A partnership is a business structure where two or more individuals or entities come together to conduct a business venture. Each partner contributes money, property, skills, or labor to the business and shares profits and losses. Most partnerships have an agreement that states every partner’s rights and responsibilities, how much ownership each has, and how profits and losses are split. If you start a partnership and want to end it, then you can exit the arrangement by dissolving the partnership.
Key Takeaways
- Partnerships involve two or more individuals, corporations, or other entities coming together to form a business.
- General partnerships have only general partners, whereas a limited partnership (LP) has at least one limited partner and one general partner.
- Limited partners are like investors. They are only liable for partnership debts to the extent of their investment and are not allowed to participate in the management of the partnership.
- Partnerships must file an annual tax return on IRS Form 1065. Information from Form 1065 is summarized and allocated to each partner on Schedule K-1, which is then used by the partner to report the income on their tax return.
- Partners share in the profits and losses of the business in whatever way they agree upon—not necessarily based on ownership percentage.
Advantages & Disadvantages of the Partnership Business Structure
| Advantages | Disadvantages |
|---|---|
| Partnerships enable two or more people to pool their resources and talents to start a business. | All of the partners are personally liable for the debts and liabilities of the business. |
| Any new partner is not personally liable for obligations arising before joining the partnership. | If one partner does something illegal or unethical, then the other partners can be held responsible. |
| Partnerships are easier and less expensive to set up than other business structures, such as corporations. | All income to general partners are subject to self-employment tax. |
| Shared responsibilities and management allows partners to allocate risk, management and responsibility. | The decision made by one partner can bind other partners. |
| Partnerships allow partners to avoid double taxation because income and losses flow through to the partner’s tax return. | Depending on the state where the partnership is formed, if one partner leaves, then the partnership dissolves. |
Choosing the right business type for your company is an important decision. You can learn more about the different entities in our guides on:
General Partnerships vs Limited Partnerships
A general partnership is a partnership where all partners are general partners, whereas a limited partnership has at least one limited partner and one general partner. General partners control a business and are financially responsible for everything that goes on in it, while a limited partner is not.
General Partnerships | Limited Partnerships |
|---|---|
Each partner is entitled to a share of the profits. Profits and losses are shared between the partners in whatever manner specified in the partnership agreement. | Partners do not participate in the management of the business and are only investors. |
Partners are equally responsible and liable for the business. | Partners are only liable up to the amount of their investment |
Partners are personally liable for the debts and obligations of the business | Partners do not have to pay self-employment tax on their earnings from the partnership |
The income of all partners are subject to self-employment tax. |
How Partnerships Are Taxed
The great thing about a partnership is that it is not taxed as a separate entity, but rather the profits and losses of the partnership are passed through to the individual partners, who report them on their individual tax returns. Specifically, a partnership must file an information return—Form 1065, U.S. Return of Partnership Income—to report their income, deductions, gains, losses and then allocate those items to each partner. Partners are first allocated income for any guaranteed payments. The remaining income and expenses are then allocated among partners in any manner specified in the partnership agreement.
Our Form 1065 step-by-step guide will walk you through the process. We also included a free downloadable checklist to help you monitor your progress.
Examples of Partnerships
As a business model, partnerships work well for industries where all owners perform work for the company to produce a product or to serve customers. To provide some context, let’s look at some businesses that are organized as partnerships:
- Gucci and Adidas (consumer textile companies)
- Spotify and Uber (technology companies)
- Wachtell, Lipton, and Rosen & Katz (law firm)
- PPBMares LLP (accounting firm)
How To Start a Partnership
Step 1: Decide on the type of partnership.
Choose between a general partnership and an LP based on how much each partner is willing to risk and how much they want to be involved in running the business.
Step 2: Choose a name for your business.
Check if the name is taken, then register it with your state agency. Typically, when doing a search for a business organization, most states allow you to use the “Name” search query on their state’s business website, such as Maryland Business Exchange.
When you type in the name of the business and click “search,” the database will show you any names that are connected to the name you typed in. If the query does not result in your business name, you are free to use it for your business.
Step 3: Create a partnership agreement.
