What is a Partnership?
A partnership is a business formation where a relationship exists between multiple persons who come together to carry on a business or trade. Each individual in the partnership will contribute property, money, labor or skill and in turn, share the profits and losses the business generates.
Partnerships are required to file annual information returns with the Internal Revenue Service to report the income, deductions, losses, gains, etc. from its business operations. This tax obligation, however, does not include income taxes—a partnership does not have to pay federal income tax. Instead, the formation passes its income through; all profits or losses—and their attached tax obligation—are transferred to the individual partners of the formation. Each partner, therefore, must include his or her share of the formation’s income or loss in their individual tax return.
By formal definition, a partnership is a business entity with multiple owners, who have not filed papers with the state to become a limited liability company or corporation. There are two basic types of partnerships: limited partnerships and general partnerships.
A partnership is the most basic and cheapest co-owned business structure to establish and maintain. However, there are fundamental facts that you should acknowledge before you form or enter a partnership.
Liability Issues Concerning Partnerships:
Personal Liability for Owners: Partners in the formation are personally liable for the entity’s debts and obligations, including all court judgments. This responsibility means that if the partnership itself cannot fulfill a payment obligation (i.e. rent, payment for supplies, loan repayments etc.) to their creditors, the individual partner(s) is personally liable to pay-off the debts.
There are, however, a few exceptions to this personal liability characteristic. For instance, some partners may have limited personal liability if the formation is constructed as a limited partnership. The limited partnership structure places personal liability on the general partner—the individual who wholly runs the business. In this setting, the limited partners are more or less, passive investors—they will lose no more than their original investment in the partnership. Moreover, some states offer special limited liability protection.
Entrepreneurs or investors concerned with personal liability issues will typically choose to incorporate their business or operate as a limited liability company.
Joint Authority Issues Concerning Partnerships:
Any individual partner in a partnership can typically bind the whole formation to another business deal or contract. For example, if a partner signs a contract with a supplier at a price the partnership cannot afford, another partners can be held personally responsible for the funds owed under the contract.
There are only a few limits regarding a partner’s ability to commit the partnership to a business deal. For example, one partner cannot bind the formation to a sale for the majority of the partnership’s assets. The ability for a partner to maneuver and engage in a business deal is affirmed in the formation’s partnership agreement. This document places limits on the partners within the formation. In most partnership formations without a partnership agreement, the individual partners have the ability to bind each other to a business deal.
Each individual partner can be held accountable—and subsequently sued—for the full amount of the formation’s debt obligations. If this occurs, an individual partner may be able to file a suit against the other partners for their shares of the debts. Because of this combination of personal liability with regards to debt—and the fact that each partners has the authority to bind the formation—it is critical that partners trust one another.
Tax Issues Associated with Partnerships:
A partnership formation is not a separate taxable entity from its owners; the Internal Revenue Service labels a Partnership as a “pass-through entity.” This categorization implies that the partnership itself is not susceptible to the income tax obligation for any profit earned. The business income of the partnership “passes through” the business to the individual partners, who in turn, are required to report their share of profits or losses on their individual income tax returns. Moreover, each partner is required to make a quarterly estimated tax payment to the Internal Revenue Service per year. Partners aligned with the formation are not employees.
Because of this classification, they are not to be issued a W-2 form. Although the partnership, as a formation, does not pay taxes, it is required to file IRS Form 1065 (an information tax form) each year. This information form arranges each partner’s share of the formation’s profits or losses. The Internal Revenue Service reviews this information to ensure that the partners are reporting their income accurately. In addition to Form 1065, the partnership must also file Schedule K-1 to the Internal Revenue Service and to each partner. In turn, each individual partner is required to report the profit and loss information on their individual tax return (Form 1040) with the Schedule E attached.
Because a partnership does not have a department to compute and withhold income taxes, each individual partner must set aside enough cash to pay taxes on their share of the formation’s annual profits. A partner must estimate their tax obligation they will owe for the year and provide payment to the IRS each quarter.
The Internal Revenue Service will require each partner to pay incomes taxes on their distributive share. The distributive share refers to the individual’s portion of profits to which the individual partner is entitled to under the partnership agreement or state law (only if the partnership does not form an agreement). The IRS will treat each partner as though they received their distributive share each year. This ruling means that the partner must pay taxes on their share of the formation’s profits (sales minus expenses) regardless of how much money they actually earn or take from the entity.
Individuals in a partnership—in addition to personal income taxes—are required to pay a “self-employment tax” for all of the profits allocated to the individual from the partnership. The self-employment tax will consist of contributions to Medicare and Social Security programs.
Partners maintain different tax obligations than regular employees of a corporation or other business formation. Because an employer does not withhold taxes from partners’ paychecks, the partner must pay them with their regular income taxes. Furthermore, a partner must pay twice as much as employees, because the employees’ contributions are matched by their employer. That being said, a partner can deduct of their self-employment contribution from their income, which in turn, lower their tax obligation.
What is the Partnership Agreement?
The partnership agreement is the foundation of the formation; it is the document that spells out the individual rights and responsibilities of the partnership. If the partners do not construct a partnership agreement, state laws will govern the distribution of profit, liability issues and other critical aspects of the formation.
