Disadvantages of Partnerships

By: Jennifer Brazer

Jennifer is the author of From Cubicle to Cloud and Founder/CEO of Complete Controller, a pioneering financial services firm that helps entrepreneurs break free of traditional constraints and scale their businesses to new heights.

Fact Checked By: Brittany McMillen

 

Disadvantages of Partnerships: Key Risks Every Business Owner Must Consider

Disadvantages of partnerships include unlimited personal liability for business debts, profit-sharing conflicts, decision-making disagreements, tax complications, and difficult exit strategies that can threaten both business success and personal assets. These fundamental challenges affect partnerships across all industries, regardless of size or structure.

I’ve spent two decades guiding business owners through financial decisions, and one truth remains constant: partnerships fail at alarming rates, with over 50% ending due to preventable conflicts. Through my work at Complete Controller, I’ve witnessed the aftermath of hastily formed partnerships that crumbled under the weight of ambiguous agreements and misaligned expectations. In this comprehensive guide, I’ll walk you through the critical partnership pitfalls I’ve observed firsthand, providing actionable strategies to protect your interests if you choose this business structure.

What are the disadvantages of partnerships and why should business owners care?

• Partnerships expose owners to shared liability, profit disputes, decision deadlocks, tax complexities, and challenging exit scenarios that can threaten both business viability and personal assets.
• Unlimited liability means your personal savings, home, and investments could be seized to cover business debts incurred by any partner.
• Without proper documentation, profit distribution becomes contentious when partners contribute unequally or value contributions differently.
• Decision gridlock occurs when partners have equal authority but different visions, slowing growth and creating operational inefficiencies.
• Exit strategies become particularly problematic without pre-established buyout terms, often leading to costly litigation and business dissolution.

Shared Liability: The Financial Risk Most Entrepreneurs Overlook

The most significant disadvantage of partnerships is the unlimited personal liability that general partners face. Unlike corporations or LLCs, general partnerships offer no legal separation between your business and personal finances.

This liability extends beyond your own actions to encompass decisions made by your partners. If your business partner makes a costly mistake, signs an unfavorable contract, or incurs substantial debt, your personal assets—including your home, vehicles, and savings—can be seized to satisfy those obligations. This “joint and several liability” means creditors can pursue any partner for the full amount owed, regardless of who created the liability.

Limited partnerships and Limited Liability Partnerships (LLPs) offer some protection, but they come with their own restrictions. Limited partners sacrifice management control for liability protection, while LLPs (available primarily for professional service firms) still expose partners to personal liability for their own negligence or malpractice.

• General partnerships expose all partners to unlimited liability for all business debts
• Limited partnerships protect limited partners but require them to remain passive investors
• LLPs shield partners from other partners’ negligence but not from their own actions or contractual debts

The legal implications of partnerships vary by state, making it crucial to understand local laws before formalizing any business relationship.

Profit-Sharing Conflicts: When “Fair” Becomes a Battlefield

Even partnerships that begin with the best intentions frequently deteriorate when money enters the equation. While a 50-50 split might seem equitable on paper, it rarely accounts for the reality of business operations.

Partners often contribute unequally—whether through capital investment, time commitment, expertise, client relationships, or operational responsibilities. Without clear documentation addressing these differences, resentment builds quickly.

The classic “sweat equity” debate emerges when one partner works 80-hour weeks while another maintains regular hours but contributed more startup capital. Who deserves more of the profits? Without predetermined formulas accounting for both capital and labor contributions, these discussions become heated.

Silent partners vs. active operators

Conflicts frequently arise between investing partners (who provide capital but limited involvement) and operating partners (who run daily operations). When the business succeeds, silent partners may feel entitled to equal profits despite minimal effort, while active partners resent sharing rewards with those who didn’t “earn” them through daily work.

A real-world example I encountered involved a professional services firm where the founding partner provided all client relationships and 80% of billable hours, while the junior partner handled administrative duties. Their 60-40 profit split seemed reasonable until growth required hiring support staff, effectively replacing the junior partner‘s contributions. The resulting compensation dispute eventually dissolved the partnership.

