Unlike normal business structures, partnerships act a bit differently. There are several different types of variables that need to be taken into consideration, like the type of partnership that you may want to form. Believe it or not, this can involve one party having all of the liabilities thrown upon them while the other party involved in the partnership receives little to no liability at all. Additionally, partnerships can act as a great way for a start-up because of the split of labor and capital. So let’s take a deep dive into how exactly partnerships operate! From taxes to building your own partnership, here’s everything you need to know.
A partnership can be defined as a business structure that involves two or more individuals who share ownership. This also involves each party having a share of the profits and liabilities.
However, it is also important to mention that not every partnership operates the exact same way. That’s right; there are several different types of partnerships, and each has its own way of operating. Some carry more weight to liabilities, while others are committed to sharing everything.
Let’s break down some of the main partnerships that you may see floating around:
This is your typical run-of-the-mill partnership. This structure operates heavily as a team. You all share your profits, and you all are liable for everything that happens within the partnership as well.
To put it in perspective, let’s say you make a general partnership with your friend. Your partnership involves selling baseball cards. You each put in $15 to buy a pack of cards. Your friend buys $15 worth of packs, and you do the same. From the cards you buy, you notice that you got a rare card worth up to $50! Now, although you got the rare card from your pack, you still decide to honor your general partnership and split the $50 with your friend. Now, each of you earns $25 in profit from that one rare card.
This partnership operates heavily on one party while the other doesn’t have anything to lose. In a limited partnership, one partner seems to be doing everything. They manage the business, make decisions on where to sell, and how their overall business works. This partner not only makes all of the decisions, but they also take full responsibility over any debts or liabilities from the business. The other partners involved in this structure do not have to take part in any of that. At times, the other partner can be an investor in terms of money or supplies.
To break it down, let’s say you decide to open a lemonade stand to take advantage of the summer weather. Your friend also wants to take part in your lemonade stand, but his days are limited, so they can’t show up to run the stand. So your friend offers to give you money for the cups to help in some way. You buy all of the lemons, make the lemonade stand, advertise your business as needed, and of course, make the lemonade. You make some profit and decide to give 30% of your profit to your friend for helping with the cups.
For individuals who are keen on taking accountability, look no further than this partnership. This structure almost operates the same way as a general partnership, however, things are vastly different when it comes to liabilities. In a limited liability partnership, all parties involved have limited liability. This means that if one party suddenly gets sued, then only that party has to endure the debts that come from the case.
Think about it this way: let’s say that you start a consulting business with your two other friends. You each do your part and have different clients. The business goes well until one day, you overhear that friend A has given terrible business advice to a client. This leads to that friend getting sued while you and friend B are safe from the case.
Like other business structures, partnerships also have to file with the IRS to report profit and loss. That’s right, there is no partnership structure that can save you from filing with the IRS. Now let’s dive into the specifics on what you need to know about taxes and partnerships.
Partnerships are a pass-through entity. That’s right, this means that your partnership does not have to pay any sort of federal income tax. Instead, the profits and losses from the partnership are “passed through” and recorded to each of your partners’ tax returns. Regardless of your structure, each member is responsible for doing their part to fill their share of the profits and losses of the partnership.
While partnerships don’t have to pay any sort of federal tax the IRS, partnerships are still required to file out a form to report the income earned from the partnership as a whole. Yes, unfortunately, there is some double-filing involved. To do this, partnerships must fill out Form 1065.
From the Partnership tax return, each partner is issued Schedule K-1 to report their share of the partnership's income, credits, equity, etc, on their personal tax return.
Like with any business structure, there are always going to be some great benefits that come with being in a partnership, and there are some negatives as well. These benefits and disadvantages can help determine whether a partnership may be something that you are looking for.
First, let’s dive into the benefits that come with being a part of a partnership. Here are some main benefits to consider.
As the name of this business structure states, partnerships rely heavily on sharing responsibility. You get the chance to work with someone who can help with any sort of labor or financial startup. Not only is it easier to have two or more people working on a business, but it also adds up to more capital put through the initial phase of the business. Like they always say, the more the merrier.
Unlike other business structures, partnerships don’t have to worry about losing money on corporate federal tax. The profits and losses “pass through” to each partner, which avoids the need to pay that corporate tax. On top of this, there are no shareholders or dividends that need to be paid out, so partnerships also don’t have to worry about paying out dividends like corporations do.
While this benefit does not apply to general partnerships, it is still worth mentioning that partnerships do offer the safety that other business structures have over liabilities. Those who may be worried about sharing liability can choose to opt for a limited liability partnership. This allows for each member to be held accountable and every party involved may be able to keep their assets despite of a major liability hitting one party.
Probably the most common disadvantage that you’ll see in a partnership is the risk of having to deal with not just your liability, but also your partner’s liabilities as well. Unless there has been an agreement to arrange a limited or limited liability partnership, then you have to look out for one another. Remember, this is a shared responsibility, so whatever happens to one partner can affect everyone else.
While the idea of a partnership with a friend or close peer sounds like the best idea ever, every partnership will always be prone to some form of disagreement. Now, although this sounds like a small hurdle in your partnership, a small disagreement can lead to a domino affect of more disagreements coming your way. With this being a group effort, all parties involved must be on the same page, and one small disagreement can make or break a partnership, depending on how the two or more parties try to solve it.
Since a partnership involves two or more parties acting as employees in their business, earnings from the partnership may be subject to self-employment tax on the partner’s personal tax return. This applies to partners who actively participate in the business. “Silent” partners are generally not subject to self-employment tax on earnings from the business.
Now that we’ve taken a look at the various partnership types and the necessary info regarding taxes and benefits/disadvantages, let’s move on to the next big step. How can you set up your partnership?
Like with any business, in order to get started, you must come up with a name. This can be either
This is what separates a partnership from every other business structure. For a partnership to be recognized, there must be some form of legal agreement between the two or more parties involved. This is also where you can decide if the partnership will be either a general partnership or if it will fall under a different structure.
While a partnership doesn’t have to pay corporate taxes, it is still required to register the partnership in the state under which it will be operating. Depending on the state, there may be additional forms or fees that may need to be sent out. In order to figure this out, we recommend you visit your state’s Secretary of State website.
Lastly, although the partnership may not have any employees, you will likely need an employer identification number. An EIN is required in order to file your business tax return. An EIN can also be helpful if you are considering opening a business bank account so that you can split your personal and business finances.
Partnerships can be a risky venture due to the heavy responsibility that both parties have to endure. Depending on the partnership structure, liabilities can spread through like wildfire on each side. However, partnerships can also offer some major benefits in business. Whether it be the combined effort of labor or the huge investment of capital from each side. Choosing to form a partnership can bring in incredible success in a business if done effectively.
While starting a partnership can seem exciting, making sure that your taxes and finances are in order may not. Contact the LedgerFi team today, while your partnership thrives, we’ll handle the tax side of things!