Distinguishing a Formal Corporation from an Informal Partnership
Updated: Oct 6
It is not uncommon for two or more parties to engage in a business endeavor together without filing any formal paperwork (this makes most attorneys cringe!). In this blog, we explore some of the key distinctions between creating a true corporate entity as opposed to carrying on as an informal partnership.
The first key distinction is that of creation. A corporation must be formally created by filing Articles of Incorporation with the Office of the Secretary of State. In contrast, a partnership may be created informally, meaning that the law may treat two or more people as “partners”, even though they had no intention of entering into a formal business relationship with each other. Much case law has come out of the fact that one person believed the parties to be in a formal partnership arrangement, while the other did not…so partners beware! A smarter decision is to have an open dialogue prior to deciding to work with anyone, and form the proper entity type for your business (such as a corporation).
The next distinction pertains to the duration - or time period of existence - of each arrangement. A corporation enjoys perpetual duration, meaning that the only way for a corporation to cease to exist is for it to go through a formal dissolution and winding-up process. This contrasts with a partnership, which may automatically end upon the happening of specific events (i.e. – one party chooses to leave).
Separation of Ownership & Control
A corporation is owned by its shareholders. The shareholders invest their money into the corporation in exchange for certain rights, including the right to appoint the Board of Directors and the right to vote (amongst other things). The right to control the day-to-day operation of the corporation remains with the elected Board of Directors, as well as with executive officers (these folks are appointed by the Board). The officers have the authority to make all decisions regarding the corporation, unless the Articles of Incorporation state otherwise, and require a specific matter to receive shareholder approval. In stark contrast, a partnership has virtually none of these formalities: the parties make decisions together – or don’t. Similar to the scenario above, one party’s disagreement could lead to the end of the partnership.
One major benefit of a corporation is that the shareholders enjoy limited liability protection. What this means is that a shareholder’s maximum loss is limited to the amount of their initial investment in the company, and thus, a shareholder cannot be held liable beyond that for the corporation’s losses, except in very specific circumstances. On the other hand, in a partnership, the partners are personally liable for all of the debts and liabilities of the partnership.
Transferability of Shares
If you trade on the stock market, you are well aware of the fact that a corporation’s shareholders may freely transfer their shares, meaning that shares may be bought and sold to anyone. This is commonplace for publicly-traded companies. It is important to note, however, that a private corporation might have transferability restrictions provided for in its shareholder agreement. This is a smart move for privately-held companies so as to ensure that not just anyone can become an owner, and thus, decision-maker! Conversely, an informal partnership will cease to exist if one party decides she or he no longer wishes to be involved (you are likely seeing a theme here).
There are many benefits to incorporating your business, and it is an important decision that should not be taken lightly. If you are considering incorporating your business (or if you would like to start a business under a different structure), it is always advisable to consult an attorney and CPA to determine which business structure is best suited for you. If you’re looking to incorporate your business in Connecticut, Massachusetts or Rhode Island, you can contact us at: email@example.com or (860) 552-7770.