What is a partnership?
Is there strength in numbers? A business partnership represents a company owned and operated by two or more partners. Together, these partners share in the company's profits and losses. But not all partnerships are created equal. This guide will explain how various types of partnerships function and how to form a business partnership of your own.
How does a partnership work?
A business partnership consists of two or more persons who agree to share the risks, profits, and losses of operating a business. This type of arrangement is common in such industries as:
- Real estate
However, any business can form a partnership provided its members go through the right steps.
Like a sole proprietorship, business partnerships are not considered separate legal entities. This setup means that the profits from the business are passed on to each member, who will have to account for this revenue when they file their personal income taxes.
Partnership vs. limited liability company
A limited liability company (LLC) combines aspects of a sole proprietorship with the liability protection of a corporation. That makes an LLC distinct from other business entities in that it grants greater protection from errors or omissions.
If two or more individuals run a limited liability company, it is automatically treated as a partnership for income tax purposes. But in an LLC, all members are shielded from personal liability. In a partnership, only limited partners are afforded this protection.
Types of business partnerships
There are four main types of partnerships, each with its own unique strengths and weaknesses:
The most basic type of partnership is simply a general partnership. Generally, you can form partnerships simply by signing a partnership agreement in most cases.
In this arrangement, general partners share in the profits, though they also share equally in the company's debts and liabilities. That means each general partner has unlimited liability regarding the actions of the other partners. For example, if a general partner takes out a business loan, the other general partners will be legally obligated to pay it back.
A general partnership is the easiest to form and will automatically dissolve if one of the general partners dies or files for bankruptcy.
In a limited partnership, at least one partner (known as the general partner) is entirely responsible for the operation of the business. The other (limited) partners invest in the business for financial gains but have no say in the company's day-to-day operations.
Limited partnerships allow a limited partner to share in the profits, but they can never lose more than they've invested initially. However, these passive investors will not have the decision-making power granted to general partners.
Some states allow limited partnerships to appoint an LLC as the general partner. This setup means that no one has to bear full personal liability for the business.
Limited liability partnership
A limited liability partnership (LLP) operates like a general partnership but provides liability protection for each other's actions. This approach means that individual partners still bear responsibility for the partnership's debts and legal liabilities but are shielded from the business decisions of their other partners.
Some legal and accounting firms make a further distinction between equity partners and salaried partners. Salaried partners do not have an ownership stake in the company but may receive bonuses based on financial performance.
Depending on your state laws, limited liability partnerships may be reserved for certain professions, including lawyers and physicians.
Limited liability limited partnership
Certain states allow partners to form a limited liability limited partnership (LLLC). Like a limited partnership, an LLLC relies on a general partner to actively manage the business, while limited partners still invest. But the LLLC limits the general partner's liability so that all members have protection.
However, this is a relatively new business structure and is not recognized across all states. This setup may not be the best structure to choose if you do business in multiple states.
Advantages of partnerships
There are many reasons why you might consider forming a partnership business:
Partners can provide their business with more working capital by pooling their resources. This financing is particularly important during the startup phase and can ease the burden on each individual partner.
Small businesses thrive on connections and relationships. Multiple business partners provide a broader network of friends, family members, and business associates. This integration means that the partnership can benefit from this wider group of potential business connections.
Sole proprietors are limited to their own skills and experience. But when you work alongside other business professionals, you benefit from their broader skillsets and diverse backgrounds.
Partnerships don't just pool their resources — they also provide a fresh set of eyes. Your partners can help you see your business from a new angle, which can help tackle problems and offer new strategies.
Simplified tax payment
Partnerships are not regarded as separate legal entities by the Internal Revenue Service (IRS). This integration means that the partnership income is passed on to each member, who will report their portion of the revenue on their personal income tax return.
Disadvantages of partnerships
Before you jump into a partnership, there are some drawbacks to consider:
In a partnership, each participant is personally responsible for the business debts and decisions of the other partners. Unless you are a limited partner, you will be fully liable for the decisions of your business partners. Because you are personally responable, your personal assets may be in jeopardy if your partners make a poor decision.
If you're used to making all of the decisions about your business, you may feel frustrated when you share these decisions between two or more people. To move the business forward, you'll need to learn the art of compromise, which can be difficult when it's an area you're passionate about.
