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