In our study of the prevalent business structures you may wonder what options are available for entrepreneurs who go into business together. We’ll discuss one of the options as we answer the question, What is a Partnership Business?
A partnership is a relationship existing between two or more persons who agree to carry on a trade or business. Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business.
This is a concise partnership definition. Below I’ll discuss in greater detail what a partnership business is.
Types of General Partnership Businesses
The partnership is one of the oldest business organizations known to the commercial world. Before we get started, it’s important to understand that there are four main types of partnerships:
- General partnership (discussed in detail below)
- Limited partnership
- Limited liability partnership
- Limited Liability Limited Partnership
Although each of these entities shares several common characteristics, they each have distinct and unique features that set them apart from each from both a legal and financial perspective.
In this article, we’re going to limit our focus on the first and most basic class of partnership: the General Partnership. So, keep reading to learn all about this business structure, including some of its key legal and financial features and the benefits and drawbacks of using it.
Note: I am a small business owner who writes on business-related topics. Such topics often include legal elements. The information here is not legal advice. Utilize the topics here in preparation for your discussion with your legal counsel.
What is a Partnership Business
The general partnership has a very straightforward and remarkably broad definition that consists of four elements. A general partnership is, quite simply:
- an agreement
- between two or more people
- to carry on a business together as co-owners
- for a profit.
Thus, as long as these elements are fulfilled, intentionally or unintentionally, those two or more persons have formed a partnership.
How is a Business Partnership Formed
As we alluded to above, forming a partnership is remarkably easy. Indeed, a pair of entrepreneurs could even form a partnership accidentally without even knowing it! This feature of the general partnership has some legal implications that are quite far-reaching, and we’ll look at those in a bit more detail later on. But for now, it’s enough to know that as long as the four elements of a general partnership are fulfilled, the persons who have fulfilled those elements will be seen as partners in the eyes of the law.
Is a Business Partnership a Business Entity
If you’re a frequent reader of this site, you likely understand that other business entities such as LLCs and corporations are distinct legal entities that the law recognizes as separate and apart from their owners.
General partnerships, by contrast, are not separate legal entities. In other words, a general partnership is not its own legal “person” like a corporation or an LLC. Rather, general partnerships are simply legal arrangements that create rights and liabilities between the partners themselves and between the partners and third parties that they do business with.
Examples of a Partnership Business
Because general partnerships offer no liability protection for their partners (more on this shortly), it is exceedingly rare for businesses to operate as a general partnership in today’s modern business world. Even quintessential businesses that we think of as “partnerships,” such as law firms or accounting firms, are in reality almost always structured as Limited Liability Partnerships, LLCs, or Professional Corporations, not general partnerships.
Still, it’s quite easy to lay out an example of a general partnership, and an example helps illustrate the overall concept of a general partnership.
Let’s assume that you and your friend are looking for a way to make a little extra money on the weekends. You both enjoy mowing lawns, so you get together and decide to go knock on a few doors in your neighborhood offering to mow your neighbor’s lawns for a set fee. The two of you have likely formed a general partnership because (1) the two of you; (2) made an agreement; (3) to carry on a business together as co-owners; (4) for profit.
By contrast, if you and your friend independently went around offering to mow your neighbor’s lawns for a fee, you would not have formed a partnership because you didn’t agree to pursue the business together (instead, you created a sole proprietorship. Also, if you and your friend simply volunteered to mow your neighbor’s lawns together for no fee, you likewise would not have created a partnership because you did not agree to pursue your lawn mowing venture for profit.
Finally, if you agreed to employ your friend in pursuit of your lawn mowing business, you likely would not have formed a general partnership because the two of you did not agree to pursue the business together as co-owners. In the case there is one owner and one employee.
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How Much does it Cost to Start a General Partnership
Because a general partnership is not a separate legal entity that relies on the power of the state for recognition, it costs nothing to “form” a partnership.
There are, however, certain expenses that any prudent partner should incur if he or she is serious about operating his or her business as a general partnership.
The most important of these expenses would be the cost of hiring an attorney to draft a partnership agreement. The partnership agreement is essentially a contract between the partners that sets out the internal rules by which the partnership will operate. These include matters such as management responsibilities, compensation, and dissolution of the partnership.
So, while it technically costs nothing to form a general partnership (partners are not required to pay a filing fee, or have their entity recognized by the state), the partners should, at the very least, spend the money to hire an attorney to draft a comprehensive partnership agreement that sets out the rights and responsibilities of each of the partners.
Ownership of General Partnership
General partnerships, as you can probably guess, are owned by the partners, and the law assumes each partner has an equal ownership stake in the partnership absent of a partnership agreement.
The partners can, of course, provide for a different arrangement in their partnership agreement. But absent a different arrangement between the partners, each one is deemed to own an equal share of business, thereby entitling them each to an equal share of the profits and rendering them liable for an equal share of the expenses. This should further indicate the importance of a comprehensive partnership agreement.
General Partnerships and Liability
Before we go any further, it’s very important to understand the key feature of a general partnership: unlimited personal liability of the partners. While entities such as LLCs and corporations shield their owners from personal liability in most situations, general partnerships offer no such protection.
