What is a California Partnership?
Partnerships are often used as both the organizing entity for professional entities and the third most common entity for use by companies. For tax purposes, the Partnership is often referred to as a "pass-through entity," since the entity itself is not taxed (although it will be taxed in California if it has income from California sources and has more than $1,000,000 or more in annual gross receipts in California). Instead, the income and losses are passed through to the partners (who will be operating a trade or business). Since the partners will be responsible for paying taxes on their share of the partnership income, the partnership itself does not pay income taxes.
There are several types of partnerships that are used in California.
A general partnership, per California Corporations Code Section 16201(a), "is an association of two or more persons to carry on as co-owners a business for profit." In addition, a general partnership is created by a written agreement, oral agreement or even the conduct of the parties.
A limited partnership is a partnership, per California Corporations Code Section 15901(b), "having one or more general partners and one or more limited partners." As the name suggests, a limited partner is a partner who is averse to the risk of the company and whose liability is limited. So unless a limited partner does something to violate his/her "limited" status by taking an active role in the operations of the company , the limited partner’s liability for the obligations of the limited partnership is limited to the amount of consideration he/she contributed to the partnership.
A limited liability partnership ("LLP"), per California Corporations Code Section 16951(a), is a partnership registered as an LLP under the laws of the state. For purposes of tax, a LLP is treated in the same manner as a limited partnership. The LLP’s partners can participate in the LLP without risking personal liability; however, unlike a limited partner, an LLP partner can also take part in the management of the LLP and maintain that liability protection.
Finally, another type of partnership is a limited liability limited partnership ("LLLP"). The FTB does not recognize a LLLP for purposes of partnership filing requirements. A LLLP is an elective partnership form made available under California Corporations Code Section 15909.02(m) and available to limited partnerships. With the LLLP status, a general partner is able to limit his/her liability to the same extent as a limited partner without risking loss of the status as a general partner.
All partnerships (including sole proprietorships), unless they are disregarded entities, are required to file a federal tax return on Form 1065, even if the partnership has no income or expenses during the tax year. For California tax purposes, a partnership is required to file an FTB Form 565 if:
A Form 568 is required for LLCs that elect to be taxed as a partnership.
Importance of Accurate Filing
It is critical for all California partners to understand the requirements of filing a Partnership Agreement in order to minimize any potential adverse tax consequences and to preserve the rights of all partners when entering into business transactions. South Dakota law does require that a Partnership Agreement be filed with the Secretary of State, however it is highly unlikely that not filing a Partnership Agreement in South Dakota would create any tax consequences.
California law sets forth numerous filing requirements for partnerships that enter into business in California. All out-of-state partnerships entering into a business in California must file a Statement of Information with the California Secretary of State within 90 days of doing business regardless of whether a Partnership Agreement was filed elsewhere. (Cal. Corp. Code 17702.09(c)(3)) This annual Statement of Information must be accompanied by a $20.00 filing fee and a $50.00 penalty fee if the report is filed late. (Cal. Corp. Code 17702.09(d)(1)(A))
When establishing a partnership in California all partners must consent in writing. Once a partnership has been formed it must obtain an IRS Employer Identification Number (EIN) from the Internal Revenue Service and file an initial Statement of Information. In the initial Statement of Information, this annual statement must be accompanied by a $20.00 filing fee and a $250.00 penalty fee if the report is filed late. (Cal. Corp. Code 17702.09(d)(2)(A))
If a partner fails to file a statement of information as specified, they may be guilty of a misdemeanor. (Cal. Corp. Code 17702.09(g)) In addition, every partner will also be subject to penalties of $250.00. (Cal. Corp. Code 17702.09(f))
The failure to comply with any of the filing requirements set forth in California Law can have significant legal and tax liability for a partner including: the loss of liability protection, the loss of business entity status, an inability to seek damages for breaches of the Partnership Agreement, possible forfeiture of business opportunities, refusal of the State to grant the partnership a business license and the loss of liability protection to a partners spouse if he or she was injured on the job.
Initial Filing Obligations
California has adopted the Uniform Partnership Act (Corp. Code Sections 16100 et seq.), which governs general and limited partnerships. The filing requirements for a partnership are simple and few. Unless a partnership agreement provides otherwise, general partnerships are created without any formalities, and a written partnership agreement will not even be required. While a written agreement is not necessary (though advisable), any one of the partners may register a fictitious name statement if the partnership will be operating under a fictitious business name. Fictitious name statements are filed in the Office of County Clerk in the county in which the partnership will maintain its principal place of business and are valid for five years. California does not require partnerships to obtain a license, such as a business license. In fact, the only additional filing requirements for general partnerships are for those intending to hire employees and for partnerships subject to taxation.
Partnerships that will be hiring one or more employees must obtain an employer identification number (EIN) from the Internal Revenue Service (IRS). Partnerships are also required to file a Statement of Partnership Authority with the California Secretary of State if they will have any real property. A Statement of Partnership Authority is not required of partnerships that do not hold real property in California. Partnerships are subject to an annual tax upon filing their Statement of Information. Limited partnerships must be formed by filing a certificate of limited partnership with the California Secretary of State. Partnerships subject to the Franchise Tax Board’s annual tax must file a Partnership Tax Information (California Form 565) with the Franchise Tax Board on or before 15 days after the close of the taxable year.
Most small to mid-sized general business partnerships will not be subject to any other annual filing requirements.
Annual Filing Obligations
California partnerships are required to file an initial Statement of Information (SOI) to the Secretary of State. The SOI is an annual filing within 90 days of registering with the California Secretary of State. The $20 filing fee is due upon submission of the SOI.
Partnerships formed in states other than California should also file an SOI if they are doing business in California as a foreign entity (generally, when they have actual physical presence in California). Foreign entities must file an SOI with the California Secretary of State within 90 days of registering to do business in California.
