What Is a Partnership


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

The Partnership Agreement

Although a written partnership agreement is not ordinarily required by law, it is always a good idea for partners to formalize their business relationship in writing. Among other aspects of the business relationship, even the most basic partnership agreement should specify,

  • The business name,

  • The official business address,

  • The identities of the partners, and

  • How profits are to be divided between the partners.

In addition,

  • Contributions - The agreement should also reflect each partner's contribution to the partnership, the value of that contribution, and the resulting ownership interest.

  • Duties and Authority - If partners will not have equal management duties and decision-making authority, the partnership agreement should describe the duties and authority granted to each partner. If partners share decision-making responsibility, it makes sense to describe how decisions will be made in the event of a disagreement.

  • Adding Partners - The partnership agreement may also specify what happens if you wish to bring in a new partner.

  • Dispute Resolution - 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.

  • Removing Partners - The agreement should provide for what will happen if a partner decides to leave the partnership or wants to be bought out by the other partners, 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. Although creating a fair formula may be complicated, and it may be necessary to revisit the formula as the partnership matures, having an agreed formula for valuation can save a partnership a considerable amount of money in accounting and legal fees in the event of a dispute over the partnership's value.

Liability Issues

Partners face liability issues that are reduced or eliminated for most other business entities. A partner is normally 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.

Professionals who are considering forming a partnership should also consider forming a business entity that may offer them greater protection from the negligence of other members of the firm, such as a limited liability company or a professional corporation. Members of an LLC pay pass-through taxes on the profits, but the LLC 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. Traditional corporations offer the greatest level of protection from liability, but they carry additional costs and complexity.

The Limited Partnership

Most partnerships take the form of general partnerships, in which all partners have some management authority. Even if not actively involved in management, a general partner may be held personally liable for the debts and obligations of the partnership.

Partners who know that they will not be involved in the management of the partnership may instead choose to form a limited partnership. A limited partnership is comprised of 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. The limited partnership structure is often used for real estate transactions, for which 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 the partnership's 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 want 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 between 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

A corporation offers a number of potential advantages over a partnership:

  • Limited Liability - Shareholders of a corporation are normally shielded from personal liability for the debts and obligations of the corporation, while general partners are personally liable for the partnership's debts. A corporation, or another limited liability entity, will provide partners with significant protection from the debts of the business and from the wrongful acts of other partners and employees, while a partnership does not.

  • Tax Benefits - As a corporation can earn its own income and pay its own income taxes, a corporation may enjoy tax savings that are not available to a partnership. Shareholders of a corporation who are not also employees of the corporation pay taxes only on the funds distributed to them by the business, usually in the form of dividends. 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 a partnership.

  • Your accountant can help you determine the financial benefits that might be derived from incorporation, whether as a traditional business corporation, LLC or professional corporation.

Copyright © 2004 Aaron Larson, All rights reserved. No portion of this article may be reproduced without the express written permission of the copyright holder. If you use a quotation, excerpt or paraphrase of this article, except as otherwise authorized in writing by the author of the article you must cite this article as a source for your work and include a link back to the original article from any online materials that incorporate or are derived from the content of this article.

This article was last reviewed or amended on Jul 9, 2016.