Partnerships: Rules and FAQ

on 06/02/2015 by David Szostek

Partnerships: Rules and FAQ

People or companies that conduct business together, but have not filed any formal organizational documents to obtain a corporation or other state-issued entity may be classified as a partnership, whether they intend to be one or not. Those can raise issues and about partnership transactions and potential liabilities that the participants may have never intended:

  • Partnership Definition

A partnership is an association of two or more persons who are co-owners and share profits. Partners can contribute money (a capital investment in the business project) or services in return for a share of the profits.

  • Creating a Partnership

There are no formalities for a business relationship to become a general partnership. You don’t have to have anything in writing. (Although there’s no requirement for a written partnership agreement, it is a good idea to have a written document). The key factors are that two or more people are carrying on as co-owners and sharing profits.

  • How partnerships are run

The only requirement is that, in the absence of a written agreement, partners don’t draw a salary and the partners share profits and losses equally. Partners have a duty of loyalty to the other partners and must not enrich themselves at the expense of the partnership.

Partners have a duty to provide financial accounting to the other partners.

A written partnership agreement could outline procedures for making major business decisions, how profits and losses will be split (if different than split evenly between the number of partners), and how much control each partner maintains.

  • Limited liability partnerships (LLP’s) must have a written document stating that a limited partner has invested money into the partnership and retains little or no control over the partnership’s operations. This way limited partners will not be held liable for the partnership’s debt obligations and the partnership won’t be influenced too greatly by the limited partner.
  • Personal liability for business obligations

Partners are personally liable for the business obligations of the partnership. If the partnership can’t afford to pay creditors or the business fails, the partners are individually responsible to pay for the debts and creditors can go after personal assets such as bank accounts, cars, and even homes.

  • Taxes

Taxes are paid through personal income tax filings of individual partners. As a partner, you have income through your share of the profits (or a loss if the partnership is losing money), and you report this income on your personal taxes. The partnership itself reports profits and losses to the IRS on a Form 1065 (so the IRS knows how much you receive), and you pay the taxes on your portion of those earnings). If your partnership earnings are from your active participation in the partnership’s activities, like if you work at a front counter of the partnership’s business regularly, you may also be subject to self-employment taxes on any partnership earnings. And since the partnership does not have to distribute its earnings, unless the partners make an agreement to the contrary, then a partner could have a tax liability from its partnership earnings, even if the partner never received any money from the partnership.

Contact us to avoid falling in this trap and to help determine the best entity choice for your particular situation and goals.