Understanding Partnerships: Types, Taxation, and How They Work

Last updated 04/09/2024 by

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Summary:

Partnerships are a popular business structure that allows two or more people to share ownership and management of a company. There are several types of partnerships, each with its own unique characteristics and tax implications.

Whether you’re looking to start a business with some friends or just one co-worker, you’ll need to choose a business structure that’s right for you. In addition to S corps and LLCs, you can also opt for a partnership.

Today, we’ll take a closer look at partnerships, how they work, and the advantages and disadvantages of this business structure.

What is a partnership?

A partnership is a business entity where two or more people, known as partners, decide to run a business together. In a partnership, each partner contributes money, property, labor, or skills to the business. In exchange, they share in the profits and losses of the company.

Partnerships can be formed for any legal business purpose, and they can be between individuals, corporations, or other partnerships. There are several kinds of partnerships, some of which we’ll discuss below. That said, each type of partnership has its own advantages and disadvantages. Before forming a partnership, consider consulting with an attorney or tax advisor to determine which type of partnership is best for your business.

Types of partnership

Partnerships come in different forms, each with its unique features and legal implications. Choosing the right type of partnership for your business depends on your specific needs and goals.

General partnership. A general partnership is the most common type of partnership. In a general partnership, all partners share equal responsibility for the business’s management and debt obligations. Each partner is also liable for the other partner’s actions within the scope of the business.
Limited partnership. A limited partnership has two types of partners: general partners and limited partners. General partners manage the business and are personally liable for the company’s debts and obligations. Limited partners, on the other hand, are passive investors who contribute capital but have no control over the business’s management. They’re only liable for the company’s debts and obligations up to the amount they invested.
Limited liability partnership. A limited liability partnership (LLP) is a partnership in which all partners have limited liability for the business’s debts and obligations. This type of partnership provides more protection for partners’ personal assets than a general partnership. LLPs are popular among professional services firms, such as law and accounting firms.
Joint venture. A joint venture is a partnership between two or more parties to carry out a specific business venture. Joint ventures are typically formed for a short period and for a specific purpose. Each party contributes capital, expertise, or other resources to the venture and shares the profits and losses.
Silent partnership. A silent partnership, also known as a sleeping partner, is a type of partnership in which one partner provides capital but has no involvement in the business’s management or operations. The silent partner shares in the profits and losses of the business but is not liable for its debts and obligations.

Partnership taxation

Partnerships are popular business structures because they allow for shared ownership and liability among partners. However, one of the most significant advantages of a partnership is how it’s taxed.

In a partnership, the business itself isn’t taxed. Instead, the partners are taxed on their share of the partnership’s income. This type of taxation is called pass-through taxation.

Pass-through taxation

Pass-through taxation is the default taxation method for partnerships. This means that the partnership itself does not pay federal income tax. Instead, the profits and losses of the partnership are “passed through” to the partners, who report them on their individual tax returns.

Each partner’s share of the partnership’s income, gains, losses, deductions, and credits are reported on Schedule K-1 (Form 1065), which each partner attaches to their personal tax return. The partners then pay taxes on their share of the partnership’s income at their individual tax rates.

Self-employment tax

In addition to income tax, partners are also subject to self-employment tax. Self-employment tax is a tax that is paid by individuals who work for themselves, such as sole proprietors and partners in a partnership. The tax funds Social Security and Medicare programs.

Partners are considered self-employed and are therefore subject to self-employment tax, which partners must pay on their share of the partnership’s net earnings.

IMPORTANT! It’s worth noting that general partners are subject to self-employment tax on all of their earnings from the partnership. Limited partners, on the other hand, are only subject to self-employment tax on their guaranteed payments and their share of the partnership’s profits if they participate in the partnership’s management.

Advantages and disadvantages of partnerships

Partnerships are a popular business structure for many reasons, even though they come with some downsides. Before forming a business structure like this, make sure you consider both the advantages and disadvantages.

WEIGH THE RISKS AND BENEFITS

Here is a list of the benefits and drawbacks to consider.

Pros

Shared responsibility. In a partnership, partners share the workload and financial responsibility.
Shared risk. This type of business allows for shared liability, meaning that if the business runs into financial or legal trouble, the partners share the burden.
Combined skills and expertise. Partnerships allow for partners with different skills and expertise to come together to start and run a business.
Tax benefits. Partnerships are taxed as pass-through entities, meaning that the partnership itself does not pay taxes. Instead, the profits and losses of the business pass through to the partners, who report them on their individual tax returns.

Cons

Shared profits. Partnerships require that partners share profits, which can cause conflict if partners have different ideas about how the profits should be divided.
Shared decision-making. This business structure requires that major business decisions are made jointly, which can slow down the decision-making process.
Shared liability. Partnerships also mean shared liability, which means that each partner is personally responsible for the debts and obligations of the business.
Personal issues. Since everyone works together in a partnership, this business model can be affected by personal issues, such as disputes between partners or changes in personal circumstances.

How to form a partnership

Forming a partnership involves several steps. Here’s a general overview of the process:

Choose a business name. Partners should choose a unique name that reflects the nature of their business. After that, they should also check to make sure that the name is not already in use.
Draft a partnership agreement. A partnership agreement outlines the terms of the partnership, including how the partners will divide profits and losses, the roles and responsibilities of each partner, and how the partnership will be dissolved if necessary.
Register the partnership. Partnerships must register with their state’s Secretary of State’s office. They’ll need to file the necessary paperwork and pay a fee.
Obtain necessary licenses and permits. Depending on the nature of the business, partners may need to obtain licenses and permits from local or state government agencies.
Obtain an EIN. Partnerships must obtain an Employer Identification Number (EIN) from the IRS. This number identifies the partnership for tax purposes.
Open a business bank account. Partnerships should open a separate bank account for the business to keep personal and business finances separate.
File necessary tax forms. Partnerships must file an annual partnership tax return (Form 1065) with the IRS. Each partner will receive a Schedule K-1 form, which shows their share of the partnership’s income, deductions, and credits.

FAQs

Can a partnership have more than two partners?

Yes, a partnership can have more than two partners. In fact, partnerships can have any number of partners, and the partnership agreement should outline the roles, responsibilities, and profit-sharing arrangements among all partners.

Can a partnership be taxed as a corporation?

Yes, a partnership can choose to be taxed as a corporation by filing Form 8832 with the IRS. However, this is not common and should only be done after consulting with a tax professional.

Can a partner have limited liability in a partnership?

Yes, in a limited partnership (LP), there can be general partners who have unlimited liability and limited partners who have limited liability.

Can a partnership be dissolved easily?

It depends on the terms outlined in the partnership agreement. If the agreement outlines an easy dissolution process, then it can be straightforward. However, if the agreement is silent on the dissolution process or outlines a complex process, it can be more difficult.

Key Takeaways

A partnership is a type of business where two or more individuals share ownership and profits.
There are different types of partnerships, including general partnerships, limited partnerships, and limited liability partnerships.
Partnerships have pass-through taxation, meaning profits and losses are passed on to the partners and are taxed on their personal tax returns.
To form a partnership, partners should draft a partnership agreement outlining roles, responsibilities, and profit-sharing arrangements.

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