The Partnership

According to the IRS, a partnership is

1. An association of two or more persons;
2. Who have not incorporated; and
3. Carry on a business for profit as co-owners.

Partnerships are formed from the moment two or more people decide to enter into business together.  Since there are no other legal requirements, a partnership may exist even if the people involved do not know or intend for their relationsip to be considered a formal partnership.  Partnerships, unlike sole proprietorships, are legal entities separate from the partners themselves.  There are essentially two types of partnerships: general and limited.  In a general partnership, each partner has unlimited liability.  In a limited partnership, only the general partner is exposed to unlimited liability.

Formation: A general partnership may be formed by an oral or written agreement, the agreement should always be in writing to prevent future problems. Generally, each partner makes a contribution to the business in the form of cash, property or services. These investments are made in exchange for an “interest” (a legal term for some kind of ownership) in the partnership. Most states and localities impose registration requirements, so make sure to review local requirements or consult a small business expert in the region.

Management: In a general partnership, each general partner has equal responsibility and authority to run the business. Additionally, any partner may represent the business without the knowledge of the other partners, so the actions of one partner may bind the entire partnership. If one partner signs a contract on behalf of the partnership, the general partnership and each partner are responsible for that contract.  In a limited partnership, the general partners are vested with management authority, and the limited partners have little to no control over the partnership’s management.

Taxation: Partnerships are taxed on a flow-through basis. This means that the partnership itself does not pay taxes; instead each individual partner is taxed on his or her share of the profits and losses. When filing taxes, partners report their share of profits and losses on their personal tax returns, regardless of whether or not the profits are distributed to the partners or kept in the business.  Partners may also pay self-employment tax of 15.3% on their share of partnership income.

Liability: All general partners are personally liable for the business debts and liabilities of the partnership, including those incurred by other partners. Limited partnerships are generally formed to encourage limited partners to invest in the business without exposing them to personal liability for the actions of general partners. Limited partners are usually not personally liable for the debts of partnership beyond what they contribute to the business.

Transferability: Unless otherwise provided for in the partnership agreement, no person or entity may become a member of a partnership without the consent of all partners. However, a partner may assign his share of the profits and losses and right to receive distributions to a third person.

Dissolution: The partnership agreement may state that a partnership will have a definite life or operate for the attainment of a specific purpose and then automatically terminate. When the life is over or the goal has been accomplished, the partnership will terminate and dissolve. Technically, a partnership terminates upon the death, disability, or withdrawal of any one partner. Partnership agreements may provide for these types of events with the share of the departed partner being purchased by the remaining partners in the partnership. A partnership will continue to exist until the winding up of partnership affairs is completed, then it will cease to exist.

Pros: Generally less expensive and require less paperwork and formalities to start and run than a corporation; flexibility in defining the partners’ relationship and allocation of income and losses; easier transferability than a sole proprietorship or an S corporation.

Cons: General partners have unlimited liability for the actions of the partnership and other partners; partnership may automatically dissolve if a general partner dies, files for bankruptcy, retires or resigns; management is more difficult since rights are not as clear-cut as in a corporation.

Bottom Line: A partnership is relatively easy to establish, but potential partners must spend time establishing the ground rules for the partnership in order to avoid future problems related to management, liability and transferability.