You’ve ready to start your business and considering doing it with a friend. You’ve probably heard of a partnership going wrong. Unfortunately, it happens a lot. When you’re running your business with another person, there are things that will come up that wouldn’t if you were working alone. But, sometimes it makes sense to operate as a partnership. This article lays out what a partnership is, the advantages & disadvantages, how to form a partnership, and the tax implications. After reading, you’ll know whether a partnership is right for you, and if so, what things you need to look out for.
What is a partnership?
A partnership is when two or more persons engage in an activity with the intent to make a profit. There is no affirmative action required to create a partnership (unlike an LLC), so if you and a friend decide to start making & selling grilled cheese sandwiches-a partnership is automatically created.
There are two main types of partnerships: general and limited. A general partnership is created automatically when two (or more) people engage in an activity with the intent to make a profit. Notice I didn’t say when two (or more) people get together with the intent of starting a business. It really doesn’t matter if you didn’t intend to start a “business”. If you joined together to do something to make money-a general partnership is created. If nothing else is created to manage the business, everything will be assumed to be 50/50. This can be changed by agreement (more on that below).
A limited partnership is still a partnership, but the difference is it allows for a special class of partners called “limited partners”. Having a limited partnership allows you to open the business up to investors, but keeps them from being able to have an active part in running the business.
Another type of partnership-like entity is the joint venture. A joint venture is similar to a general partnership, but it’s limited to a specific time period or specific project.
For the purposes of this article, we are going to talk about general partnerships. In a limited partnership many of these things don’t apply, because it allows for liability protection, requires filing a Certificate of Limited Partnership with the state, among other things.
How do you create a partnership?
Like a sole proprietorship, a general partnership is created automatically when two or more persons join together to engage in activity with the purpose of making money. Note-it doesn’t matter whether the partnership is profitable or not, just that the purpose for starting was to make money. General partnerships can be created even if the parties don’t intend on starting a business. For example, two friends get together and start discussing a business idea. Maybe they purchase a piece of equipment, discuss some more, but don’t really take it any further. Partner 1 takes the business idea and runs with it and becomes very successful. Partner 2 decides he wants a piece of the business Partner 1 created. Partner 2 sues Partner 1 and wants the court to recognize a partnership between the two and award Partner 2 half of the business Partner 1 created. As with any lawsuit, it’s going to be highly dependent on the facts of the case, but it’s at possible the court would agree a partnership was created by the initial acts of Partners 1 and 2, and Partner 1 must share the profits with Partner 2.
How is a partnership managed?
The document that determines how a partnership is managed is called a partnership agreement. In a partnership agreement, the partners can make any agreements they want. Common terms are things like: disagreements, what each partner can/can’t do on behalf of the business, how profits/losses will be shared, etc.
Without a partnership agreement, there are general rules that will be applied. Some of those are: 50/50 ownership & profit; either partner can bind the partnership to a contract, loan, etc.; and each partner has a right to participate in the management of the business.
For some people, the general rule is what’s appropriate for their situation. But, it’s always a good idea to have a partnership agreement. So many businesses start with a couple of people pumped about a business idea and think they won’t ever have any problems or disagreements about the business. This is a recipe for disaster. It’s so much better to think out the details of your business arrangement while things are going well instead of when something bad has already happened.
What are the advantages of a partnership?
- Partnerships are really easy to create. You and a friend can decide to go into business together and you’re immediately a partnership.
- If you have a business idea that’s going to take more capital to get going than you have, finding a friend to go into business with you is a way to lighten your financial load getting started. Of course, you’ll be splitting profits too, but if lack of money would keep you from getting started in the first place it might be worth it.
- Your partner may have different skills they can bring to the business to make your business successful.
What are the disadvantages of a partnership?
- The biggest disadvantage of a partnership is the lack of liability protection. A partnership provides no protection for your personal assets. This is important for two reasons: (1) you are personally responsible for all creditors and (2) you are personally responsible for anyone who is legally harmed by your business.
- Partners are what’s called joint and severally liable for actions of all other partners. That means if your partner does something that gets you in trouble legally, you are both responsible for the full amount owed. For example, partner gets in a car wreck while working in your business. Other driver sues for $50,000. Not taking insurance into account, other driver can sue you either or both of you individually for the damages. They can’t recover from both of you, but if your partner doesn’t have as much money as you, the driver can recover the entire amount from you. Then, you have to go recover from the partner.
- Partnerships can be vulnerable to dissolving, because one partner may die or decide they want out of the business.
How is a partnership taxed?
Partnerships are taxed like sole proprietors. Each partner takes ½ of the income and losses (unless a partnership agreement states otherwise) and reports it on her income taxes. No additional tax returns are required.
Do I need an attorney?
Maybe. It’s really, really important to have a partnership agreement. There are probably form agreements online, but if you decide to go that route, be very careful and make sure you thoroughly read through the agreement and understand everything you’re agreeing to.
If you’ve decided a partnership is not for you, check out this post on LLCs to see if that’s a better fit for your business.
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