Partnerships Part 2: Utilizing the Right Entity Structure to Safeguard Your Partnership and Assets
In my previous article about partnerships, we outlined what can happen if the proper documentation and structure are not put into place. The notion of running a General Partnership is likely one that seems too risky for most of us… and rightfully so.
Over the years, it has been my experience that businesses that start out as, or morph into, a Partnership will turn into chaos somewhere down the line. I’ve seen families sue each other for some of the most fixable situations and never speak again… because of the lack of structure (and communication).
With that being said, it may sound like I steer all of my clients away from operating or investing into partnerships. This couldn’t be further away from the truth. As a matter of fact, Partnerships can provide a fantastic benefit from both a compliance and taxation perspective… IF utilized correctly.
Today, we will look at the simplest way to avoid some of the pitfalls that entrepreneurs utilizing Partnerships encounter.
What is the Basis of Partnerships?
First, we need to understand how to determine how much of the partnership belongs to each partner. This is done by allocating each owner (partner) with an ownership percentage of the business. In accounting terms, this is referred to as “basis”.
The term “basis” refers to your financial investment in a partnership. It represents your share of the partnership’s liabilities and assets, which dictates your tax obligations and benefits. Understanding your basis is essential because it affects how much income you can withdraw tax-free, how much of a loss you can claim, and the tax treatment when you sell or transfer your partnership interest.
For example, let’s say you and a partner invest $50,000 each into a partnership, and the business takes out a $100,000 loan. Your basis includes both your initial cash investment and your share of the partnership’s liabilities. This calculation is critical when determining how much profit or loss you report on your tax return.
The concept of basis is a fundamental yet complex topic that cannot be fully covered in just a few sentences. It serves as the cornerstone of understanding your financial relationship with a partnership and plays a crucial role in determining your tax obligations, profit distributions, and potential liabilities. While this article provides an overview, I will explore the intricacies of basis in greater detail in a future discussion to ensure a deeper understanding.
For now, the key takeaway is that your basis represents your ownership stake in the partnership, encompassing both your initial investment and your share of the partnership’s liabilities. It essentially reflects your financial interest in the business and outlines the extent of your expectations and potential risks. Whether you’re withdrawing income, claiming losses, or considering the tax implications of selling your interest, your basis serves as the foundation for these decisions. Understanding it is essential for making informed financial and strategic choices within the partnership framework.
General vs. Limited Partners: What’s the Difference?
I know we have already discussed this in a previous article, but it is an important principle, so it’s worth repeating. A partnership typically involves two types of participants: general partners and limited partners. Each plays a distinct role with unique rights, responsibilities, and risks.
General Partners: These individuals manage the daily operations of the business. They have full control over decision-making but are personally liable for the partnership’s debts. If the business faces legal action or financial trouble, a general partner’s personal assets are at risk.
Limited Partners: Limited partners are primarily investors. They contribute capital but have no involvement in daily operations. Their liability is capped at the amount of their investment, shielding their personal assets from business debts or lawsuits. Let’s say an investor puts $250,000 into a partnership for a 25% ownership stake – this is the only amount any creditor can claim from the Limited Partner in case of a verdict against the business.
Understanding the difference between these roles is pivotal when choosing a partnership structure, as it directly impacts liability and control.
Common Types of Partnerships and Their Uses
Partnerships come in various forms, each tailored to specific business needs. Here’s a closer look at the most common types and their applications.
General Partnership (GP): A general partnership is the simplest form, requiring no formal registration. In a GP, all partners share management responsibilities and bear equal personal liability for debts. This type is often used for small businesses or short-term projects due to its ease of setup and operational flexibility.
For example, two friends opening a small bakery might choose a general partnership. However, while this structure is straightforward, it lacks liability protection, which can be a significant drawback as the business grows.
Limited Partnership (LP): A limited partnership consists of at least one general partner and one limited partner. The general partner oversees operations and assumes full liability, while the limited partner contributes funds and enjoys liability protection up to their investment.
This structure is common in industries like real estate or film production, where investors want to fund projects without being involved in daily management. For instance, a property developer (general partner) could secure funding from several limited partners to purchase and develop land.
Limited Liability Partnership (LLP): An LLP provides liability protection for all partners, shielding personal assets from business debts or malpractice claims. Each partner can also participate in management, making it a popular choice for professional firms like law practices, accounting firms, and medical groups.
Imagine a group of attorneys or doctors forming an LLP. If one partner faces a malpractice suit, the other partners’ personal assets remain safe, and the firm’s assets cover any liability.
Limited Liability Limited Partnership (LLLP): An LLLP combines features of an LP and an LLP. While it includes general and limited partners, even the general partner has liability protection, making it an attractive option for businesses seeking added security.
For example, a family business managing multiple real estate investments might choose an LLLP to protect the managing partner’s personal assets while maintaining flexibility in operations.
Choosing the Right Structure for Your Partnership
Selecting the ideal partnership structure depends on your business goals, risk tolerance, and tax strategy. Here are some factors to consider:
Liability Protection: If safeguarding personal assets is a priority, consider an LLP or LLLP. These structures minimize personal risk, particularly in industries prone to lawsuits.
Tax Treatment: Partnerships are pass-through entities, meaning profits and losses flow through to the partners’ personal tax returns. However, the way liabilities and income are allocated can differ. For instance, an LP allows limited partners to enjoy passive income without self-employment tax, which may be a tax advantage.
Management Needs: If you prefer centralized decision-making, an LP with a single general partner may work best. However, if all partners want equal say, an LLP could be more appropriate.
Investor Attraction: Limited partnerships are appealing to investors because they offer liability protection without requiring operational involvement. This structure can help attract funding for capital-intensive ventures.
A Case Study: The Johnson Family Business
To illustrate, let’s look at the Johnson family, who wanted to pool resources to start a real estate development company. They chose an LLLP structure. Mark, the oldest sibling, acted as the general partner overseeing operations, while the other siblings contributed funds as limited partners.
The LLLP provided asset protection for everyone involved, including Mark, the general partner. As the business grew, the family appreciated the clear separation between personal and business assets, as well as the tax efficiency of their chosen structure.
Why It Pays to Consult a Tax Strategist
It goes without saying… but when choosing the right entity structure is about more than minimizing taxes; it’s about aligning your business’s financial and operational goals with a structure that offers the best protection and benefits. To ensure that the enterprise is structured correctly, you should always consult your legal counsel to ensure that your inside and outside liabilities are covered from all angles. Please note that additional complexities, such as operating in different states and jurisdictions, will likely require the involvement of several different attorneys to account for different state legislation.
A tax strategist on the other hand, can analyze your specific situation and recommend the most advantageous entity, ensuring compliance with the latest tax laws and maximizing your financial outcome.
For example, restructuring from a general partnership to an LLP might reduce your personal liability without significantly altering your tax obligations. These subtle adjustments can save you thousands of dollars while safeguarding your assets.
Bringing It All Together
Partnerships are a powerful tool for pooling resources and expertise, but they come with critical decisions about structure, liability, and taxation. From the simplicity of a general partnership to the sophisticated asset protection of an LLLP, the right choice depends on your unique goals and risk tolerance.
The journey to selecting the ideal entity structure doesn’t have to be overwhelming. By understanding the nuances of each type of partnership and working with an experienced tax strategist, you can confidently protect your assets and set your business up for long-term success.
Welcome to the New Age of Accounting. Let’s begin.
