Table of Contents
- What is partnership in business?
- How does a Partnership Business Work?
- Taxes and Partnerships
- Characteristics of partnership (features)
- Types of partnership in business
- Advantages of partnership
- Disadvantages of partnership
- Partnership agreement
- Dissolution of Partnership
What is partnership in business?
Partnership in business refers to a formal arrangement by two or more persons to manage and operate a business and share the profits. We can define it as an unincorporated business in which an association of two to twenty persons. It is usually formed by a legal agreement to decide to run a business together. They share the risks, liabilities, and profits of the business together. It is an agreement between two or more people to oversee or operate a business and share its profits and liabilities
In broad terms, a partnership can be any activity that multiple parties jointly undertake in. These parties could be governments, non-profits organizations, businesses, or private individuals. The goals of a partnership change or differ widely.
Looking at it in a narrow sense of a profit-driven venture two or more individuals undertake in, there are different categories/types of partnership which we will be looking at in the course of this article.
How does a Partnership Business Work?
Looking at it in a narrow sense of a profit-driven venture, two or more individuals undertake to make a profit. There are different categories/types of partnership which we will be looking at in the course of this article.
In a general partnership, all the parties for partners are equally liable, both legally and financially. Every individual within the business is personally responsible for the debts that accrue to the business. This means that creditors/claimants can go after the personal assets of the partners. Because of this, it is necessary to be careful and selective when choosing partners. They equally share their profits and losses and the definite terms and ways of profit sharing will be outlined in the agreement.
A partnership agreement usually governs the business. It is usually a legal practitioner that draws up the agreement. In the course of drafting a partnership agreement, they should include an expulsion clause, stating in detail the conditions or grounds for expelling a partner.
Every partner should contribute capital, skills, or both based on the agreement they reached. Each partner receives a proportion of profit based on the agreement. Sometimes, they may borrow money from banks. They all take part in the major decisions together.
The partnership business itself does not pay business taxes, they pass taxes through to every individual partner to file on his own tax returns usually through a schedule K-1.
Taxes and Partnerships
There is no federal law/legislature guiding the operations of partnerships, but nevertheless, the Internal Revenue Code (Chapter 1, Subchapter K) includes detailed rules on their federal tax treatment.
Partnerships in themselves do not pay income tax, the tax responsibility passes through to every partner who is not considered an employee for tax purposes.
Individuals in partnerships tend to receive more favorable tax treatment than if they founded a corporation. That is, the government taxes corporate profits, as are the dividends the corporation pays to owners or shareholders. On the other hand, they do not double-tax the partnership profits in this way.
Characteristics of partnership (features)
Agreement between Partners
It is a companion of two or more individuals and it arises from an agreement or a contract. The agreement forms the basis of the association among the partners. Such agreements come in a written form, an oral agreement is equally legitimate. It is always advisable for every partner to have a copy of the written agreement in order to avoid controversies.
Two or More Persons
For a partnership business to be in place, there should be two or more persons possessing a common goal. In other words, the minimum number of partners in an enterprise can be two, however, there is a constraint on their maximum number of people. The maximum number should be twenty, that is, it should not exceed twenty.
Sharing of Profit
This is another significant component of the partnership. The assent between partners has to share gains and losses of a trading concern. However, the definition held in the Partnership Act makes it clear that a partnership is an association between people who have consented to share the gains of a business. The sharing of loss is implicit, the way they share gains and losses is vital. Every partner receives a proportion of gains and losses based on the agreement.
It is an important thing for a firm to carry some kind of business and should have a profit motive. The target is usually profit, growth, and expansion.
The partners are the owners and also the agent of their firms. Any action that one partner takes in the business can affect other partners and the firm. We can also conclude that this point acts as a test of partnership for all the partners because there is no partnership without mutuality.
The partners jointly bear risks of the enterprise, they are collectively responsible for the debts that accrue to the business. Creditors can go after the personal assets of the partners. Therefore, every partner in a partnership has unlimited liability.
The business is not a separate legal entity, therefore it cannot sue or be sued in its own name.
