What Is a Business Partnership?
A business partnership can provide new or existing companies with the access to skills, capital and support necessary for success — but there are risks.
A general partnership, for instance, is easy to set up, but can leave members liable for the debts of the business and their partners. Limited partnerships and limited liability partnerships offer greater protections, but rules regarding their formation vary by state.
Before deciding on a business entity, be sure to consider partnership business advantages and drawbacks versus other available business structures.
What is a business partnership?
A business partnership is a way of structuring a company owned by two or more individuals. Common examples of partnerships include law firms, real estate firms and physician groups.
But not all partnerships are the same. The type of business partnership that’s right for you depends on the level of liability you and your partner(s) want to accept for the business’s debts and any lawsuits that may be filed against it.
Laws in the state where you’re doing business may also restrict the type of partnership you can consider. For example, some professional service providers can’t legally form an LLC in California. In other states, an LLC may be more advantageous than a partnership.
Pros and cons of running a business as a partnership
Consider the pros and cons before forming a business partnership.
Pros
Simplified formation: Business partnerships, particularly general partnerships, are relatively easy to establish, requiring fewer forms and fewer fees than corporations.
Tax benefits: In most states, profits from a partnership are passed through to partners’ personal tax returns, and partners may even be able to claim a pass-through deduction. Limited partners may also be exempt from self-employment tax.
Few ongoing compliance requirements: While ongoing compliance requirements vary by state and depend on the type of partnership, a business partnership generally requires less legal upkeep than a corporation.
May provide more liability protection if a partner is negligent: In some cases, an LLP may provide greater protection for the business than an LLC if an individual partner is found guilty of negligence.
Cons
Limited liability may be restricted to certain professions: In most states, only certain licensed professionals, like lawyers, doctors and accountants, have the option to form an LLP.
Differences in state laws can complicate expansion: Though there are few rules for general partnerships, state laws regarding LLPs vary significantly. Some states may not recognize LLPs, which can make expansion difficult once you’ve chosen that structure.
Partners may be personally liable for business debt in some states: In some states, even limited partners may be personally responsible for business debts incurred by the partnership.
Types of business partnerships
General partnerships
A general partnership is the simplest and most common type of business partnership. Each member typically shares equal operational and legal liability, including day-to-day responsibilities as well as income and losses. This means that each partner’s personal assets can be used to settle the business’s debts.
The partnership benefits from pass-through taxation, but individual partners must also pay self-employment tax.
Limited partnerships
A limited partnership is an arrangement between a general partner(s) with unlimited liability and a limited partner(s) who maintains basic limited liability protections.
Unlike general partners, limited partners invest capital into the business but don’t have operational control over the business. That limited partner’s total profit shares typically depend on the amount of capital they invest into the company and may be less or more than general partners.
Limited partners pay taxes on their share of the profit but aren’t subject to self-employment tax.
Limited liability partnerships
In a limited liability partnership, all partners benefit from limited liability protections. Partners are still personally liable for their individual negligence and, depending on the state, may be responsible for some of the partnership’s debts, but they generally aren’t liable for the harmful actions of other partners.
State laws dictate what type of business can or cannot become an LLP, but the eligible businesses are typically limited to professional service businesses, such as physicians, dentists, accountants and law practices.
Limited liability limited partnerships
A limited liability limited partnership (LLLP) is an option for structuring your business in about half of U.S. states. It allows for one or more general partners to run the business while other limited partners sit back, much like a limited partnership, but it protects all partners involved from being personally liable for business debts or lawsuits against the business.
Because this new structure isn’t recognized by all states, it may not be the right choice for partnerships that operate in multiple states or plan to expand.
Splitting responsibilities and profits in a partnership
When forming a partnership, you’ll define the roles and responsibilities of each partner, along with their compensation, in a partnership agreement.
Ownership doesn’t need to be split equally among the partners. Each partner contributes something to the business, but not every partner needs to invest money or be involved in day-to-day operations — a non-equity partner can provide their time and expertise without contributing any cash, and a silent partner can provide capital without taking on any management responsibilities.
Partnerships don’t have shareholders, so profits and losses are divided among the partners, but your partnership agreement can specify the share that each partner receives. In the case of a general partnership with no partnership agreement, profits and losses are divided equally among the partners. But other types of partnerships, including limited partnerships, typically require a partnership agreement.
The type of partnership you choose will also impact each partner’s personal liability, which may affect how partners are compensated. For example, general partners have unlimited liability, so the business owners may decide that their exposure deserves additional compensation.
