce those misunderstandings, provide guidance in times of turmoil, set expectations of the partners, and can preserve the positive relationship of the partners.