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.
Structuring a Business Partnership: Who Qualifies?
The first step you need to take in forming a business partnership is to figure out who is in the partnership. Partnerships can be formed with two or more partners, although Ennico points out that partnerships with large numbers of partners (more than 10) can become unwieldy to manage. Professional firms with 50 or more partners have extremely detailed agreements spelling out rigid procedures over who gets admitted, who signs the lease, the structure of the partnership, etc. "It can get very involved," Ennico says. Partners can include employees, spouses, family members, or associates. There may be reasons arguing against including a spouse as a partner; for example, if you transfer title to your personal assets into your spouse's name to protect your personal property in the event the partnership is sued, the spouse cannot have any involvement in the partnership business whatsoever, according to Ennico.
If you are teaming up with someone else to perform services for a mutual client (for example, a website developer who subcontracts the design work to another consultant) and do not with to make that person your formal business partner, make sure the other person signs an agreement stating clearly that they are not your partner or agent. Ennico further recommends that you notify the client in writing or by e-mail that you are NOT in partnership with that person. Otherwise, Ennico says there's a risk the client may view you as partners and will hold both of you accountable as such if something goes wrong.
Structuring a Business Partnership: General or Limited?
There are two types of partnerships. Which one is the right kind for you?
- General partnerships are formed when two or more people agree to enter into business together to make a profit. You don't even need to put anything in writing (although you should) or file any type of notice with state or local authorities. The feature that distinguishes this from other business arrangements -- and makes it a dangerous business form -- is the joint and several liability of the partners. That means each partner is liable for any debts of the partnership or of any partners on behalf of the business. "Try to avoid forming a partnership," Ennico says. "The operating agreement for a Limited Liability Company (LLC) contains almost all the same provisions as a partnership agreement, and the cost is about the same."
- Limited partnerships are a variation, in which a business partnership is comprised of at least one general partner and one limited partner. "The limited partner gets this name because he or she enjoyed limited personal liability," Weltman says. "The extent of exposure for partnership debts is essentially the limited partner's investment in the partnership." The limited partner is a silent partner, contributing money to the venture but without any right to direct how it operates or otherwise being involved in the running of the partnership business. Also, a limited partnership can only be formed by creating a formal agreement in accordance with state law and filing certain documents with your state Secretary of State's office. In a handful of states, you may also need to publish a "notice of formation" in local newspapers.
Structuring a Business Partnership: Writing a Business Plan
While this exercise is not mandatory, it is extremely helpful to ensure success of a partnership. "The plan serves as a roadmap for the partnership to implement actions necessary to start up and grow the company," Weltman says. "It also is useful in making you focus on various aspects of the business, such as where you plan to obtain start-up capital and whether you will be selling through the Web." A business plan should describe the responsibilities of each partner for the business, including who will be the head or managing partner.
Structuring a Business Partnership: Choosing a Name
Finding the right name for your business can describe what the business is all about. "Frequently, the fact that the business is a partnership is explained by the name, such as Wang and Williams Associates," says Weltman. "Other times, the name may relate to the product or service being offered by the partnership." After choosing the name, you need to protect it. Do this by making sure a suitable Internet domain name is available for your partnership, as most businesses these days should establish a website. Even if you don't set up a website immediately, reserve the name by registering your site. Check availability of the name you want to use through Register.com or other domain name providers. You will also need to register your partnership name with a local government, for which there is usually a modest fee. And while it's not required, it's often a good idea to gain legal protection for your partnership in the form of a trademark. Learn about trademark protection from the U.S. Patent and Trademark Office.
Structuring a Business Partnership: Understanding Your Tax Obligations
A business partnership does not pay taxes on income. The partnership is a pass-through entity and the individual partners pay tax on their distributive share of partnership income passed through to them. Each year, the partnership files a return, Form 1065, to report to the IRS the income, gains, losses, deductions, and credits from the business, Weltman says. It also files a Schedule K-1 for each partner, allocating a share of each item of income, deductions, etc. according to the terms of the partnership agreement. Similar reporting may be required at the state level.
Each partner reports his or her share of income on Schedule C of his or her personal income tax Form 1040. If the partnership is profitable, each partner must pay self-employment taxes on his or her net earnings. These taxes cover the employer and employee share of Social Security and Medicare taxes. Because a partner is not an employee (a partner is a self-employed person), there is no withholding from a paycheck to cover income and self-employment taxes. Instead, these taxes are paid through quarterly estimated tax payments.
There are special rule for husband-wife ventures. If a married couple operates a venture in which each materially participates and they file a joint return, they can opt not to file Form 1065. Instead, they can file a single Schedule C (the form used by sole proprietors) to report their share of business income and expenses.
Structuring a Business Partnership: Other Details
Weltman says to make sure to deal with various other business matters before your partnership begins operations:
- Obtain a federal employer identification number. A new partnership must obtain a federal employer identification number (EIN). This can be done instantaneously and at no cost from the IRS. When partners exit the partnership, or new partners are added, your partnership may need to obtain a new EIN as it is considered a "new" partnership for tax purposes.
- Obtain licenses and permits. Depending on your type of business, the partnership and/or each partner may be required to have a license or permit to operate legally.
- Choose a location. Decide the "official" address for the partnership. With technology enabling partners to work from remote locations, it is helpful to designate one place to receive partnership mail. If partners operate from their respective homes, the partnership can obtain an address from such companies as a UPS Store or a virtual office.
