Starting a business as a partnership: Partnership = Marriage
Updated: Dec 7, 2021
A successful business partnership is similar to a good marriage. Both partners request not just short term mutual interest but long term compatibility. Each partner needs to put in the effort to strengthen the partnership, to develop the partnership in the long run, and to move on to the next stage. However, compatibility from the partnership doesn’t mean being exactly of agreeing to everything on what other partner does. I have seen a lot of successful business partnerships, their operational method involve some give and take. They might have an argument in the meeting, but their goals are always to help the partnership.
It is a good metaphor to compare a business partnership with a marriage. In general, one person can’t make all the decision in the partnership, the same as a marriage. Each partner needs compatible values and vision, compatible financial resource and expectations, and compatible goals.
In this article, we will look at the structure and taxation of a partnership.
Starting a partnership
You may be starting your partnership with one or more other owners. There are several decisions you will need to make about the roles, responsibilities, and payments regarding these members. First, you need to decide how much initial partner must contribute, and how much new partners in the future will contribute. In term of contribution, it could be money, property, and/or labor hours. For instance, a partner is going to work for free for the partnership in exchange of 50% of the partner share. Second, you need to decide what types of partners you want in the partnership. You can be a general partner, who do the work and make decisions, or you can be a limited partner, who contribute but don’t make the day-to-day decision. Third, you need to decide what of part the profit does each partner get. In general, profits of the partnership are divided between partners according to their contribution or percentage of partner share in the partnership. Obviously, partners will share the losses of the partnership in the same percentage.
Advantage of partnership
The partnership is easy and inexpensive to set up. There are no formal or legal steps required in forming a partnership, unlike forming a corporation, for which you have to file with your state government. However, if your business entity is currently LLC, and you have more than one member, your business will be treated as a partnership.
It is another way to attract prospective employees or "talent." A business potentially can reach new heights when complementary skill sets are gathered under a partnership. A partnership can also serve as an incentive to attract new employees if they realize they may become partners at some point. For example, any large public accounting firm can be the best example of a business partnership. They initially offer positions as an employee to the accountants and wait until they see the real talent from some outstanding accountant, so they offer the opportunity for the outstanding accountants to become part of the firm as partners.
Disadvantages of a partnership
Perhaps the biggest drawback is that each partner is jointly and severally liable for the debts and obligations of the business. If a creditor sue a single partner for all of the partnership debt owed and this partner is responsible for paying the full amount to the creditor. Once a partner pays off the creditor, he or she can seek "contribution" from the other partners.
Any asset you contribute to the partnership is jointly owned by you and your partners, and there's no assurance you will get it back when the partnership is dissolved.
Any time you share decision-making responsibilities with other parties; there is the potential for disagreements. Partners are co-owners and that means they share management and financial control over the business. As mentioned before, the partnership is similar to a marriage. One person can’t make a decision for all. Therefore, disagreement and argument always happen in partnership.
In the worst case of closing the partnership, you still need to get approval from another partner. Partners can withdraw, how much notice they must provide, and how the assets will be distributed. This section may also deal with other issues, such as what happens if one partner retires, goes bankrupt, becomes disabled, or dies. When such events occur, the departing partner's share of a business doesn't automatically get divided between the remaining partners. It is an asset that may be transferred by law to someone (such as a deceased partner's heirs, or to the partner's ex-spouse in a divorce proceeding) that you don't want to be partners with.
How Partnership Are Taxed
Partnerships themselves are not actually subject to Federal income tax. Instead, they are similar to sole proprietorships, which are pass-through entities. While the partnership itself is not taxed on its income, each of the partners will be taxed upon his or her share of the income from the partnership.
Filing Tax Returns: 1065 & Schedule K-1
Even though the partnership itself does not pay income taxes, it must file Form 1065 with the IRS. This form is an informational return the IRS reviews to determine whether the partners are reporting their income correctly. The partnership must also provide a Schedule K-1 to the IRS and to each partner, which breaks down each partner's share of the business's profits and losses. In turn, each partner reports this profit and loss information on his or her individual tax return (Form 1040), with Schedule E attached.
For example, John and Adam own and operate a partnership. Their partnership agreement states that they’re each entitled to exactly 50% of the partnership’s income. If on Schedule K, the partnership shows ordinary business income of $50,000 and interest income of $200, each partner’s Schedule K-1 will reflect $25,000 of ordinary business income and $100 of interest income. This income will eventually show up on each partner’s regular income tax return (Form 1040).
Self-Employment Tax for Partnerships
If you are actively involved in running a partnership, in addition to income taxes, the IRS requires you to pay "self-employment" taxes on all partnership profits allocated to you. Self-employment taxes consist of contributions to the Social Security and Medicare programs, similar to the payroll taxes employees must pay. This makes sense given the rule that we just discussed income maintaining its classification when allocated to a partner on his or her K-1.
What if no distribution to partners, do they need to pay taxes? (Allocated Profit vs. Distributed Profit)
One thing that surprises the owners of many partnerships when their first tax season rolls around is the fact that partners get taxed on their allocated share of the partnership’s profit, even if nothing was distributed to them.
For example: John, Alvin, and Adam start a partnership. Their partnership agreement states the profit or loss will be evenly allocated to the partners.
In the first year, their partnership makes $120,000. However, they are sure that their business could grow quickly if they had the capital, so they decide not to distribute any cash to the partners. Instead, they make plans to use all $120,000 to buy new equipment next year.
Although the fact that none of the partners actually receive any cash payout, they are each going to be a tax on $40,000 of business income (1/3 of the $120,000 total). Therefore, each is taxed on his or her allocated profit of $40,000 rather than his or her distributed profit, which is $0.
Bonus Section: Tax Cuts and Jobs Act
As a pass-through business entity owner, partners in a partnership may be able to deduct 20% of their business income with the 20% pass-through deduction established under the Tax Cuts and Jobs Act. For example, if you have $50,000 in pass-through income, you could qualify to deduct $10,000, reducing your income tax by wrapping $2,200 if you are in the 22% income tax bracket.
The pass-through deduction is a personal deduction partner can take on their Form 1040 whether or not itemize. It is not an “above the line” deduction on the first page of Form 1040 that reduces the adjusted gross income (AGI). Moreover, the deduction only reduces income taxes, not Social Security or Medicare taxes.