Table of Contents
- 3 Types of Partnerships
- Partnerships, Uncle Sam and his Taxes
- Advantage of a Partnership
- Disadvantages of a Partnership
- Final Word
In my last blog post, I examined sole proprietorship. Today I want to talk about partnerships. They are the easiest and most inexpensive business structure when there are two or more owners. They do resemble sole proprietorships with a few changes besides just the number of owners.
3 Types of Partnership Businesses
- General Partnership
- Limited Partnership (LPs)
- Limited Liability Partnership (LLPs)
What is a General Partnership?
I guess the best definition is an unincorporated business owned and run by two or more people. There are a lot of ways to set it up. One of the reasons it is so simple is it is the default structure if there are multiple owners for legal and tax purposes.
Even if you do not register with your state, if there are financial or legal reasons to evaluate, a general partnership would be the slot it fits in. While you don’t have to register with the state, it is best to do so to lock in your name, especially when using a “Doing Business As” (DBA) as your business name.
Just like with the sole proprietorship, the entity and the owners are not separate, therefore your taxes for the business’s profits or losses pass through to the owners’ personal tax filings in their portion of ownership.
A lot of articles probably narrow it down to equal ownership and equal responsibilities for the business’s profit or loss. But the truth couldn’t be farther from the truth. Neither percent of ownership nor responsibilities have to be equal to be a general partnership.
There are plenty of partnerships where one person is bringing finance and the other knowledge or labor. In my solo article, I talked about Bill Smith and his lawn cutting service. Let’s say you are Bob (from my last article) and have little to no money, but have experience mowing and the time and energy to do the job. I have money/quality mower/etc. that would help you do the job but I don’t have time, energy, and quite frankly desire to do the work.
We could still have a partnership where I provide what I do for my agreed percentage and you provide what you do for your percentage. That percent might often be 50/50 but it doesn’t have to be. Even in partnerships where it is equal ownership, often owner roles are divided by their strengths.
Like a sole proprietorship, since there is no distinction between owners and business, the burden of losses, debts, and liabilities of the business fall directly on the owners personally. There is no protection for personal assets or accounts outside of the business. While the ownership can be divided by percentages in sharing the profits and losses, the debt and liabilities are actually 100% on all of the owners individually.
In my example, I made you the hard worker with little money and myself with money and assets but not working the jobs. Guess what, if our partnership messes up and gets sued by one of those yards’ owners and the partnership is found liable, you don’t have money or assets to collect so I end up paying for most or all of the damages, like it or not.
The same is true for the liabilities, if we borrowed money or charged on a credit card for any equipment or gas when the bill comes due its owed and I bear the burden of paying if the money business owed hasn’t been paid yet since you and the business don’t have it.
Also, since there is more than one owner, there can be disagreements from time to time on issues in the partnership. With the sole proprietorship you bear all, but you have the autonomy to do as you wish with no one else’s opinion mattering. With the partnership, differing minds come into play. While not required by the state when having a general partnership, it is best practice to have a partnership agreement in place prior to starting the business.
In this, you outline everything you can think of that might be tough decisions in the future- from what responsibilities each bears, percentage of ownership, etc. to what happens if one partner wants to leave or dies. While it might cost money upfront, hiring an attorney with experience might save a lot of money and headaches down the line having them speak to you, make suggestions based on law and experience, and draft this agreement.
What is a Limited Partnership (LPs)?
Limited Partnerships are a variation where the business has at least one general partner who has day-to-day decision authority and at least one limited partner who doesn’t have the day-to-day authority but has limited powers and responsibilities in the business. There must be a partnership agreement written detailing these details.
There are no percentage requirements for the distinction of general and limited; and while the general partner will still have 100% liability for debts, the limited partner is limited in their liability up to their amount of contribution.
Let’s take my scenario with Bob again. Bob could be the general partner who makes all the day-to-day decisions, and I could be a limited partner who gets a 25% limited partnership position for my initial contributions to the start of the business. Bob gets 75% of profits and bears 100% possible liability but I am in the position to get 25% of profit and never bear more than 25% of the liability.
