How to Structure a Partnership
Partnerships are incredibly common--and incredibly hard to sustain. Here's how to set up a partnership that is equitable, efficient, and mutually rewarding.
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When two or more people start a business or carry on a trade together to turn a profit, the result can often be a strong union that blends complementary skills, financial resources, customers and connections to help the venture succeed. But, sometimes, such relationships can sour, the business can fail, and the parties can decide to go their separate ways. In the eyes of the law, by the very nature of entering into business with another party, you may be considered a partnership -- whether you have a written agreement or not. It's best to follow certain legal and practical steps to structure this relationship so that it is a win-win for all concerned.
The number of business partnerships in the U.S. has been growing steadily by an annual rate of about 5.6 percent a year to more than 3 million in 2007, according to the most recent records reported by the U.S. Internal Revenue Service. The total net income for these partnerships has also been on the rise, increasing by 2.5 percent from 2006 to a total $683 billion for 2007, IRS figures show.
With that much money at stake, it's important for partnerships to spell out what each person contributes, whether in terms of financing, property, labor or customers, and what each person expects in terms of profits and ownership. A partnership agreement can be solidified by an oral agreement between partners, but experts recommend putting the terms down in writing.
"I liken the partnership agreement to a prenup negotiated before a marriage," says Barbara Weltman, a tax and business attorney and author of such books as J.K. Lasser's Small Business Taxes (Wiley 2009). "When everybody loves each other and has the best of intentions, it's a good idea to work out the 'what ifs.' You want to decide in advance who is getting what, who is doing what, who is responsible for what, and how to resolve disagreements -- what happens if one person wants to retire or one partner wants to expand and the other doesn't?"
The following pages will cover the benefits and disadvantages of a partnership, how to structure a partnership in a written agreement to protect yourself and the business, and steps you need to take in forming a partnership.
Why Form a Partnership?
Once you have an idea for a company, whether this means selling a product or a service, understand the consequences of opting to become a partnership. As a business partner, you need to be prepared to devote time, use business methods, and get set up properly so you can make more money, minimize taxes, and generally avoid potential problems. Here are the pros and cons of forming a business partnership:
Benefits of a partnership
- This type of business entity is easy and inexpensive to set up. There are no formal or legal steps required in forming a partnership, unlike forming a corporation, for which you have to file with your state government. As long as you join with at least one other person and have the intention of making a profit from your business, you are automatically a general partnership, Weltman says.
- Filing income tax returns is easy. A general partnership is a "pass through" entity, meaning the partners -- and not the partnership -- are taxed individually. That means that the partnership return is merely an information return, telling the IRS about the partnership's income and expenses; the partners pay tax on their share of partnership income on their personal returns.
- It's a way to attract prospective employees or "talent." A business potentially can reach new heights when complementary skill sets are gathered under a partnership. A partnership can also serve as an incentive to attract new employees if they realize they may become partners at some point.
Disadvantages of a partnership
- Perhaps the biggest drawback is that each partner is jointly and severally liable for the debts and obligations of the business. "A creditor can sue a single partner for all of the partnership debt owed and this partner is responsible for paying the full amount to the creditor," Weltman says. Once a partner pays off the creditor, he or she can seek "contribution" from the other partner(s).
- All your personal assets are potentially at risk. This is why some attorneys, such as Cliff Ennico, nationally syndicated small business columnist and author of Small Business Survival Guide (Adams Media 2005), suggest that you are better off incorporating your business or forming a limited liability company (LLC) rather than structuring it as a partnership. Incorporating can help shield personal assets if your business is sued, or if your business partner is sued.
- Any asset you contribute to the partnership is jointly owned by you and your partners, and there's no assurance you will get it back when the partnership is dissolved.
- Profits that a business makes under a partnership must be shared with others.
- Unlike in a corporation, you may not be able to deduct some employee benefits from business income on tax returns.
- Any time you share decision-making responsibilities with other parties; there is the potential for disagreements. Partners are co-owners and that means they share management and financial control over the business.
Dig Deeper: The Pros and Cons of Business Partnerships
Structuring a Business Partnership: Who Qualifies?