If a partnership fails to comply with the SOI reporting requirements on a timely basis, the California Secretary of State will impose penalties in the form of franchise tax and interest on the late filing. Failing to file can also result in the loss of limited liability protection and administrative dissolution.
Tax Filing Obligations
California ignores federal due dates for tax return purposes. As a rule, entity tax returns are due by the 15th day of the third month following the close of the entity’s taxable year. If that day falls on a weekend, the return is due on the next business day. For a California partnership return, the filing deadline is the 15th day of the 4th month after the close of the partnership’s taxable year . For a composite return made on behalf of all nonresident partners of a California partnership, the filing deadline is the 15th day of the 4th month following the close of the taxable year of the partnership. Partnerships deciding to be taxed as an association generally file a Form 100, California Corporation Franchise or Income Tax Return, rather than a Form 565, Partnership Return of Income. California Partnership Returns (Forms 565 and 568) must be filed with the Franchise Tax Board and payment must be made to the State.
Amendments & Changes to a Partnership
California law requires that the California Secretary of State be informed of amendments to Partnership Agreements and changes in partnership structure, such as a new partner, partner withdrawal, partner death or a change in the partnership address.
In addition to the California Secretary of State requirements, many counties have local filing requirements that differ from the statewide requirements.
Pursuant to the California Corporations Code, Partnerships must file the following forms:
• LP-1 (Statement of Partnership Authority) – A new Partnership must file the LP-1 upon formation and any time there are amendments to the Partnership Agreement. The LP-1 must be filed in every California county where the Partnership is "doing business" at least every 2 fiscal years.
• LP-2 (Statement of Partner Dissocation) – A Partnership must file this form when a partner withdraws, the partnership is dissolved, partnership assets are distributed and/or a partner’s interest is transferred. The LP-2 must be filed in every California county where the Partnership is "doing business" within 90 days after the withdrawal, dissolution or distribution.
• LP-5 (Civil Penalty) – A penalty is imposed if a partnership does not file an LP-2 and/or LP-4 within 90 days after the withdrawal, dissolution and/or distribution. Additionally, the California Secretary of State does not inform the county when an LP-2 and/or LP-4 is filed. Therefore, an LP-5 must be filed every time an LP-2 and/or LP-4 is filed so that the California Secretary of State can inform every county of the filing. This form must be filed in every California county in which the partnership does business within 90 days after the filing of the LP-2 and/or LP-4.
• LP-4 or LP-3 (Amendment to Statement). An LP-4 must be filed every time the Partnership Agreement is amended. The California Secretary of State will not file an LP-4 and the county does not confirm receipt of same. So, an LP-3 must be filed in every California county in which the Partnership does business at least every 2 fiscal years to inform the county that the Partnership Agreement has been amended.
Dissolving a Partnership
Partnership interests are usually for an unlimited term, with no defined "end date" on the relationship. Like any relationship, however, sometimes things go wrong. That is why it is important to have an exit strategy in the partnership agreement that includes methods to disband your partnership when the time is right. California has an entire chapter of the California Corporations Code at Section 16800 entitled "Dissolution and Winding Up", which includes all of the many requirements to disband a partnership (many of which are specific to the type of partnership). In summary, the partnership must file with the Secretary of State a "Certificate of Dissolution" along with a "Certificate of Winding Up", which can be downloaded from the Secretary of State’s website. If the partnership was formed under the Uniform Partnership Act prior to 2011, the law requires written consent from at least two-thirds (2/3) of the general partners, while a California partnership formed thereafter (2011 or later) must be dissolved by the consent of all general partners (unless there is some other specific method to do so in the partnership agreement itself). The Certificate of Dissolution must contain specific information including the partnership name, the date of dissolution, and the reasons for dissolution. The partnership must then wind up its business and distribute all assets-unless certain specified assets are not permitted to be dissolved, in which case the remaining assets should be distributed to the remaining partners. Partners must also notify all known creditors of the dissolution within 30 days, and try to locate any unknown creditors. If a partner does not promote the dissolution and notify the creditors in good faith within 120 days of the date of dissolution, then that partner remains liable to any third party which extended credit to the partnership during the period of the partner’s failure to act. Once all the assets have been distributed and second tier distributions occur if any partners must also discharge all known claims; and then, finally, publish a notice of dissolution for at least four (4) consecutive weeks in a newspaper of general circulation in the county in which the partnership became or is registered.
Common Missteps and How To Avoid Them
One of the most common mistakes partnerships make is failing to file with jurisdictions where their partnership deals are being done even when the business is being run out of California. The most recent trend on the rise in California is "mining" partnerships for money. In this scheme, an investment fund enters into a document request with a general partner and demands production of the financial records. Then, they sell the information to unhappy investors seeking to sue the fund. California entities are at risk of these document demands from aggressive and/or unethical litigants that develop a nifty script for a 30(b)(6) deposition and threaten to involve California state authorities. It is best to be able to provide documents on good form, alone.
Another way partnerships get into trouble filing in California is by inadvertently entering into a California partnership through contract . This type of partnership is called "partnership by estoppel," and is created when people deal with each other as if they were partners, but the group never intended to create a partnership. They never intended to share profits. They never intended to share losses. No one planned to file. In this case, the group usually has to file as a California general partnership to avoid double jeopardy on the assets. For the California franchise tax, the only cost to file is the $800 minimum annual tax and the $20 Statement of Information.
Another problem we see regularly is when multi-jurisdictional partnerships fail to file in other states where the business is being done. For example, in Mississippi, if you have one deal in the state, it is important to file there. Also, you must update your filing when you end your deal, or you could face a stiff penalty.