What is a partnership? This means different things in different situations. In this context, we’re discussing business partnerships from a legal and tax perspective.
What is a Partnership?
A partnership is a legal construct where two or more persons or entities work together with the intent to make a profit. That’s a mouthful! Fortunately, it ends up being a fairly easy concept in practice.
Types of Entities
As said above, partnerships require two or more persons or entities. These can be individuals or they can be companies. A partnership can even be a combination of people and businesses. What matters is that there’s more than one.
Intent to Make a Profit
In order to form a partnership, all you need is the intent to make a profit and a substantial step. This can be as simple as pitching an idea together or as complicated as building a network of vendors and customers. Scale doesn’t matter.
More often then it should, people end up creating accidental partnerships. These occur when people intend to work together, but don’t intend to be in business together. Often times, under the law, it does not matter. There’s nothing wrong with this except for the potential liability.
In a partnership, all partners are equally and personally liable for all debts and obligations of the company. Therefore, people try to avoid this entity type or find other ways to limit personal liability. Fortunately, you have many options.
One way to limit your personal liability in a partnership is to form a limited partnership. Limited Partnerships are almost an LLC except that they require at least one general partner to be personally liable for the debts of the company.
Partnerships are taxed as pass through entities, which is advantageous in many situations. The taxes of the entity pass through to the individual tax returns of the owners. When the taxes pass through, they maintain their tax treatment. This means that a royalty to the company remains a royalty to the owner for tax purposes. Royalties have lower taxes than earned income.
Here are some examples of partnerships:
- The traditional partnership is when two people agree to go into business together, get a bank account, and provide a good or service.
- Two companies agree to hold a conference together or earn ticket sales.
- An independent contractor and a company get together to sell a new product together.
Some of these examples can be limited through contract law. Instead of being a partnership, they can become that of a company and a contractor.
My best advice is whenever you want to go into business together with someone, you discuss forming an entity to be the business right away. Take away as much of that liability as you can.
Beyond that, I highly recommend a partnership agreement to define the terms outright. These do not need to be complicated. Instead, write them in a words you both understand.
I try to avoid partnerships whenever possible, but they’re not the end of the world. Instead, you should take caution or seek advice before entering into one.