Partnership

Definition: A legal form of business operation between two or more individuals who share management and profits. The federal government recognizes several types of partnerships. The two most common are general and limited partnerships.

If your business will be owned and operated by several individuals, you'll want to take a look at structuring your business as a partnership. Partnerships come in two varieties: general partnerships and limited partnerships. In a general partnership, the partners manage the company and assume responsibility for the partnership's debts and other obligations. A limited partnership has both general and limited partners. The general partners own and operate the business and assume liability for the partnership, while the limited partners serve as investors only; they have no control over the company and are not subject to the same liabilities as the general partners.

Unless you expect to have many passive investors, limited partnerships are generally not the best choice for a new business because of all the required filings and administrative complexities. If you have two or more partners who want to be actively involved, a general partnership would be much easier to form.

One of the major advantages of a partnership is the tax treatment it enjoys. A partnership doesn't pay tax on its income but "passes through" any profits or losses to the individual partners. At tax time, the partnership must file a tax return (Form 1065) that reports its income and loss to the IRS. In addition, each partner reports his or her share of income and loss on Schedule K-1 of Form 1065.

Personal liability is a major concern if you use a general partnership to structure your business. Like sole proprietors, general partners are personally liable for the partnership's obligations and debts. Each general partner can act on behalf of the partnership, take out loans and make decisions that will affect and be binding on all the partners (if the partnership agreement permits). Keep in mind that partnerships are also more expensive to establish than sole proprietorships because they require more legal and accounting services.

If you decide to organize your business as a partnership, be sure you draft a partnership agreement that details how business decisions are made, how disputes are resolved and how to handle a buyout. You'll be glad you have this agreement if for some reason you run into difficulties with one of the partners or if someone wants out of the arrangement.

The agreement should address the purpose of the business and the authority and responsibility of each partner. It's a good idea to consult an attorney experienced with small businesses for help in drafting the agreement. Here are some other issues you'll want the agreement to address:

  • How will the ownership interest be shared? It's not necessary, for example, for two owners to equally share ownership and authority. However, if you decide to do it, make sure the proportion is stated clearly in the agreement.
  • How will decisions be made? It's a good idea to establish voting rights in case a major disagreement arises. When just two partners own the business 50-50, there's the possibility of a deadlock. To avoid this, some businesses provide in advance for a third partner, a trusted associate who may own only 1 percent of the business but whose vote can break a tie.
  • When one partner withdraws, how will the purchase price be determined? One possibility is to agree on a neutral third party, such as your banker or accountant, to find an appraiser to determine the price of the partnership interest.
  • If a partner withdraws from the partnership, when will the money be paid? Depending on the partnership agreement, you can agree that the money be paid over three, five or 10 years, with interest. You don't want to be hit with a cash-flow crisis if the entire price has to be paid on the spot on one lump sum.
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