Frequently Asked Questions about Business Partnerships

A partnership is a business arrangement between two or more individuals that have not filed papers with their state to become a limited liability company (LLC) or corporation. A partnership is a very popular business arrangement since it is the simplest and least expensive way to create and maintain a business structure. However, there are some important facts that must be taken into account when setting up a partnership.

This guide will walk through the ins and outs of partnership creation and the most common questions that people have when setting up their own partnerships.

What is a Partnership and How is it Created?

A partnership is a business owned by two or more people that have not filed papers to become a corporation or LLC. No paperwork is necessary to create a partnership -- the arrangement begins as soon as the individuals involved start doing business with each other. Although not required by law, many partners work out the details of how they will manage their business and formalize their arrangement using a written Partnership Agreement. Without a partnership agreement, the laws of the state where the business is located will govern the partnership.

Partnerships must meet the same local registration requirements as any other new business in operation. Most counties and cities require that a business register with the county or city and pay a minimum tax. The partnership may also need to acquire an employment identification number (EIN) from the IRS, a seller's license from the state, and a zoning permit from the local planning board.

What's Included in a Partnership Agreement?

Each state has its own laws that govern partnerships, contained in the state's Uniform Partnership Act (the "UPA"). These statutes describe the basic laws and rules that apply to partnerships in that state and control many aspects of the partnership unless different rules are written into a partnership agreement. A thorough partnership agreement covers the following territory:

Name of the partnership -- One of the most essential elements of a partnership is agreeing on a name. The name of the partnership can be the names of the individuals who are part of the partnership or it can be a fictitious name. If it is a fictitious name, it should be a name that is not already in use by another business and registered with the county clerk.
Contributions to the partnership -- The partners should agree on, and then record in their partnership agreement, who will contribute monetary funds, property, and/or services to the business to get the business off the ground. This usually dictates what ownership percentage each partner will have.
Allocations of profits and losses -- The partners should decide whether profits and losses will be allocated to the partners in proportion to their interest in the business or using some other method.
Partner's authority -- If the partners want one or all of the partners to obtain the others' consent before binding the partnership to contracts or debts, this should be made clear in the partnership agreement.
Management structure -- Most partnership agreements work out guidelines to cover the management basics. For example, a partnership agreement might describe who is responsible for handling customer relations, keeping the books, training the employees, or dealing with suppliers and shippers. These details are specific to the needs of the particular partnership, but are prudent to include for the sake of clarity and avoiding future confusion.
Admission of new partners and exit of current partners -- As a business grows, the partners may consider bringing on new partners to invest and continue to expand the business. A partnership agreement can outline the process through which this can happen. Just as, if not more, important, the partnership agreement should also cover what will happen when current partners want to leave, either by choice or necessity. The agreement can describe the buyout arrangement that will allow partners, or their heirs, to disinvest and leave the partnership.
Dispute resolution -- Even the most solid partnerships have to deal with disagreements or disputes among the partners. To mitigate this stress, a partnership agreement can outline in advance how disagreements will be handled. For example, the agreement could require alternative dispute resolution, such as mediation or arbitration, before the partners wind up in court.

Is a Written Partnership Agreement Required for All Partnerships?

Though there are no laws specifying that partnerships must have a written partnership agreement in place, it is usually a good idea to do so. Without a written partnership agreement, the partners run the risk of having the default rules in their state's partnership laws govern the partnership in ways that the partners do not intend. Creating a written partnership agreement also gives the partners a chance to discuss their expectations of each other, define how they will each participate in the business, outline the responsibilities they will each take on, and help work out any other tricky issues before major problems crop up.

Are there Special Rules for Running a Partnership?

Partnerships are very popular because, unlike corporations, they involve relatively informal and straightforward business structures. Partnerships are not required to hold annual meetings, prepare corporate minutes, elect officers, or issue stock certificates. Generally, partners all share equally in the management of the partnership and its profits and losses. All partners assume equal responsibility for the debts and liabilities of the partnership. These and other details are typically outlined in a partnership agreement.

What is the Difference between a Limited Partnership and a General Partnership?

There are two different kinds of partnerships that can be formed. The most common sort of partnership is a general partnership where all partners participate in the daily management of the business to some extent.

Limited partnerships, however, have at least one general partner who controls the business' day to day operations and is personally responsible for the debts of the business, and passive partners that are also known as limited partners. Limited partners contribute investment money to the business but have minimal control over daily business decisions and operations. Limited partnerships are most often set up by companies that invest money in other businesses or real estate. In exchange for ceding management power and control, a limited partner's personal liability is limited solely to the amount they invested in the business. The limited partner's investment can be used to pay of partnership debts, but their personal assets cannot be touched to pay off the debts of the business. This is known as "limited liability." Limited partnerships can be very complicated and involve complex securities laws that often apply to the sale of shares in a limited partnership interest.