• Establish profit-sharing formulas tied to measurable contributions
• Create separate compensation structures for labor (salary) versus capital investment (distributions)
• Review and adjust agreements annually as roles and contributions evolve

The most successful partnerships I’ve observed implement tiered profit distribution systems that account for both capital investment returns and compensation for actual work performed.

Decision-Making Deadlocks: The Paralysis of Equal Authority

Perhaps the most operationally damaging aspect of partnerships is the potential for decision deadlock. Without clear governance structures, equal partners must reach consensus on every significant decision—from hiring choices to marketing strategies to expansion opportunities.

This requirement for unanimity creates paralysis when partners have different risk tolerances, growth visions, or management philosophies. I’ve seen promising businesses stagnate for years because partners couldn’t agree on fundamental strategic directions.

The consequences extend beyond missed opportunities to operational inefficiencies. Staff receive conflicting directives, vendors deal with inconsistent expectations, and clients experience service discrepancies—all symptoms of partnership discord.

The emotional cost of partnership conflicts

The interpersonal tension from ongoing disagreements creates an additional burden that affects not just business operations but personal well-being. Many partnerships involve family members or close friends, making conflicts particularly painful and difficult to resolve objectively.

• Create detailed operating agreements that specify decision authority for different aspects of the business
• Establish dispute resolution mechanisms like mediation before conflicts arise
• Consider bringing in third-party advisors for major decisions
• Implement tiered approval thresholds based on financial impact

Remember that challenges in partnership dynamics often stem from leadership style mismatches rather than business disagreements. Partners with complementary skills but incompatible decision-making approaches will struggle regardless of their expertise.

Exit Strategy Nightmares: The “How Do We Break Up?” Crisis

The most painful partnership disadvantage often emerges at the end—when partners need to part ways. Without predetermined exit provisions, dissolution becomes messy, expensive, and potentially destructive to the business itself.

Common scenarios I’ve witnessed include:

• Partner buyouts without valuation formulas: When one partner wants to leave but there’s no agreed-upon method for determining business value, negotiations stall and often become adversarial.

• Death or disability without succession plans: If a partner passes away or becomes unable to participate, their ownership interest often transfers to family members with different priorities or expertise.

• Forced liquidations: When partners can’t agree on continuation terms, the business must be sold or liquidated, often at distressed prices that benefit neither party.

• Business sale disputes: When an acquisition opportunity arises, partners may disagree on acceptable terms or whether to sell at all.

The Hendershot Cowart case provides a sobering example. When one partner attempted a lowball buyout offer at far below market value, courts ruled the offer breached fiduciary duties—resulting in significant damages awarded to the wronged partner. This illustrates how exit disagreements frequently escalate to litigation.

Creating comprehensive buy-sell agreements that address triggering events (retirement, death, disability, voluntary departure), valuation methods, payment terms, and non-compete provisions is essential before partnership formation—not during dissolution when emotions run high.

These issues with partnership businesses require proactive planning rather than reactive problem-solving.

Tax Complexities: The IRS Complications Partners Face

Partnerships create unique tax challenges that many entrepreneurs don’t anticipate until they’re filing returns. Unlike corporations, partnerships are “pass-through” entities where business income flows directly to partners’ personal tax returns—regardless of whether profits are distributed or retained in the business.

This creates several disadvantages:

Self-employment tax burden

Partners pay 15.3% in self-employment taxes on their share of partnership income—significantly higher than what corporate shareholders pay on dividends. This tax applies even if profits remain in the business for growth or cash reserves.

Phantom income challenges

Partners must pay taxes on their share of profits even if cash isn’t distributed—creating “phantom income” situations where tax bills arrive without corresponding cash to pay them. This commonly occurs when partnerships reinvest profits for growth.