The Partnership Agreement is regulated under the Uniform Partnership Act. This legislation states that each state (with the exception of Louisiana) possesses its own regulations governing partnerships. These statutes construct the basic legal regulations that apply to the formations and will control several aspects of the partnership’s life unless a partner or owner establishes different rules in their particular partnership agreement.
What is Included in the Partnership Agreement?
Below is a list of the primary section of a partnership agreement. Partners should consider the following issues when constructing the partnership agreement:
Name of the Partnership: One of the first thing listed on the agreement should be the name of the partnership. Partners can use their own names or can adopt and register a fictitious name. If the partners agree on a fictitious title, they must make sure that the name is not already in use or trademarked—the partners must file their fictitious name statement with their county clerk’s office.
Contributions: It is essential that the partners agree and record who is going to contribute cash, property and other assets to the partnership before it opens. It is also essential that the partners also agree on the ownership percentage awarded to each partner.
Allocate Profits and Losses: Partners must agree on how the profits and losses of the formation will be divided. Will the profits and losses be allocated in relation to the partner’s percentage interest in the formation? Or will each partner be given a regular draw? Will the profits be distributed at the end of the quarter or at the end of the year? The partners, who will have different ideas and financial needs, must agree on how the funds will be divided and transferred.
Authority Issues: Without constructing a partnership agreement, a partner may bind the formation to a contract without the consent of the other partners. If the partners wish to have one or more partners obtain the others’ consent before obligating the formation, they must elucidate this aspect in their agreement.
Decision Making: This portion of the partnership agreement should illuminate the process for engaging in fundamental business activities. The partnership, may for example, wish to engage in a vote before a business maneuver can be engaged. The partnership agreement will have to elucidate on what constitutes a major or minor maneuver.
Management Duties: This portion of the partnership agreement illuminates on the individual partner’s specific duties and responsibilities. Who will manage the formation’s books? Who is responsible for dealing with customers? Who negotiates with suppliers? And who supervises employees?
New Employees: If the partnership needs to expand, the agreement must outline the process for bringing in new partners. The partners will need to agree on a procedure for admitting new partners.
Withdrawals: If a partner passes away or withdrawals from the business, the partners must establish rules and a process regarding buyouts and transitions. In addition to the withdrawal aspect, the partners must agree on a procedure to resolve any disputes or conflicts that may arise.
Types of Partnerships:
A general partnership is a form of business structure where multiple persons come together and agree on forming an unincorporated business model. A general partnership maintains the following features:
• A general partnership is formed by two or more individuals
• A general partnership is created by an agreement and proof of existence
• The owners of a general partnership are all personally liable for all debts and legal actions that the company may face.
• A general partnership features partners who share equal liability and responsibility
Limited Liability Partnerships:
A limited liability partnership is a type of partnership where some or all of the partners possess limited liability. The formation, thus, exhibits elements of corporations and partnerships. Under this formation, one partner is not liable or responsible for another partner’s negligence or gross misconduct. In a limited liability partnership, some partners face a level of liability that is similar to that of a shareholder in a corporation. That being said, unlike a corporate shareholder, a partner has the right to manage the business directly—shareholders elect a board of directors to handle the entity’s day-to-day business.
The laws surrounding limited liability partnerships will vary based on a jurisdiction’s distinct laws. For example, some countries require a limited liability partnership to have at least one “general partner” with unlimited liability.
A limited liability partnership is distinct from limited partnerships (in some areas) because a limited partnership will require the presence of at least one unlimited partner, as well as, passive and limited liability investors. Because of these regulations, in some countries, a limited liability partnership is better suited for entities where investors which to assume active roles in management.
A limited partnership is a business formation that is similar to a general partnership, except that in addition general partners, there are one or more limited partners. The limited partnership is therefore a formation where only one partner is required to face all liability (general partner).
As is common in a general partnership, the general partners in a limited partnership maintain the authority to act as an agent—this allows them to bind all the other partners in contracts and other ventures.
Like a shareholder in a corporation, limited partners have limited liability—they are liable on debts incurred by the firm to the extent of their initial investment and possess no management authority. The general partner will pay the limited partners a return on their investment (like a dividend). The extent and nature regarding the distribution of payment is outlined in the partnership agreement. As a result, a general partner will carry more liability, and if the partnership loses money, the general partner is held liable.
A partnership is an arrangement by which two or more legal persons join together in order to work together for a particular purpose. The primary form of a partnership is a business partnership, which is a partnership between individuals who have agreed to work together for the sake of advancing a business purpose.
Partnerships do not have to be business partnerships, as it is possible for organizations to form partnerships with other organizations without any kind of business interest. For example, marriage itself, under certain circumstances, might be understood as a form of partnership between two individuals.
The mention of legal entities in terms of partnerships was made specifically because it is possible for corporations to make partnerships with one another. For example, two large corporations could form a mutually beneficial business partnership with full legality, as corporations are technically legal entities.
The different purposes to which partnerships can be put define the nature of those partnerships. For example, a partnership between two different schools that allows those schools to help students exchange between the two schools, and thus, take a greater variety of classes is entirely different from a business partnership in which two corporations work together in order to earn greater profit. Nonetheless, a business partnership is one of, if not the single, most common forms of partnerships in the world today. This is in part due to the effects of a business partnership upon taxes for the constituent parties of that partnership.