Part 1: The Basics of Partnerships
So, you’re considering opening up a business with someone – or – bringing in someone to help you in your operating business. There are a few things to consider before you move forward. All the entities we have discussed until now are presumed to have only had one owner. In accountant and legal jargon, this is called a single-member entity.
The instant another person (or entity) is added to the ownership structure – it is now considered a multi-member entity. You may have heard people refer to this as a Partnership… this is what we will explore today.
What Is a Partnership?
At its core, a partnership is a business relationship between two or more individuals or entities who come together to run a venture. Unlike sole proprietorships or corporations, partnerships distribute responsibilities, profits, and liabilities among the partners based on the agreed terms.
Imagine two friends, Sarah and Tom, who decide to start a bakery. Sarah handles the operations, while Tom manages the finances. They split profits 60/40 since Sarah does most of the work. This collaborative setup is a classic example of a partnership. But partnerships aren’t limited to individuals; businesses can partner, too.
Can All Entities Be a Partnership?
While partnerships may seem universal, not every entity qualifies. Partnerships are typically formed by individuals, LLCs, corporations, or other entities that wish to join forces. However, certain entities, such as nonprofit organizations, have restrictions on forming partnerships unless their objectives align with nonprofit goals.
In a previous post, I discuss the in’s and out’s of the LLC entity. You can find it HERE.
It’s also essential to understand that the “default” classification for multi-member LLCs under the IRS is a partnership. This means if you start an LLC with another member and don’t elect to be taxed as a corporation, the IRS will treat your entity as a partnership.
As you can see, it is important to understand and make one clear distinction here. How the entity is viewed and treated from a Legal and IRS perspective is entirely different. Hence, all entrepreneurs need to evaluate which entity offers the best and optimal solution for their specific situation based on a multitude of factors (location, industry, inside and outside liability, and taxation.
In It’s Simplest Form: General Partnership
From a legal perspective, a general partnership is formed when two or more individuals agree to carry on a business for profit as co-owners. Unlike corporations or LLCs, a general partnership does not require formal state registration to exist. As a matter of fact, a simple oral agreement (referred to as doing business on a handshake) is technically enough to form and operate a General Partnership (very similar to operating alone in a Sole Proprietorship).
Based on my years of experience in this field, General Partnerships without the proper documentation can turn into complete nightmares if things start to go sideways. The simplicity may be acceptable in the beginning, but as the business grows… it’s advisable to create a written partnership agreement to define the terms of the arrangement.
A word of caution here: ALL partners in a general partnership share personal liability for the debts and obligations of the business. Therefore, their personal assets can be used to satisfy business debts if necessary – even if the other partner was at fault (or made the decision without the other partner’s knowledge).
YES, you did read that correctly. If your partner decides to buy a Ferrari for the business and, on the way home, crashes into a building without proper insurance. Even though you had nothing to do with the accident, didn’t agree to buy the car, and were completely unaware of this happening – creditors could come after your assets since you are in a Partnership and therefore responsible for the liabilities of the business.
You may ask yourself… why on earth would anyone enter into a Partnership? Partnerships offer great benefits IF they are structured correctly. There is a lot to unpack here…
What Makes Up a Partnership?
Partnerships are highly flexible, but their structure revolves around three key components.
First, there are the partners, who are the individuals or entities contributing capital, skills, or resources to the business. Partners share the profits, losses, and liabilities according to their partnership agreement.
Second, the agreement itself is critical. Although it is not always legally required, a written partnership agreement outlines roles, responsibilities, profit-sharing arrangements, and dispute-resolution methods. Think of it as the rulebook for your business relationship.
Finally, partnerships offer significant flexibility in profit and loss sharing. Partners can customize allocations based on contributions or agreements rather than splitting profits equally.
What Documentation and Filings Are Needed?
Setting up a partnership is relatively straightforward but comes with specific requirements to stay compliant. In addition to the Partnership Agreement (remember, this may not always be mandatory in every state), all Partnerships must obtain an Employer Identification Number (EIN) from the IRS, even if they don’t hire employees.
Tax reporting for partnerships involves several steps. Partnerships must file Form 1065 annually, which details the business’s income, deductions, gains, and losses.
Each partner receives a Schedule K-1, outlining their share of the partnership’s income, deductions, and credits. Partners use this information to report their share on their individual tax returns.
Because partnerships are pass-through entities, partners may need to make quarterly estimated tax payments to cover their share of the partnership’s income. State-level tax obligations, such as income or franchise taxes, may also apply depending on your location.
Wrapping It All Up
Partnerships can be a powerful tool for entrepreneurs who value collaboration, flexibility, and tax efficiency. However, they require careful planning and a solid understanding of tax obligations. By drafting a robust partnership agreement, staying compliant with IRS filings, and collaborating effectively, you can unlock the full potential of this entity structure.
Please note that this is only the basics of Partnerships. We will continue to discuss the benefits of the Partnership structure and how to limit your inside and outside liability when operating a Partnership in the near future.
Welcome to the New Age of Accounting. Let’s begin.