Complex reporting requirements

Partnerships must file Form 1065 and provide K-1s to each partner, creating additional compliance requirements. Each partner’s share of various income types (ordinary income, capital gains, etc.) must be separately stated and reported.

Increasing audit risks

While historical partnership audit rates were low (0.05%), recent IRS initiatives have increased partnership audits by 76% using new AI tools and additional funding. The tax implications of partnerships now include greater scrutiny of profit allocations and distributions.

• Partners need larger tax reserves than corporate owners
• Special allocations of profits/losses require substantial economic effect documentation
• Tax planning must account for both entity and individual considerations
• Partnership tax elections affect all partners, creating potential conflicts

Converting to S-corporation status after establishing profitability can mitigate some of these tax disadvantages, but such conversions require unanimous partner approval—highlighting again how consensus requirements constrain flexibility.

Cultural and Operational Misalignment: When Business Cultures Clash

Beyond legal and financial disadvantages, partnerships often suffer from fundamental misalignment in operating philosophies, risk tolerance, work ethics, and communication styles. These “soft” factors frequently cause partnership dissolution even when the business itself remains viable.

Common operational conflicts include:

• Workload distribution: Partners often disagree about who’s contributing fairly, especially when responsibilities differ in visibility or measurability.

• Risk tolerance differences: Conservative partners resist growth initiatives that more aggressive partners consider essential.

• Work-life balance disparities: Partners with different personal situations often clash over time commitment expectations.

• Quality vs. efficiency priorities: Partners may have fundamentally different views on service delivery or product standards.

• Client relationship ownership: Disputes over who “owns” client relationships create tension, especially regarding compensation tied to business development.

I worked with a marketing agency partnership that dissolved despite strong financials because one partner prioritized creative excellence while the other focused on operational efficiency. Neither approach was wrong, but their incompatibility created constant friction that eventually became unbearable.

• Conduct thorough “cultural due diligence” before partnership formation
• Create explicit agreements about performance expectations and operational values
• Implement regular partnership reviews focusing on relationship health, not just financial metrics
• Consider personality and working style assessments during partnership formation

The strongest partnerships combine complementary skills with aligned values—particularly regarding quality standards, client service philosophy, and growth priorities.

Mitigation Strategies: Protecting Yourself While Preserving Partnership Benefits

Despite these significant disadvantages, partnerships offer valuable benefits—including shared risk, complementary expertise, and expanded capacity—that make them worth considering with proper protections.

The “bulletproof” partnership agreement

The foundation of partnership risk mitigation is a comprehensive agreement addressing:

• Capital contributions and valuation of non-cash contributions
• Profit distribution formulas based on multiple factors
• Management authority and decision thresholds for different categories
• Dispute resolution procedures including mediation
• Buy-sell provisions with valuation methods and payment terms
• Restrictive covenants (non-compete, confidentiality, etc.)
• Admission of new partners and requirements for consent

Entity structure optimization

Consider alternatives to general partnerships:

• LLP status for professional service firms provides liability protection while maintaining partnership taxation
• LLC taxed as partnership offers liability protection with partnership tax benefits
• Corporate structures with shareholder agreements can provide similar collaborative benefits with greater liability protection

Insurance protection

Comprehensive insurance coverage helps mitigate partnership risks:

• Professional liability (E&O) insurance for service businesses
• General liability coverage for third-party claims
• Employment practices liability insurance for HR claims
• Key person insurance funding buy-sell agreements
• Business overhead insurance for partner disability scenarios

Final Thoughts: Making Partnerships Work Despite the Disadvantages

After two decades helping businesses navigate partnership challenges, I’ve found that successful partnerships share common elements: thorough planning, explicit agreements, regular communication, and aligned values.

The disadvantages of partnerships are significant but manageable with proper structure and documentation. The key is addressing potential problems before they emerge rather than trying to resolve them during conflict.

For partners considering formalization, invest in professional guidance from attorneys and accountants with partnership expertise. For existing partnerships facing challenges, consider partnership counseling or mediation before issues threaten business viability.