Write a partnership agreement that spells out each partner’s roles and duties, their percentage of ownership, how profits and losses will be split, and how disagreements will be handled. If you need help creating a partnership agreement, you can use our free partnership agreement template.
Partnership agreements are not required by the IRS—simply start conducting business while splitting profits, and you’re a partnership. However, taking on a partner is a serious matter, and we highly recommend always having a written partnership agreement.
Step 4: Obtain the necessary licenses and permits.
Depending on the nature of your business, you may need to obtain licenses and permits from federal, state, and local authorities. Select your state in the drop-down menu below to see more information.
Step 5: Register for taxes.
Obtain an employer identification number (EIN) from the IRS and register for state and local taxes. You can learn more about this by reading our guide on how to get an EIN.
Step 6: Open a business bank account.
Open a separate bank account for your partnership business to keep your personal and business finances separate. You can learn more about this through our guide on how to separate business and personal finances.
Also, our article on how to open a business bank account will guide you through the account opening process. It even includes a free downloadable checklist of documents banks typically require.
Before entering a partnership, it’s important you understand how to end or dissolve a partnership. Partnerships are usually made with the idea that they will last at least until the death of one of the partners. However, one partner may decide to go their own way and leave the partnership.
If you want to break up with a partner, there are a few things you can do:
Step 1: Notify your partner: You should notify your partner of your intention to dissociate. This should be done in writing and should include the reason for dissociation.
Step 2: Sort out the details: You and your partner should work out the details of the dissociation, including the division of assets and liabilities. This can be done through negotiation or mediation.
Step 3: File the necessary paperwork: Once you have worked out the details of the dissociation, you will need to file the necessary paperwork with the state. This may include filing a certificate of dissolution or a statement of dissociation.
If a partner chooses to dissociate, that does not mean that the partnership is dissolved. Dissolution is an entirely separate process, discussed below.
Partnership dissolution can be a difficult process for any business. Dissolving a partnership involves more than just ending the agreement between the partners. It requires taking care of legal, financial, and tax matters. Let’s look at a few steps you should take if you want to dissolve your partnership.
Step 1: Notify customers: You should notify all your customers that the partnership has dissolved so that they can locate a new service or product provider and wind up any business with you.
Step 2: Notify creditors: You should notify any creditors that you may have and pay any outstanding financial obligations.
Step 3: Draft a dissolution agreement: If you and your partner have decided to dissolve your partnership, you should discuss the terms of your dissolution and draft a dissolution agreement. The finalized agreement should nullify the terms of the original partnership agreement.
Step 4: File the dissolution agreement with the appropriate state agency: Once drafted, the dissolution agreement should be filed with your department of assessment and taxation, secretary of the state’s office or department of revenue, whichever is appropriate in your state.
Step 5: File the final tax return for the partnership. You must file IRS Form 1065, United States Return of Partnership Income, for the year it stops doing business, and you must check the “final return” box, which is near the top of the front page of the return below the information about the company. You should do the same thing on Schedule K-1, Partner’s Share of Income, Deductions, Credits, and more.
Tax Effect of a Partnership Dissolution
The dissolution of a partnership is usually not a taxable event but can involve incredibly complicated accounting if noncash assets are transferred to the partners in the dissolution. Essentially, the partner’s basis in the partnership interest is transferred into the basis of any noncash assets received. Thus, rather than recognizing any gain or loss on the liquidating transfer, the basis in noncash assets are adjusted.
We recommend that even the most confident do-it-yourself (DIY) tax preparer seek the help of a seasoned tax professional if they receive any noncash assets from the liquidation of a partnership.
Frequently Asked Questions (FAQs)
Some of the most important things that should be in a partnership deal are the partnership’s name and purpose, what each partner will bring to the table, how profits and losses will be split among the partners, how decisions will be made within the partnership, who will manage and run it, how disagreements will be settled, and how the partnership will end.
When one partner dies, the partnership can either end or continue if there is an heir to inherit the deceased partner’s share of the partnership.
Yes, a partnership can hire employees and pay the employees’ wages. However, partners cannot be paid wages through payroll.
Bottom Line
A partnership is a business arrangement between two or more people who agree to share income and losses. This business arrangement gives you flexibility, access to more cash, and a chance to make more money.
