A partnership is an association of two or more persons, known as general partners, who act as co-owners of a business and operate it for profit. The other two major forms of business are a sole proprietorship and a corporation.

Since each state has specific laws on the formation and dissolution of partnerships, as well as laws regarding the legal responsibilities of each partner, business owners are well advised to consult an attorney and a tax accountant before establishing a partnership.

A partnership is relatively simple to establish and does not require the same amount of record keeping as a corporation. Another advantage of a partnership is that income is taxed only once. By contrast, most corporations are taxed twice -- they pay taxes on their income, and if there are shareholders, they in turn pay taxes on the share of the corporation's income that they receive as dividends.

Partnerships need only file an information return (a form indicating the partnership's income, expenses, and profits or losses) with the Internal Revenue Service, but the partnership itself does not pay taxes. Each partner pays federal, state, and local taxes on their income from the partnership as if it were personal income.

The chief disadvantage of being a general partner is that you can be held personally responsible for another partner's negligence or carelessness. This means that if your partnership is unable to meet its financial obligations, you may have to use your personal assets to pay off debtors, even though you personally may not be at fault. If the partnership defaults on a loan, for example, the bank has the right to sue any general partner to collect this debt. If you own a car or a home, the court may order you to sell that property and turn the proceeds over to the bank. (If you and your spouse own the property jointly, the bank is entitled to only one-half the proceeds.)

Another disadvantage of a partnership is that if one partner decides to sever the business relationship, then the partnership generally dissolves. The bankruptcy or death of a partner usually results in the end of the partnership.

Partnership Agreement

Once you and another person have decided to form a partnership, you should prepare an agreement. If you plan to be in business for more than one year, the agreement must be in writing. If you are planning a short-term business venture, an oral agreement may suffice, but it is still best to put everything down on paper to avoid potential misunderstandings and disagreements. Your partnership agreement should include the following:

  • The name of the partnership and the names of each of the partners.
  • A general description of the type of business that will be conducted.
  • The powers and duties of the partners, including any limitations or restrictions.
  • The financial contributions each partner will make.
  • How profits and losses are to be divided.
  • How partners can leave the business and how new partners can be added.
  • What steps must be taken to dissolve the partnership.

Limited Partnerships

If you and another person have all the necessary business skills but insufficient capital, you might be better served by a limited partnership -- a business made up of one or more general partners and one or more special partners with limited liability. Unlike a general partner, who is personally responsible for all debts and obligations of the partnership, a limited partner can lose only the amount of capital he has invested in the business.

A limited partner has relatively little power within the partnership because he is not allowed to be actively involved in the management of the business; he is merely a financial contributor. Nevertheless, he has the right to be informed of all business matters relating to the company and to share in its profits. (His profits, like those of a general partner, are treated as personal income for federal tax purposes.) If a limited partner starts making management decisions, his status immediately changes to general partner, and he becomes personally responsible for any business debts.

Ending a Partnership

After a partnership is dissolved, the partners are no longer authorized to conduct business together. To formally end the partnership, they must discharge all business obligations to creditors and divide all assets and any remaining profits among themselves.

Source: Reader's Digest's Legal Problem Solver: A Quick-and-Easy Action Guide to the Law, 1994, updated 1998

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