Partnerships can be complex depending on the scope of business operations and the number of partners involved. To reduce the potential for complexities or conflicts among partners within this type of business structure, the creation of a partnership agreement is a necessity. A partnership agreement is the legal document that dictates the way a business is run and details the relationship between each partner.
Although each partnership agreement differs based on business objectives, certain terms should be detailed in the document, including percentage of ownership, division of profit and loss, length of the partnership, decision making and resolving disputes, partner authority, and withdrawal or death of a partner.
Key Takeaways
- Many small businesses are organized as partnerships, which require formal documentation before being established.
- The partnership agreement spells out who owns what portion of the firm, how profits and losses will be split, and the assignment of roles and duties.
- The partnership agreement will also typically spell how out disputes are to be adjudicated and what happens if one of the partners dies prematurely.
Percentage of Ownership
Within the partnership agreement, individuals commit to what each partner is going to contribute to the business. Partners may agree to pay capital into the company as a cash contribution to help cover startup costs or contributions of equipment, and services or property may be pledged within the partnership agreement. Typically these contributions dictate the percentage of ownership each partner has in the business, and as such as are important terms within the partnership agreement.
Division of Profit and Loss
Partners can agree to share in profits and losses in line with their percentage of ownership, or this division can be allocated to each partner equally regardless of ownership stake. It is necessary these terms are detailed clearly in the partnership agreement in an effort to avoid conflicts throughout the life of the business. The partnership agreement should also dictate when profit can be withdrawn from the business.
Length of the Partnership
It is common for partnerships to continue operations for an unspecified amount of time, but there are instances where a business is designed to dissolve or end after reaching a specific milestone or a certain number of years. A partnership agreement should include this information, even when the time frame is unspecified.
Decision Making and Resolving Disputes
The most common conflicts in a partnership arise due to challenges with decision making and disputes between partners. Within the partnership agreement, terms are laid out regarding the decision-making process that may include a voting system or another method to enforce checks and balances among partners. In addition to decision-making procedures, a partnership agreement should include instructions on how to resolve disputes among partners. This is typically achieved through a mediation clause in the agreement meant to provide a means to resolve disagreements among partners without the need for court intervention.
Authority
Partner authority, also known as binding power, should also be defined within the agreement. Binding the business to a debt or other contractual agreement can expose the company to an unmanageable level of risk. To avoid this potentially costly situation, the partnership agreement should include terms relating to which partners hold the authority to bind the company and the process taken in those cases.
Withdrawal or Death
The rules for handling the departure of a partner due to death or withdrawal from the business should also be included in the agreement. These terms could include a buy and sell agreement detailing the valuation process or may require each partner to maintain a life insurance policy designating the other partners as the beneficiaries.
What Is a Partnership?
A partnership is a formal arrangement by two or more parties to manage and operate a business and share its profits.
There are several types of partnership arrangements. In particular, in a partnership business, all partners share liabilities and profits equally, while in others, partners may have limited liability. There also is the so-called "silent partner," in which one party is not involved in the day-to-day operations of the business.
Key Takeaways
- A partnership is an arrangement between two or more people to oversee business operations and share its profits and liabilities.
- In a general partnership company, all members share both profits and liabilities.
- Professionals like doctors and lawyers often form a limited liability partnership.
- There may be tax benefits to a partnership compared to a corporation.
Partnership
How a Partnership Works
In a broad sense, a partnership can be any endeavor undertaken jointly by multiple parties. The parties may be governments, nonprofits enterprises, businesses, or private individuals. The goals of a partnership also vary widely.
Within the narrow sense of a for-profit venture undertaken by two or more individuals, there are three main categories of partnership: general partnership, limited partnership, and limited liability partnership.
In a general partnership, all parties share legal and financial liability equally. The individuals are personally responsible for the debts the partnership takes on. Profits are also shared equally. The specifics of profit sharing will almost certainly be laid out in writing in a partnership agreement.
When drafting a partnership agreement, an expulsion clause should be included, detailing what events are grounds for expelling a partner.
Limited liability partnerships (LLPs) are a common structure for professionals, such as accountants, lawyers, and architects. This arrangement limits partners' personal liability so that, for example, if one partner is sued for malpractice, the assets of other partners are not at risk. Some law and accounting firms make a further distinction between equity partners and salaried partners. The latter is more senior than associates but does not have an ownership stake. They are generally paid bonuses based on the firm's profits.
Limited partnerships are a hybrid of general partnerships and limited liability partnerships. At least one partner must be a general partner, with full personal liability for the partnership's debts. At least one other is a silent partner whose liability is limited to the amount invested. This silent partner generally does not participate in the management or day-to-day operation of the partnership.
Finally, the awkwardly-named limited liability limited partnership is a new and relatively uncommon variety. This is a limited partnership that provides a greater shield from liability for its general partners.
Taxes and Partnerships
There is no federal statute defining partnerships, but nevertheless, the Internal Revenue Code (Chapter 1, Subchapter K) includes detailed rules on their federal tax treatment.
Partnerships do not pay income tax. The tax responsibility passes through to the partners, who are not considered employees for tax purposes.
Individuals in partnerships may receive more favorable tax treatment than if they founded a corporation. That is, corporate profits are taxed, as are the dividends paid to owners or shareholders. Partnerships' profits, on the other hand, are not double-taxed in this way.
Special Considerations
The basic varieties of partnerships can be found throughout common law jurisdictions, such as the United States, the U.K., and the Commonwealth nations. There are, however, differences in the laws governing them in each jurisdiction.
The U.S. has no federal statute that defines the various forms of partnership. However, every state except Louisiana has adopted one form or another of the Uniform Partnership Act; so, the laws are similar from state to state. The standard version of the act defines the partnership as a separate legal entity from its partners, which is a departure from the previous legal treatment of partnerships.
Other common law jurisdictions, including England, do not consider partnerships to be independent legal entities.
How Does a Partnership Differ From Other Forms of Business Organization?
A partnership is a way of structuring a business that involves two or more individuals (the partners). It
involves a contractual agreement (the partnership agreement) between all of the partners that set the terms and conditions of their business relationship, including the distribution of ownership, responsibilities, and profits and losses. Partnerships outline and clearly define a business relationship and responsibility.
Unlike LLCs or corporations, however, partners are personally held liable for any business debts of the partnership, which means that creditors or other claimants can go after the partners' personal assets. Because of this, individuals who wish to form a partnership should be extremely selective when choosing partners.
If Partners Don't Have Limited Liability Why Set Up a Partnership?
Partnerships have several benefits. They are often easier to set up than LLCs or corporations and do not involve a formal incorporation process through a government. This has the added benefit of not being subject to the same rules and regulations that apply to corporations and LLCs. Partnerships also tend to be more tax-friendly.
What About Limited Partnerships?
In limited partnerships (LPs), there are general partners who maintain operations of the firm and have full liability, whereas limited (silent) partners, who are often passive investors or otherwise not involved in day-to-day operations, enjoy limited liability. A limited liability partnership (LLP) is different from an LP. In an LLP, partners are not exempt from liability for the debts of the partnership, but they may be exempt from liability for actions of other partners. A limited liability limited partnership (LLLP) is a relatively new business form that combines aspects of LPs and LLPs.
Do Partnerships Pay Taxes?
The partnership itself does not pay business taxes. Instead, taxes are passed through to the individual partners to file on their own tax returns, often via a Schedule K.
What Types of Businesses Are Best-Suited for Partnerships?
Partnerships are often best for a group of professionals in the same line of work where each partner has an active role in running the business. These often include medical professionals, lawyers, accountants, consultants, finance & investing, and architects.