A partnership is a type of business entity used by business owners to share in the day-to-day responsibilities and profits of a business. It is one of the simplest types of business formations. No formal state filing is required to form a partnership. However, some states require the partnership to register with the state. Generally, when one enters a business with another person, a partnership is formed. This is true whether or not there is an intention to form a partnership or whether a formal written agreement exists. The partners govern and manage the business equally regardless of their initial investments unless a written agreement states differently.
Advantages of Partnerships
A primary advantage of a partnership is that of taxation. A partnership does not pay federal or state taxes, but must file a statement of each partner’s yearly profits and losses. There is no “double taxation” involved with a partnership. (“Double taxation” occurs when both an individual and a business are taxed on the same income.) In partnerships, the profits and losses are “passed-through” to the individual partner. That partner then claims income or deducts losses on his tax return based on his proportionate share of the partnership’s income or losses. Partners are also required to pay estimated taxes and self-employment taxes.
Sometimes the general partners of a partnership will form an LLC (limited liability company) or corporation to act as the general partner. In this way, the partnership is shielded from liability for lawsuits and the debts of the business.
Another advantage of a partnership is that money can be raised for the new business through each of the partner’s contributing capital. More money and employees may be attracted to the business through the possibility of partnership being offered to those employees in the future.
Disadvantages of Partnerships
Partners, while sharing in joint authority, also share in joint liability. This means that one partner can make a decision that binds the remaining partners. There are some decisions a partner is precluded from making on their own. However, if a person relies upon the partner’s representation that a partner has authority to make certain decisions, the entire partnership may be held liable for those decisions.
In some states, under the theory of joint and several liability, a creditor of the partnership may seek relief against one or all of the partners to satisfy a debt. A partner’s only recourse is to seek a proportional payment from the remaining partners.
Another disadvantage to a partnership is that the IRS limits the deductions that may be taken for health and life insurance. Last but not least, as the partnership takes on additional partners, the possibility of disagreement among the partners also increases.
A partnership is a form of business that is commonly used. However, a partner has unlimited personal liability for the partnership’s liabilities and the decisions of the other partners. Choosing appropriate and responsible partners is critical in beginning a new partnership. Also of great importance is placing the rights and responsibilities of each partner into a formal written agreement to minimize friction and future unintended consequences.