What is a Partnership in Business?
A partnership from a business prospective refers to a legal business structure where 2 or more people engage in an unincorporated business. Partnerships are an arrangement by two or more individuals and agree to share the profits and liabilities of the business. The most basic form of a business partnership, a general partnership, is an informal business structure similar to a Sole Proprietorship, as opposed to formal business structures like LLCs and Corporations. Informal business structures, including general partnerships, are not recognized as a separate entity from the business’s owner, whereas formal business structures like LLCs and Corporations are recognized as being separate entities from their owners.Table of Contents:
Partnerships have a variety of different types that can vary depending upon what is allowed by state statute. Generally speaking, there are 3 primary types of Partnerships in the US:
The most common type of Partnership is a General Partnership. General partnerships (GP) are a type of partnership where all members share the financial and legal liability equally. All members take on an equal responsibility for the debts of the business and share equally in any profits. In most cases when the partnership is formed legally these responsibilities and how profits will be split should be specifically stated. Additionally, when writing the partnership agreement, information should be included about what would happen if a partner was to leave or be removed from the partnership.
Limited liability partnerships (LLP) are a slightly more complex form of partnerships. With this form of partnership, the assets of the individual members of the partnership are separate from other members. This is often done to protect members from lawsuits so that if one member is sued the other members assets are not at risk. This form of partnership is seen most commonly for professional businesses (accountants, lawyers, architects and doctors for example). With some of these partnerships some partners may not be owners but instead be salaried partners who get bonuses based on the business’ profits but have no ownership stake in the business.
Limited partnerships (LP) are a combination of a general partnership and a limited liability partnership. With this partnership structure at least one partner is considered a general partner and has personal responsibility for the partnership’s debts. Other partners are silent partners who invest in the business and receive a share of the profits. These silent partners generally are not involved in the day to day operation of the business and do not participate in the management of the partnership.
Partnerships have a variety of advantages, of which there are three core that help distinguish it from other business structures:
- Simple and Inexpensive to Start
- Ability to Expand Ownership
- Pass-Through Taxation
Simple and Inexpensive to Start
Partnerships primary advantage is that they are easy and low cost to start up. Most states have either no formal process to start a partnership or only require a name registration. As a result the easiest and least expensive way to start a business with 2 or more owners is a Partnership. You’ll still be required to complete the other required filings such as a DBA/Trade Name as well as drafting a partnership agreement.
Ability to Expand Ownership
When starting a business as a Partnership, one of the biggest advantages you’ll have is the ability to expand your ownership group. This ability is important as it can allow you to bring in investors after the business has started. While this is not as preferable as the investments opportunities available to Corporations, it does provide the ability to add smaller scale investors. In addition to allowing investors to join, this ability can also be used as a incentive for employees to become a partner. Law firms are an example of using the expansion of ownership as an incentive for employees who can become a partner.
The way partnerships are taxed by default is known as pass-through taxation. Partnerships are not subject to corporate income tax, thus they avoid double taxation. Taxes are not paid directly by a Partnership. Instead the profits (or lossses) are passed directly to the owners as outlined in their partnership agreement and the owners are then responsible for paying their share of the income they received from the partnership on their personal tax return.
While partnerships do offer a variety of advantages there are 3 core disadvantages that we believe you should consider about a Partnership:
- Unlimited Liability for General Partners
- No Taxation Flexibility
- Lack of Stability
Unlimited Liability for General Partners
If you operate as a general partnership (which is the default and most common type of partnership) you will have full personal liability for any debts, obligations and actions of the business. For general partners, this is a significant risk as you can be held personally liable for any debts or if the business gets sued, just as a Sole Proprietor would. In addition to this, general partners can even be held liable for other general partners as well.
This means that your partners and your own personal assets such as a your home, car and personal bank account could be subject to risk if your business is unable to pay business debts or is sued. While there are some types of partnership where some partners will not have personal liability, such as a limited partnership, this can limit the role and actions that the limited partner can engage in. You could also operate as a limited liability partnership (LLP) to have a higher level of liability protection but in many states LLPs have less protection as a result of what is known as a “limited shield”. When comparing an LLC to a partnership this is the biggest difference between the two. Because of the significant liability risk of a general partnership, many small business owners choose to operate as an LLC to ensure they have more personal liability protection.
No Taxation Flexibility
Partnerships lack any flexibility when it comes to their taxation. Unlike an LLC where a business can elect different taxation statuses by the IRS, such as S Corporation taxation, a partnership can only operate as a default, pass-through tax entity. As a result, partnerships owners are subject to the maximum amount of self-employment tax. In addition to this partners must pay taxes on their portion of the business’ income, even if they did not receive any distributed income.
Lack of Stability
Another significant disadvantage of a partnership is that they have much less stability. If there is a not a formal process defined in the partnership agreement, a business operating as a partnership that has an owner leave or die could be subject to automatic dissolution. If a partner leaves, the majority of the remaining partners must agree to continue the business and the remaining partners are required to buy out the departing partner. This can cause serious issues if the remaining partners lack the funds to buyout the departing partner.
How is a partnership formed?
Partnerships are formed when two or more individuals or entities agree to do business together. This can be done without a formal agreement, but this is not recommended as it can lead to disagreements at a later date. A partnership agreement, which is a written document that informs all partners how the business will operate, is generally suggested to be used.
In addition to creating a partnership agreement a partnership will need to complete a DBA/Trade Name filing to register their business name.
How are partnerships taxed?
Partnerships are taxed as pass-through entities. Partnerships are not subject to Federal income taxes and instead the partners are taxed based on their shares of any income received on their personal income taxes.
Partnerships vs. LLC
Partnerships and LLCs are different legal structures. Partnerships are an informal business structure that requires little to no registration process. LLCs are a formal structure that is formed by filing Articles of Organization (or equivalent) in their state of formation. LLCs provide limited liability protection for its owners, while general partnerships leave owners with unlimited personal liability.