Before you establish a business partnership, you should investigate the various types of partnerships that are available and how each of them works.
What Is a Business Partnership?
A business partnership is a legal relationship that is most often formed by a written agreement between two or more individuals or companies. The partners invest their money in the business, and each partner benefits from any profits and sustains part of any losses. The partnership as a business often must register with all states where it does business. Each state may have several different kinds of partnerships that you can form, so it’s important to know the possibilities before you register.
How Does a Partnership Work?
Some partnerships include individuals who work in the business, while other partnerships may include partners who have limited participation and also limited liability for the business’s debts and any lawsuits filed against it. A partnership, as opposed to a corporation, is not a separate entity from the individual owners. A partnership is similar to a sole proprietor or independent contractor business because with both of those types of businesses, the business isn’t separate from the owners for liability purposes. Income tax is not paid by the partnership itself. After profits or losses are divided among the partners, each partner pays income tax on their individual tax return.
Types of Partnerships
Before you start a partnership, you will need to decide what type of partnership you want. There are three different kinds that are commonly set up.
A general partnership (GP) consists of partners who participate in the day-to-day operations of the partnership and who have liability as owners for debts and lawsuits. A limited partnership (LP) has one or more general partners who manage the business and retain liability for its decisions and one or more limited partners who don’t participate in the operations of the business and who don’t have liability. A limited liability partnership (LLP) extends legal protection from liability to all partners, including general partners. An LLP is often formed by partners in the same professional category, such as accountants, architects, and lawyers. The partnership protects partners from liability from the actions of other partners.
Types of Partners in a Partnership
Partners may be individuals, groups of individuals, companies, and corporations. Depending on the type of partnership and the levels of partnership hierarchy, a partnership can have different types of partners.
General partners and limited partners: General partners participate in managing the partnership and often have liability for partnership debts and obligations. Limited partners invest but do not participate in management.Different levels of partners: For example, there may be junior and senior partners. These partnership types may have different duties, responsibilities, and levels of input and investment requirements.
Partnership vs. LLC
A limited liability company (LLC) with two or more members (owners) is treated as a partnership for income tax purposes. The main difference between an LLC and a partnership is that in an LLC, members are generally shielded from personal liability for the company. In many partnerships, only limited partners are protected from personal liability for the company.
Forming a Partnership
Partnerships are usually registered with the state or states in which they do business, but the requirement to register and the types of partnerships available vary from state to state. Partnerships use a partnership agreement to clarify the relationship between the partners; what contributions, including cash, they will make to the partnership; the roles and responsibilities of the partners; and each partner’s distributive share in profits and losses. This agreement is often just between the partners; it’s not generally registered with a state. Check with your state’s secretary of state to determine the requirements for registering your partnership in your state. Some states allow different types of partnerships and partners within those partnerships.
Creating a Partnership Agreement
A strong partnership agreement addresses how decision-making power will be allocated and how disputes will be resolved. It should answer all the “what if” questions about what happens in a number of typical situations. For example, it should spell out what happens when a partner wants to leave the partnership. State law will apply if there is nothing in the partnership agreement that lays out how to handle the separation—or any other issue that arises.
Joining an Existing Partnership
An individual can join a partnership at the beginning or after the partnership has been operating. The incoming partner must invest in the partnership, bringing capital (usually money) into the business and creating a capital account. The amount of the investment and other factors, like the amount of liability the partner is willing to take on, determine the new partner’s investment and share of the profits (and losses) of the business each year.
How Partners Are Paid
Partners are owners, not employees, so they don’t generally get a regular paycheck. Each partner receives a distributive share of the profits and losses of the business each year. Payments are made based on the partnership agreement, and the partners are taxed individually on these payments. In addition, some partners may receive a guaranteed payment which isn’t tied to their partnership share. This payment is usually for services like management duties.
How Partners Pay Income Tax
The partnership’s income tax is passed through to the partners, and the partnership files an information return (Form 1065) with the IRS. Individual partners pay income taxes on their share of the profit or loss of the partnership. The partners receive a Schedule K-1 showing their tax liability from the business for the year. The Schedule K-1 is included with the partner’s other income on their personal tax return (Form 1040 or Form 1040-SR).