Each partner in a general partnership is personally responsible for all the debts and liabilities of the partnership regardless of which partner incurred the debt. The legal term for this concept is “joint and several liability.”
To illustrate, let’s return to the lawn mowing example set out above. Say your partner mows a lawn, but accidentally runs over the client’s roses, causing $100 in damage. The client could, of course, sue your partner for those damages. But the client could also sue you even though your partner was the one that caused the damage. And even though $100 is a relatively minor sum, general partners’ personal liability is unlimited.
So, let’s change the facts a bit. Instead of the flowers being run-of-the-mill roses that the client could replace at the local greenhouse, let’s say they are world-class, one-of-a-kind, award-winning roses, and destroying them caused $100,000 in damage. Let’s also assume that you own a home or other assets, while your partner rents his home and does not have any other assets. Assuming the client wins his lawsuit, they could then place a lien on your home or other assets in order to satisfy the judgment.
That’s what we mean by “personal liability.” It means that if the partnership owes money to a third party for any reason, whether it’s payment due on a contract, a legal judgment, or any other reason, that third party can seek to collect the sum out of the assets of any of the partners.
How is a General Partnership Taxed
Because general partnerships are not distinct legal entities, they are not taxed separately from their owners. Instead, all partnership income is “passed through” to the partners, according to the partnership agreement. The partners then pay individual income tax based on the distributions they receive from the partnership.
General Partnership Tax Rate
Additionally, because partnership income is taxed at the individual level, it will be taxed at whatever rate the receiving partner is subject to. Accordingly, the partnership’s income will be taxed at a rate of 10% to 37% based on the total adjusted gross income of each partner.
You can find a complete breakdown of the 2020 tax brackets and marginal income tax rates from the IRS here.
How frequently are General Partnerships Taxed
General partnerships are typically taxed just once per year when each partner files their individual income tax return. General partnerships can elect to be taxed as S-corporations, which may result in quarterly tax liability in some situations. But in general, the partners’ taxes are due only once per year.
It also bears noting that general partners are responsible for paying both income tax and the self-employment tax. The self-employment tax rate consists of a 12.4% Social Security tax and a 2.9% Medicare tax, resulting in an overall rate of 15.3% for 2020. Self-employment tax is due on 92.35% of net profit (gross revenue less business expenses, IRS). The 12.4% Social Security tax, however, is due only on the first $137,700 of self-employment income.
How are General Partners Compensated
General partners are compensated as agreed in their partnership agreement. The textbook example of general partnership compensation involves the partners splitting expenses, then dividing up the remaining profits proportionally among themselves and receiving a “distribution” of those profits either periodically throughout the year or in a lump sum.
Partners, however, can also agree to pay each other a set salary, then divide any remaining profit as a bonus as they see fit.
General Partnership Investment Opportunities
General partnerships, by their very nature, are not great great business structures for outside investors. Recall that a general partnership is nothing more than an agreement between two or more people to carry on a business together as co-owners for profit.
Thus, if an outside party invested in a general partnership, they would simply become another general partner because, by investing money, the investor is agreeing to jointly pursue the for-profit business venture with the other partners, regardless of the level of involvement the investor intends to have in the day-to-day management of the business.
Lifespan of a General Partnership
General partnerships exist as long as the partners continue pursuing the business. This is to say that although general partnerships do not technically exist in perpetuity like corporations do, it nevertheless requires some action in order to dissolve a general partnership.
The action that triggers dissolution may be intentional, but it does not have to be. A partner could choose to leave a partnership, thereby dissolving the partnership. But a partner could also pass away or become legally incapacitated. Either of those actions, while unintentional, would likewise dissolve the partnership.
Partnerships are also subject to judicial dissolution, meaning one or more of the partners goes to court seeking an order to dissolve the partnership. This typically happens if one or more partners materially breaches the partnership agreement and the partners cannot reconcile their differences.
Requirements for Maintaining a General Partnership
As you can probably discern from the preceding section, partners in general need only to remain in agreement to pursue a for-profit business venture together in order for a general partnership’s existence to continue.
As long as the elements of partnership that were agreed upon continue to exist, so too will the general partnership.
General Partnership Advantages & Disadvantages
We hope you’ve gotten a sense of the advantages and disadvantages of a general partnership so far. But we’ll set out the main points in the table below for quick reference:
Pros:
- Easy and inexpensive to form
- Pass-through taxation
- Easy to dissolve
Cons:
- Unlimited joint and several liability
- Difficult for third parties to investors
Conclusion
We’ve answered the question, what is a partnership business. General partnerships are one of the oldest types of business structures. It provides a way for two or more people to combine their talents and expertise in pursuit of a joint venture. However, it is quite antiquated compared to modern business structures. In most circumstances, the burden of filing fees and increased administrative complexities associated with limited liability entities outweighs the risks of assuming liability for your partners’ actions.
In the past, general partnerships were attractive because of their pass-through taxation. But now that limited liability entities exist that also enjoy pass-through taxation, general partnerships are becoming less and less common.
Note: This article is written based on the definitions established here in the United States of America. Similar business structures exist worldwide. Definitions are different and nuanced based on the jurisdiction in which you reside.
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Sources:
- IRS: Partnerships
- IRS: Self-Employment Tax