How to form a partnership
When establishing a business partnership, you’ll want to follow the steps below. You may want to consult an attorney for help choosing a structure and drafting a partnership agreement, especially if your situation is complex or your business operates in multiple states.
- Choose a business partner: Find someone who has the skills, expertise and/or capital to help your business succeed, and make sure you agree on how the partnership will be structured and how the business will be managed.
- Choose a partnership structure: If you’re running a low-risk business, a general partnership may be the easiest structure to establish and maintain. However, taking the extra steps to achieve limited liability for some or all of the partners may pay off in the long run. Consider your state laws and your business needs when choosing between an LP, LLP and LLLP.
- Write a partnership agreement: Draft a comprehensive partnership agreement outlining how the business will operate and how profits and losses will be distributed. We’ll provide more tips below.
- Get an employer identification number (EIN): All partnerships are required to apply for an EIN from the Internal Revenue Service (IRS). You can apply online or by phone, mail or fax.
- Fulfill your state’s regulatory requirements: Depending on your state and your business type and structure, you may need to apply for a business license, obtain certain permits and/or register to pay business taxes. You may also need to designate a registered agent.
- Buy small business insurance: Professionals in some states may be required to purchase malpractice insurance, errors & omissions insurance or professional liability insurance that meets state standards, depending on the industry and the business structure you choose. Your business may also require other types of small business insurance.
- Fulfill your ongoing requirements: Make sure to file annual reports, pay taxes, maintain licensure and fulfill any other compliance requirements as determined by state law.
What to include in a partnership agreement
A comprehensive partnership agreement should include the following:
- The names and titles of each partner and the name of the partnership
- The partnership structure and liability of each partner
- The contributions of each partner, including capital, intellectual property and labor
- The management duties and labor responsibilities of each partner
- A process for hiring employees and contractors
- A strategy for finding/reaching clients or customers
- The ownership shares and compensation for each partner, including salary and benefits
- The portion of profits that should be reinvested
- A plan for transferring a partner’s interest should they decide to leave the partnership
- A process for evaluating any offers to buy the business
- A set of rules for selecting new partners or expanding the business
- An equitable process for making business decisions
- A process for resolving disputes between partners
- A plan for distributing business assets in the event of a dissolution
Tax considerations of a business partnership
We mentioned earlier that all partnerships are considered pass-through entities, meaning that each partner reports income and losses through their personal income taxes. As such, the partnership itself is not required to pay federal income tax.
Partners are taxed based on their distributive share, defined as the profits they received as part of their partnership agreement or, if no agreement was drawn, in accordance with state law.
Payroll taxes
Like any other business, if a partnership hires employees, the entity will need to meet federal and state (if applicable) payroll tax obligations. However, it’s important to note that partners should not be considered or taxed as employees.
Tax forms
Tax filing requirements can vary by circumstance, but here are some of the most common forms partnerships must typically fill out:
- Form 1065: This is the IRS form partners would attach to their personal federal income tax returns, along with their corresponding Schedule K-1 tax form. Form 1065 is used to report a partnership’s income, losses and deductions. Schedule K-1 identifies each partner’s share of the partnership’s income, deductions, credits and other items.
- Form 1040: This is the U.S. Individual Income Tax Return filled out by a majority of Americans. General or limited partners typically must attach Schedule SE to figure the tax due on net earnings from self-employment. You may be required to pay estimated tax quarterly.
Like the federal government, states generally do not tax partnerships; however, partners would most likely be required to report income on their personal state income tax returns.
Partnership vs. LLC
Members of both partnerships and LLCs can benefit from limited liability protection, though general partners have unlimited liability with some partnership structures.
When comparing an LLP and an LLC, there’s a key difference in what happens if a partner or member commits professional wrongdoing that causes harm. All members of an LLC may be liable if one member is negligent, while a lawsuit brought against one negligent partner in an LLP will only impact that partner and the employees they supervise.
State laws are another consideration when deciding between a partnership and an LLC. Depending on your state and your industry, one of these options may not be legally accessible. Laws regarding the liability of partners also vary across states, and some states don’t recognize certain partnership structures, like LLPs and LLLPs. LLCs, on the other hand, face similar regulations in each state.
It’s important to understand the requirements and provisions of each partnership structure in your state and to be mindful of the law in any state where you may expand in the future.
If you’re having difficulty deciding how to structure your small business, consider speaking with a business mentor, tax advisor or lawyer.