What is the Difference between a Partnership and a Limited Liability Company (LLC)?

When two or more people enter into a business, they form a partnership by default without needing to file any formal paperwork or have a written agreement. By contrast, forming an LLC involves business owners filing formal articles of organization with their state's LLC filing office, as well as complying with other state filing requirements.

Another major difference between these two business structures is that partners in a partnership are personally liable for any business debts of the partnership. This means that any creditors to whom the partnership owes money may go after all of the partner's personal assets. Members of an LLC are not personally liable for the company's debts and liabilities.

For more information about the different forms of business and how to decide which would be the best fit, please see the guide How to Choose the Best Legal Structure for your Business.

How are Partnerships Taxed?

For tax purposes, a partnership is not considered separate from the partners. Generally speaking, this means that the partnership itself is not required to pay any income taxes. Instead, partnership income "passes through" the business to each partner who then reports their share of the profits or losses from the business on their individual state and federal tax returns. As owners of a pass-through business entity, partners in a partnership often qualify for the 20% pass-through tax deduction established by the Tax Cuts and Jobs Act of 2017 (TCJA). Each partner must estimate their own personal taxes they will owe at the end of the year and make four quarterly estimated payments to the IRS accordingly.

So, for example, if a partnership makes a $10,000 profit with the partners splitting that equally, the partners would not be required to file taxes for the partnership itself. Instead, the partners would be required to report that partnership profit as income on their personal income tax statement, and then pay taxes on the money that way, minus the 20% pass-through tax deduction. This functions differently than other forms of businesses, such as corporations and LLCs, that are required to pay taxes through the business itself.

What Happens if a Partner Wants to Leave the Partnership?

Before going into business together, partners should discuss and decide what will happen to the partnership when one of the partners retires, dies, or decides to leave the partnership for some other reason, such as divorce, illness, moving, or bankruptcy. A Notice of Withdrawl from Partnership can be used by a partner who intends to voluntarily leave a partnership or if partners wish to eject a fellow partner from the partnership due to a breach of the partnership agreement. Further, having what is known as a "buy-sell" clause in a partnership agreement or a standalone Buy-Sell Agreement is prudent to deal ahead of time with these common issues. This way, resentments and misunderstandings are prevented and the chances of a messy lawsuit are limited.

A buy-sell clause, or buy-sell agreement, stipulates how a partner's share of the partnership may be reassigned if that partner leaves the business for some reason. Most often, the buy-sell clause stipulates that the available shares be sold to the remaining members of the partnership. They may also establish a method for determining the value of the business.

The most common buy-sell arrangements are cross-purchase and redemption. Cross-purchase agreements allow the remaining owners to buy the interests of the deceased or selling owner. Redemption agreements require the partnership to buy the interests of the selling partner. Other types of buy-sell arrangements are those that restrict who can purchase the interests of the leaving partner, such as family members, former partners, or other specified individuals.

Alternatively, the partners can decide to dissolve the partnership entirely if one of the partners decides to leave. This would entail the partners fulfilling any remaining business obligations, paying off all outstanding debts, and dividing any assets and/or profits amongst themselves. This process can be simplified by using a Partnership Dissolution Agreement.

Final Takeaways

A partnership is one of the most popular business structures due to its simplicity and ease. That being said, it's still important for partners to plan ahead and outline the contours of their partnership when they get into business with each other so everyone is on the same page. There are many common misconceptions about what a partnership entails and how it operates.

A partnership is a business owned by two or more people that have not filed papers to become a corporation or LLC.
A written partnership agreement is not required, but without a written partnership agreement, the partners run the risk of having the default rules in their state's partnership laws govern how their business operates.
Partnerships involve relatively informal and straightforward business structures.
There are two different forms of partnership.

In a general partnership, all partners participate in the day-to-day running of the business and are fully personally liable.
In a limited partnership, passive partners, also known as limited partners, contribute money but have limited control and are only liable to the amount they invested.

Unlike with a partnership, forming an LLC involves business owners filing formal articles of organization and members of an LLC are not personally liable for the company's debts and liabilities.
A partnership is not required to pay income taxes but the partners pay personal taxes on any income they make through the partnership.
Partners can leave the partnership either by dissolving the partnership itself or through a process outlined in a buy-sell agreement.

About the Author: Malissa Durham is a Legal Templates Programmer and Attorney at Wonder.Legal and is based in the U.S.A.