Difficult to sell
This particular business type can be harder to sell than others because no member of the partnership can sell the company unless all partners agree. Additionally, potential buyers may feel pressured to replicate this leadership arrangement if the business has been thriving as a partnership business.
How to legally form a partnership
While some states have adopted the Uniform Partnership Act, the creation and dissolution of partnerships are governed by state law. Forming a partnership business will generally require the following steps:
Select a business structure
First, make sure that this type of business organization is right for you. Remember, general partners will face unlimited liability for the business, putting your personal assets in jeopardy. But don't forget that there are multiple types of partnerships, and you may consider adopting a limited partnership or LLP to provide liability protection.
This decision will impact everything ranging from your tax liability to your day-to-day choices, so choose carefully. If you're unclear about how a partnership aligns with your business goals, you might consider speaking with an attorney or CPA.
Create a partnership agreement
A partnership agreement is a formal document that legally defines your business arrangement. For a partnership agreement to be legally binding, each partner will have to personally sign it and keep a copy on file.
Your partnership agreement should include the following information:
- The name and contact information for each partner
- The division of ownership between partners
- Information about who will actively manage the business
- Designation of any limited liability partnerships
- Guidance for the distribution of profits and losses
Again, all partners will need to agree on the terms of the partnership agreement before signing. Establishing the terms of the agreement beforehand can prevent problems down the line when making key decisions and resolving disputes.
Choose a name
To form your partnership, you'll need to choose a name that's available, permissible, and reflects your business type.
Each state can be very particular when it comes to choosing a name. For example, Massachusetts forbids businesses from using the name of a limited partner in the official business name. Other states may require you to include "limited partnership" in the title.
Like any business, you'll want to make sure that the name is available. Most state secretaries' websites offer an online search feature that can help you ensure that your name isn't already in use.
Register your partnership
Limited partnerships, limited liability partnerships, and limited liability limited partnerships must register their businesses with the state.
To do this, you'll need to do the following:
- Choose a home state in which you'll operate
- Check any licensing requirements
- Apply for registration
- Appoint a registered agent to accept business documents and legal notices
- Submit the application
Once the application process is complete, you'll want to store these documents in your business archives. Each partner should keep their own copy for their own records as well.
Submit annual reports
Except for general partnerships, you may need to submit regular reports to the secretary of state. Depending on your state, these reports may be due annually or biennially, and there may be a fee depending on your specific business entity.
These reports are designed to maintain basic information about your business and ensure that your records are up-to-date. Your individual state may have additional requirements for these reports, so check with your secretary of state to understand their expectations.
Manage your business relationships
No matter what business structure you choose, it helps to have the right tools on your side to manage your relationships with your valued clients.
Business owners have come to rely on Invoice2go, specialized software that allows you to send customized invoices and receive payments through an easy-to-use digital platform. Additionally, business owners access their financial data through the advanced reporting features built into the service.
Try it for free by signing up for a 30-day trial. You'll see how these tools can improve the world of business for you and your partners.
Frequently asked questions
Do you have additional questions about how a partnership works? Here are some commonly asked questions about partnerships:
The Internal Revenue Service (IRS) does not regard a partnership as a taxable entity. Instead, each business partner will report their portion of the business revenue on their personal tax return.
Your partnership agreement will specify how this revenue is distributed to each member. While some partnerships will divide profits equally, others will allocate higher percentages to some individuals.
This setup also means that general partners will have to pay self-employment taxes (covering Social Security and Medicare taxes) since each member is self-employed.
Married couples who start businesses together are automatically classified as a partnership by the IRS. However, couples can register as a Qualified Joint Venture so long as each spouse materially participates in the business.
A qualified joint venture allows each spouse to function as a sole proprietor, making filing your annual income taxes easier. An LLC can also be classified as a joint venture in some cases, though these requirements can vary by state.
What happens to a partnership if one of its members leaves or a partner dies? If the partnership has at least two remaining members, it will continue indefinitely, provided they maintain their other business requirements.
However, if only one partner remains, several options exist. If the exiting partner died, then their estate may take on responsibility until a replacement may be found. The partner's responsibilities may pass to their next of kin, though you may also find someone to take over their share of the business.
Unfortunately, if no replacement can be found, the partnership will dissolve. This possibility may highlight the importance of having a business succession plan in place so that the business continues to thrive in the event of an untimely death.