Plus, I might not have day-to-day decisions, but I could have made sure in partner agreement that I have a vote on incurring debt over a certain amount.
What is a Limited Liability Partnership (LLPs)?
As in a general partnership, all partners in an LLP can participate in the management of the partnership, because all partners are limited liability status, no general partner is required. This is a distinction from LP above in which general partners are required and have most of the power and possibly all of the liability and the required limited partners can be almost silent really, just having a financial stake.
With the shared management of an LLP, the liability is also shared, each partner is limited in their liabilities up to the percentage of their ownership.
Partnerships, Uncle Sam and his Taxes
(This applies regardless of which of the 3 partnership types you choose to be)
Partnerships and Income Taxes
Like with the sole proprietorship, you will owe taxes on your share of profits (or losses) through your personal income tax filing (1040 or 1040EZ) as well as attach a Schedule K-1 which the partnership prepares showing how the business divides its profit/loss for the year. Accountants may cost money, but often if no partner is a financial expert, they are at least needed when you start a business to make sure everything required is filled out properly and given to each partner to file with their returns.
Also, like with a sole proprietorship, you are each responsible for paying your “quarterly” estimated taxes. This means that Uncle Sam isn’t going to wait until April when you file your 1040 and attachments to get his money. Each April 15, June 15, September 15, and January 15 you must send in an estimated amount of taxes for that year, and then by April 15th of the following year, send in 1040 showing if you guessed right, overpaid, and need a refund, or hopefully not underpaid and owe more (with a penalty if too grossly underpaid).
Partnerships and Self-Employment Tax
As if Uncle Sam wasn’t already dipping in your funds, he wants each partner to pay for being self-employed (since no boss to do it for you) to take care of Social Security and Medicare taxes.
Self-employment taxes (at the time of writing this) are 15.3% of each partner’s percent of net earnings. That is divided as 12.4% for Social Security tax and 2.9% for Medicare tax. And again, this is over and above income tax…not a replacement for it.
You only pay Social Security on the first $137,700 you make currently, so that’s good news if you are killing it in your business. (On I side note if you are making that amount 1. Move to a better business structure to save on this and 2. If you are looking for somewhere to spend it, I am always available for donations. LOL)
You need to add to your 1040 and Schedule K-1, a Schedule SE where you calculate your self-employment tax amount.
So Todd, What are the Advantages of a Partnership?
- Partnerships are easy and inexpensive to start, especially general partnerships
- Easy to convert later as need for protection grows
- Shared burden of business losses
Alright, and the Disadvantages of a Partnership?
- Personal liability for business’s liabilities (true with all 3)
- Each general partner could be 100% liable for business’s liabilities
- Problems arise with multiple decision-makers
Final Word
So, what is my final word? If your partnership is in a low-risk job, where you don’t have to have a lot of upfront cost, a low chance of the business being sued, or none of you have a lot of personal assets yet to be risked, a general partnership is a cost-effective great starter structure that you can move into a more protected structure like a Limited Liability Partnership (or LLC or Corporation) as you begin to grow the business, increase chances of being sued, or start to personally have assets that need protecting.
If one or more partners are really just looking for an investment with a partner who will run the business but needs their contributions, a limited Partnership might be just what you are looking for.
If all the owners are going to be contributing to the day-to-day, and are willing to exchange the limiting liability for the more structured model, LLP is what you are looking for, at least until you grow to need an LLC or Corporate structure.
Like a sole proprietorship, partnerships are an easy and inexpensive structure for two or more owners to start, but take some of the burdens off of total responsibility for funding, losses, and can share work to make it successful.
It is also my advice to file with the IRS for an EIN. Not only does it look more professional, but it might be required to apply for loans or credit cards.
If you missed my article on sole proprietorship, here is another chance.
To see the next on the “Easy Guide to 4 Types of Business Structures” click the button below.
