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The Partnership

By Aaron Larson

Law Offices of Aaron Larson

August, 2004

Contents

• The Partnership Agreement
• Liability Issues
• The Limited Partnership
• Allocation of Profits
• Taxation
• Should You Incorporate?

The partnership is a business entity ordinarily comprised of two or more individuals, although under some circumstances a partnership will be formed between other business entities, or between individuals and a business entity. The partnership is relatively inexpensive and simple to create and maintain, but poses tax and liability issues which are similar to those of a sole proprietorship.

The Partnership Agreement

While a written partnership agreement is not ordinarily required, it is always a good idea for partners to formalize their business relationship in writing. The partnership agreement should specify, among other things, the business name, the official business address, the identities of the partners, and how profits are to be divided between the partners. The agreement should also reflect each partner's contribution to the partnership, the value of that contribution, and the resulting ownership interest. If you do not intend the partners to have equal management duties and decision-making authority, the partnership agreement should indicate the duties and authority granted to each partner.

The partnership agreement may also specify what happens if you wish to bring in a new partner, if a partner decides to leave or wishes to be bought out, and what happens if the other partners wish to eject or buy out a partner, including a formula for valuing the partner's share. Many partnerships encounter significant difficulties when a partner dies or wishes to quit, and there is no agreed-upon formula for determining the amount the other partners must pay to buy out that partner's interest.

You may also wish to specify a method of resolution of disputes between partners, such as mediation or arbitration, so as to keep partnership disputes out of court.

Liability Issues

There are significant liability issues raised by the partnership. Ordinarily, a partner is individually liable not only for business debts and liabilities, but also for most business-related conduct of the other partners. For example, in a law firm partnership where one partner commits an act of legal malpractice, all of the other partners will ordinarily be personally liable for any resultant damages award, and their personal assets will be subject to seizure to cover that award. That is, for purposes of liability, the acts of one partner are attributed to all of the other partners.

Similarly, if one partner binds the partnership into a business arrangement or contract, all other partners are bound by that action. Thus, if a partner goes out and leases equipment or takes out a loan in the name of the partnership, even if the other partners don't feel that they were properly consulted or that it was a wise business move, the partnership will ordinarily remain liable for the payments, and if the partnership fails to make payments the other partners may be personally liable. (You can ordinarily avoid this type of liability by incorporating as a limited liability company.)

The Limited Partnership

Most partnerships take the form of "general partnerships", where all partners have some management authority. Another option is to create a "limited partnership", where there are "general partners" who direct the business of the partnership, and "limited partners" who have no management role. The general partner may be another business entity, such as a corporation or LLC. This structure is often used for real estate transactions, where investors sign on as limited partners, and the general partner manages the property.

Limited partners have little or no role in the management of the business, and in return for surrendering that authority their responsibility for business debts and liabilities is limited to the amount of their investment.

Due to the complicated laws and regulations governing limited partnerships, it is a good idea to work with a lawyer if you choose to utilize this business form.

Allocation of Profits

Ordinarily, partnership profits are distributed according to percentage of ownership. That is, if one partner owns sixty percent of the partnership, that partner would receive sixty percent of the profits. The allocation of profits can be modified pursuant to the terms of the partnership agreement. However, if profits are not allocated according to percentage of ownership, you should check to make sure that your method of allocation is consistent with state and federal tax law.

Taxation

As a general rule, partnership income is not treated as distinct from personal income, and it is thus taxable to the business partners in the year it is earned. After profits or losses are allocated according to the partnership agreement, the partnership files a form with the IRS which reflects the income it earned and how that income was allocated amongst the partners. The partners are responsible to individually report that income or loss on their personal tax returns. Even if partners must leave their profits in the business, or voluntarily do so to fund the business in the coming year, they must nonetheless pay taxes on that income. The partnership may deduct from its profits its legitimate business expenses in advance of its distribution of those profits to the partners. A partnership will ordinarily be required to file an annual informational tax return with the IRS.

The income partners earn remains subject to income and "self employment tax" (Medicare and Social Security contributions), and partners are responsible to pay those taxes at the end of the year. In most cases, partners will be required to make quarterly payments of their estimated tax liability, to both the state and to the federal government.

Should You Incorporate

As a corporation can earn its own income and pay its own income taxes, there may be an advantage to a partnership to incorporate, rather than having the partnership income continue to pass through to the partners. Owners of a corporation pay taxes only on the funds distributed to them by the business, usually in the form of dividends. (If the owner is also employed by the corporation, the owner would have the same income tax responsibilities as any other corporate employee.) Given the difference between the corporate and individual tax rate, it may benefit the partners to incorporate and have the corporation retain its own income for future expenditures, rather than paying their individual tax rate on funds retained by the partnership. An accountant can help you determine the financial benefits that might be derived from incorporation.

Some partnerships will wish to consider the limited liability company (LLC) as an alternative to a corporate structure. The LLC continues pass-through taxation of profits, but provides its members with protections against being held responsible for the debts and liabilities of the business, or for the negligent acts of other members.

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