Remember that your choice of business structure affects everything from daily operations to long-term wealth creation. Take time to evaluate whether a partnership truly serves your goals or if alternative structures might better protect your interests while providing similar benefits.

Need expert guidance on partnership structures, agreements, or tax planning? Contact our team at Complete Controller for specialized assistance navigating the complex intersection of business structure, taxation, and financial management.

FAQ

What’s the biggest financial risk in forming a business partnership?

Unlimited personal liability is the greatest financial risk. In general partnerships, your personal assets can be seized to satisfy business debts created by any partner, even without your knowledge or approval. Unlike corporations or LLCs, there’s no legal separation between business and personal finances.

How can I protect myself in a partnership without changing to a corporation?

While maintaining partnership status, you can: 1) Form a Limited Liability Partnership (LLP) where available, 2) Create a detailed partnership agreement with liability allocation provisions, 3) Obtain comprehensive business insurance coverage, 4) Implement strong internal controls requiring multiple approvals for major financial decisions, and 5) Consider a Limited Partnership structure where some partners have liability protection.

What should a good partnership agreement include to prevent conflicts?

A comprehensive partnership agreement should address: profit distribution formulas, capital contribution requirements, decision-making authority for different business aspects, dispute resolution procedures, buy-sell provisions with valuation methods, non-compete and confidentiality clauses, partner roles and responsibilities, admission of new partners, and circumstances permitting involuntary removal of partners.

How are partnerships taxed compared to corporations?

Partnerships are “pass-through” entities where profits flow directly to partners’ personal tax returns, regardless of whether cash is distributed. Partners pay self-employment tax (15.3%) on their share of income, unlike corporate shareholders who pay only income tax on dividends. Partners also face “phantom income” scenarios—paying taxes on profits retained in the business—and must report their share of business income even when cash isn’t distributed.

What’s the best way to handle a partnership dissolution?

The best approach is following pre-established buy-sell agreement terms that specify valuation methods, payment schedules, and transition procedures. Without such agreements, partners should: 1) Agree on a neutral business appraiser, 2) Consider a structured buyout with payments over time, 3) Use mediation before litigation, 4) Implement client transition plans to preserve business value, and 5) Consult with tax advisors to minimize dissolution tax impacts.

Sources

• American Express. (2023). “The Advantages and Disadvantages of a Business Partnership.” www.americanexpress.com/business
• FindLaw. (2024). “What Are the Disadvantages of Partnerships?” www.findlaw.com
• Hendershot Cowart P.C. (2021). “Case Study: Partnership Dispute Ends in Buyout.” www.hchlawyers.com/blog/2021/july/buy-sell-agreement-case-study-partnership-disputes/
• Internal Revenue Service. (2024). “Partnerships.” www.irs.gov/businesses/small-businesses-self-employed/partnerships
• Labaton Sucharow. (2003). “In re Real Estate Associates Limited Partnership Litigation.” www.labaton.com/cases/in-re-real-estate-associates-limited-partnership-litigation/
• Latham & Watkins. (2024). “IRS Launches New Large Partnership Audits.” www.lw.com/admin/upload/SiteAttachments/IRS-Launches-New-Large-Partnership-Audits
• Miller Hawkins, PLLC. (2023). “Why most business partnerships fail.” www.idahojustice.com/blog/2023/04/why-most-business-partnerships-fail/
• Sensiba. (2024). “When Are LLC Members Subject to Self-Employment Tax.” www.sensiba.com/resources/insights/when-are-llc-members-subject-to-self-employment-tax/
• Small Business Administration. (2024). “Choose your business structure.” www.sba.gov/business-guide/launch-your-business/choose-your-business-structure
• SoLegal. (2023). “Business Partnerships: Understanding the Risks and Rewards.” www.solegal.com
• Stone Sallus. (2024). “The Pros and Cons of Business Partnerships.” www.stonesallus.com
• Wikipedia. (2025). “Partnership.” www.wikipedia.org/wiki/Partnership

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