Partnership: Definition, How It Works, Taxation, and Types (original) (raw)

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 a general partnership, all partners share liabilities and profits equally. In other types of partnerships, profits may be shared in different percentages or some partners may have limited liability. Partnerships may also have a "silent partner," in which one party is not involved in the day-to-day operations of the business.

The type of partnership that business partners choose will depend on how they want to manage day-to-day operations, who is willing to be financially liable for the business, and how they want to pay taxes.

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.
• In other partnership structures, some partners may share a smaller percentage of the profits but not assume any liability for the business.
• Professionals like doctors and lawyers often form a limited liability partnership.
• There may be tax benefits to forming a partnership instead of a corporation.

Investopedia / Matthew Collins

Types of Partnerships

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 business undertaken by two or more individuals, there are three main categories of partnership: general partnership, limited partnership, and limited liability partnership.

General 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 should 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 Partnership

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 Partnership

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.

A limited liability limited partnership is a limited partnership that provides a greater shield from liability for its general partners. This is not a common type of partnership.

Taxes and Partnerships

There is no federal statute defining partnerships, but the Internal Revenue Code (Chapter 1, Subchapter K) includes detailed rules on their federal tax treatment.

Partnerships are pass-through businesses, meaning the partnership itself does not pay income tax. The tax responsibility passes through to the individual partners, who are not considered employees for tax purposes.

Individuals in partnerships may receive more favorable tax treatment than if they founded a corporation. This is because corporate profits are taxed, as are the dividends paid to owners or shareholders. The profits from a partnership, on the other hand, are not double-taxed in this way.

Advantages and Disadvantages of Partnerships

Like any business structure, a partnership comes with both benefits and drawbacks.

Most sole proprietors do not have the time or resources to run a successful business alone, and the startup stage can be the most time-consuming. A successful partnership can increase the chances that a business will launch successfully by allowing partners to pool their resources and abilities.

Creating a partnership can also make the day-to-day operations of a business more manageable than they would be if only one person were running things. Partners to benefit from one another's labor, time, and expertise. Moreover, a shrewd partner can also provide additional perspectives and insights that can help the business grow.

There is, however, risk in joining a partnership. In addition to sharing profits, the partners may also assume responsibility for any losses or debts from the other partners. There is also a higher chance of conflict or mismanagement. When the time comes to exit, it may be harder to reach an agreement about selling the business.

Pros

• Combine labor and capital to launch
• Share management and operations responsibilities
• Variety of experiences and new perspectives

Cons

• Additional debts or liabilities
• Risk disagreement or mismanagement
• Difficulty selling or exiting the business

Partnerships by Country

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, creating laws that 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.

The Uniform Partnership Act only applies to general and limited liability partnerships (LLPs). It does not apply to limited partnerships (LPs).

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 business structure that involves two or more individuals who agree to a set distribution of ownership, responsibilities, and profits and losses. Unlike the owners of LLCs or corporations, 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 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 Is a Limited Partnership vs. a Limited Liability Partnership?

In limited partnerships (LPs), general partners manage operations of the firm and have full liability. Limited (silent) partners are not involved in day-to-day operations and 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 the actions of other partners. A limited liability limited partnership (LLLP) combines aspects of LPs and LLPs.

Do Partnerships Pay Taxes?

A 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.

The Bottom Line

A partnership is a legal arrangement that allows two or more people to share responsibility for a business. Those partners share the ownership and profits, but they also share the work, responsibility, and potential losses. Partnerships are often seen as having more favorable tax treatment than corporations. A successful partnership can give a new business more opportunities to succeed, but a poorly-thought out one can cause mismanagement and disagreements.