- Obtain insurance. Because each partner's personal assets are exposed to the claims of the partnership's creditors, the best way to obtain protection is to carry adequate insurance for the unexpected. Discuss these and other types of coverage with an insurance agent: property and liability coverage, auto insurance, and health coverage.
Structuring a Business Partnership: Writing the Partnership Agreement
General partnerships can be informal, oral arrangements to share profits and losses of a business venture. However, it is highly advisable to use a formal, written partnership agreement to spell out how income, deductions, gains, losses, and credits are to be split. If the agreement is silent, then state law is used to fill in gaps -- and that could leave a lot of decisions up to the courts if you and your partner(s) have a falling out.
"Legally, you're not required to have a written partnership agreement but I think you're a fool not to have one," Ennico says. "If you don't have a written agreement, a judge looks at the partnership statute and that acts as your agreement."
That may be fine. But it may also not be so good, Ennico says, because the partnership laws in many states assume that all partners are equal. "If we set up a partnership on a handshake and agree to split the business 70-30, and we then have a falling out because you think you are working harder than I am and deserve a bigger share of the profits, the law may say we are 50-50 partners unless we can clearly document in writing, for example a signed Form 1065, our intent to create an unequal split," Ennico says.
Laws vary by state. There are sample partnership agreements available on legal websites on the Internet, such as Law Depot and LegalZoom. But a partnership agreement can be put in writing by a lawyer for between $500 to $1,000 and that might very well be worth the investment to your business, Ennico says. "Never undertake a partnership agreement without an attorney," he says. "I once handled an agreement involving a 20-member engineering firm that consisted of 90 pages plus schedules. It took more than six months for the partners to reach agreement on all the details."
Here are some critical elements to include in a partnership agreement:
1. Partnership information.
• List the name of the partnership, location, when it was formed and the purpose of the business.
• Who the partners are and their capital contributions
• Determine who the partners are and list them, their addresses, and Social Security Numbers. Then detail what the partners are putting into the partnership. These contributions may include money, intellectual property, customers, machinery, vehicles, etc.
2. Profit and loss distribution.
Each partner's "distribution percentage" – reflecting their share of partnership profits and losses – must be clearly stated in the agreement. Partners share in the profits and losses to the extent of their share in the business. If each contributes 50 percent of the start-up money, then each is entitled to 50 percent of the profits, according to Weltman. Ennico adds, "distributions of profit must be made in accordance with the partners' percentages – if you don't do that, there's a risk that the partnership tax laws may rearrange your percentages to reflect how much money you and your partners are actually taking out of the partnership checking account.
3. Rules concerning voting, admitting new partners, and management.
Determine who is going to manage the partnership, who can sign contracts, and whether partners are going to be receiving salaries for labor or services. "Unlike distributions of profit, salaries do not have to be made proportionately to the partners," says Ennico. "I frequently see situations where unequal partners decide to take equal salaries for the work they're doing to further the partnership business." You also need to determine the voting rights of the partners -- normally a simple majority vote of the partners decides what happens and what doesn't, but you can agree that important decisions be made by a "supermajority" vote of two-thirds or more of the partnership percentages.. "For example, many partnership agreements require that the partners be unanimous when deciding to admit new partners, merge with another company, sell part of their business, or make a bankruptcy filing," says Ennico.
4. The exit strategy
The most important thing to spell out in a partnership agreement is your "exit strategy" if things don't go as planned and you want to get out of the partnership. "The dirty little secret is that as long as everybody gets along and everybody communicates and everybody does what they're supposed to, no one will look at the partnership agreement again," Ennico says. "The only time anyone is going to dust off the agreement and run to an attorney is when they are unhappy and want out."
This section details how to dissolve the partnership – the circumstances under which partners can withdraw, how much notice they must provide, and how the assets will be distributed. This section may also deal with other issues, such as what happens if one partner retires, goes bankrupt, becomes disabled, or dies. When such events occur, the departing partner's share of a business doesn't automatically get divided between the remaining partners. It is an asset that may be transferred by law to someone (such as a deceased partner's heirs, or to the partner's ex-spouse in a divorce proceeding) that you don't want to be partners with. If you don't want to be a partner with that "someone else", you may want to insist on a buy/sell clause that specifies that the surviving partners have the right to buy out that "someone else" in the event of a partner's death, disability, divorce, bankruptcy or retirement. If you do this, you should specify the method of determining the value of the departing partner's share.
Ennico says your partnership agreement should clearly state "who gets what" when the partnership dissolves, and spell out rules for what the partners can and cannot do afterwards: "for example, can you still talk to your old customers? Can you take your customers with you? Are you prohibited from doing a similar business in the same geographic area as the partnership? All these things can and should be spelled out."
5. The means of dispute resolution.
In the event that partners have disagreements, you may want to include in your partnership agreement how those agreements will be worked out. You may want to specify that partners bring disputes to mediation before arbitration, go to arbitration directly, or agree to only go to arbitration.
Structuring a Business Partnership: Recommended Resources
- Business.gov: Link to your location to find applicable requirements.
- Cliff Ennico, the small business attorney quoted in this article, has an excellent outline on the advantages and disadvantages of forming partnerships, LLCs and corporations, entitled "Demystifying the Business Organization," which is available without charge on his website.
- Internal Revenue Service: View IRS Publication 541, Partnerships, for guidance on partnership taxation.
- U.S., Small Business Administration: How to choose a business structure.