Partnerships: What Entrepreneurs and Business Owners Need to Know

Partnerships have long been a widely used business entity, providing a relatively simple structure that allows multiple owners to become partners. They’re among the most popular entity structures in the United States and are used by a variety of companies, most notably professional services firms.

Partnerships are relatively easy to establish, creating a framework that allows business partners to share in the profits, liabilities, and governance of a business. They offer a range of tax benefits and are not subject to many of the regulations that corporations must comply with.

There are several types of partnerships, each with their own unique qualities. To determine whether a partnership is the right fit for their business, as well as to determine the most appropriate partnership structure, entrepreneurs should have a basic understanding of these characteristics.

In this overview, we focus on the different types of partnerships, explaining the key differences that business owners need to be aware of, both from a tax and a non-tax perspective.

This article is part of our series on entity selection. View our other articles here:

What is a Partnership?

According to the IRS, a partnership is “the relationship between two or more people to do trade or business. Each person contributes money, property, labor, or skill, and shares in the profits and losses of the business”.

Partnerships tend to be a good fit for companies with multiple owners that are relatively low-risk, stable businesses. They’re popular with professional service firms, including attorneys, consultants, architects, and others. Since they’re relatively easy to establish, many entrepreneurs begin their business as a partnership before converting to a more formal business structure once they have clarified their strategic goals.

Typically, partnerships are not registered with the federal government upon their formation, although entrepreneurs are required to register with the state and obtain any relevant business permits and licenses. When setting up this entity structure, business owners should draft a partnership agreement that defines the terms of their partnership. This document also defines the type of partnership the business will be structured as.

Common Types of Partnerships

There are several distinct types of partnerships that entrepreneurs should be aware of. They include:

General Partnership: in a general partnership, every owner bears equal legal and financial responsibility for the business and its liabilities. Profits are shared based on ownership % and would be defined in the partnership agreement. Personal liability is shared amongst the partners.

Limited Partnership: these partnerships have both a General Partner(s) and a Limited Partner(s). General Partners manage the day-to-day operations of the business and have personal liability, whereas Limited Partners are silent partners that invest in the business but do not have rights to make operational decisions. Limited partners generally do not have personal liability for any business debts.

Limited Liability Partnership (LLP): many professional service firms use LLPs. A LLP is the same as a general partnership, however as the name suggests, these partnerships limit the personal liability of partners to the amount they have invested in the business.

Limited Liability Limited Partnership (LLLP): A limited liability limited partnership is generally the same as a limited partnership. However, with this structure both general partners and limited partners may have some limited personal liability protections.

How Are Partnerships Taxed?

Partnerships are flow-through entities, meaning that the partnership itself does not pay tax. Instead, the tax responsibilities pass through to the partners, who are responsible for reporting their share of the partnership’s profits (or losses) on their personal income tax returns. Various expense deductions and tax credits may be applied to reduce these profits.

While this flow-through treatment can be favorable, partnership owners are not able to leverage many of the tax planning opportunities available to shareholders in C Corporations, such as the Qualified Small Business Stock Exclusion (QSBS). Partners must also pay taxes on profits, even if this money is left in the business as retained earnings or working capital.

Partners are not considered employees and do not receive a W-2 but instead receive Guaranteed Payments. They are considered self-employed individuals and are therefore liable for various self-employment taxes including Social Security and Medicare on their Guaranteed Payments and in many cases their allocation of profits front the partnership.

Although partnerships themselves do not pay tax, they must file an informational return that discloses the income, deductions, gains, and losses realized by the partnership. This filing, IRS Form 1065, U.S. Return of Partnership Income, must be filed by March 15th of the following tax year.

Non-Tax Considerations for Partnerships

A partnership can begin with a handshake or a verbal agreement, but it’s extremely important to have the terms of your partnership agreement documented in writing. This partnership agreement document defines the terms of your partnership: from the profits each partner will receive to what happens in the event a partner leaves the partnership.

As business partners weigh the most appropriate form of partnership for their entity, there are several non-tax issues they should consider. These include:

Skills of Other Partners: different partners often bring their own value, whether that’s a niche professional specialism or a large existing book of business. Make sure each partner brings an appropriate amount of value to the business before adding them to the partnership.

Liability: some partnership models leave all partners exposed to personal liability for the actions of other partners, whereas others provide more protection. Gauge the liability risk of your business before determining the most appropriate partnership structure.

Investors: if your business requires investment, a Limited Partnership model where investors serve as silent partners might be the best fit. If you plan to go it alone, other models typically make more sense.

Future Plans: as your business grows, you may wish to add new partners to the fold, either by promoting existing employees or attracting external talent. The procedure for this should be documented in the partnership agreement. Partners should also consider their long-term plans for the business and ensure they are aligned on their strategic goals.

Smith + Howard: Experienced Entity Structure Advisors

Opting to go with a partnership entity structure is a move that makes sense for many businesses, particularly those in the professional services industry or those at an early stage. But it’s a decision that comes with a lot of considerations, and it’s important that entrepreneurs have the right advice to make the best call for their business.

At Smith + Howard, our tax professionals have an extensive track record of advising entrepreneurs and business owners across a wide range of industries and maturity stages. We take a tailored approach centered around helping our clients achieve their long-term goals, and understand the importance of entity selection in achieving those.
Balancing tax planning concerns with operational considerations, our team will work closely with yours to help you determine the optimal entity structure for your business.

To start the process, contact a Smith + Howard advisor today.