Types of partnership in business
This is the most basic form of partnership which does not require forming a business entity with the state. In most cases, partners start their business by signing a partnership agreement. The partners share or split ownership and profits equally among themselves, though they may establish different terms in the agreement.
Under the general partnership, every partner has an independent power to bind the business to contracts and loans. Also, each partner has a total liability, this means that they are personally responsible for all of the business’s debts as well as the legal obligations. It is easy to form and dissolve this form of the business and in most cases, the partnership dissolves automatically if any of the partners dies or goes bankrupt.
Since the business is not a separate entity from its partners, they only tax profits at the personal income level, not at the company level.
Limited partnerships are formal business entities that the state authorizes. That means, it is more structured than the general partnership. They have at least one general partner who is fully responsible for the business and at least one limited partner who provides money but does not actively manage the business.
Though limited partners invest in the business for financial returns, they are not responsible for its debts and liabilities. General partners own and operate the company and they assume liabilities for the partnership. It is the general partner that has control and responsibility when it comes to the limited partnership.
This silent partner limited liability implies that limited partners can share in the profits, but they cannot lose more than what they have invested. In some states, the limited partners may not qualify for pass-through tax. These partners may lose their status as limited partners alongside the protection that accompanies if they begin to actively manage the business.
Some Limited partnerships appoint a limited liability company (LLC) as the general partner so that no one bears unlimited personal liability for the business. That option may not be available in all states. It is much more complicated than a limited partnership.
Generally, limited partnerships are very attractive to investors as a result of the fact that there are different responsibilities of the general and limited partners.
Limited liability partnership
A limited liability partnership (LLP) operates as a general partnership. All partners actively take part in managing the business though it limits their liability for one another’s actions.
Though the partners still bear full responsibility or are liable for the debts and legal liabilities of the business, they do not take responsibility for the errors and omissions of their fellow partners. Not all states permit this form of partnership and most times, the state limits them to certain professions like doctors, lawyers, and accountants.
With a limited liability partnership, a partner cannot lose his personal assets if someone takes legal action against the business they are liable for their personal wrongs.
In this case, it is easy to either add or remove partners. Unlike some other types of partnership, a partner can have liability protection from the action of other members though it depends on the state of the partners.
Limited liability limited partnership
A limited liability limited partnership (LLLP) is a more recent type of partnership and it is available in few states. It operates like a limited, with at least one general partner who manages the business, but the LLLP limits the general partner’s liability so that every partner will have liability protection.
Under this business, members enjoy protection over their personal assets. Creditors cannot sue members for the debts or the actions of the business in most cases. it offers personal liability protection and tax flexibility for every partner.
Advantages of partnership
Fewer formalities with fewer legal obligations
One of the major advantages of a partnership business is the lack of formality compared to a limited liability company. The accounting process is generally simpler here than for limited liability companies. This business does not need to complete a corporation tax return, it only needs to keep records of income and expenditure.
Also, there are fewer records to maintain. Particularly, a business partnership does not need to maintain a set of statutory or regulated books like a limited liability company.
It is easy to dissolve a business partnership at any time except for instances where there is a formal partnership agreement. This gives each partner the freedom to choose to leave whenever they wish to.
Easy to establish
The partners can agree to create the partnership either verbally or in a written form. There is no need to register with Companies House. Registering the business partnership for taxation is quite simple. Most times also, the partners will individually need to register for self-assessment, which they can do online.
Though it will take a bit longer and incur an additional cost, it is usually a sensible thing to put a partnership agreement in place. This document shows how the business will work as well as the rights and responsibilities of partners. It will also clearly state what would happen in various possible situations, including what will happen if the partners fundamentally disagree or someone wants to leave.
Sharing the burden
Unlike a sole proprietorship business, a partner can benefit from companionship and mutual support by working in a business partnership. Starting and managing a business alone can be hectic and discouraging most especially if one has not done it before. It is a collective thing.
Access to knowledge, skills, experience, and contacts
The diversity of talents, knowledge, skills, and experience can lead to greater business efficiency. Each partner may have a special skill that may lead to greater success in the business. Each partner brings their own knowledge, skills, experience, and contacts to the business. This potentially gives it a better chance of success than any of the partners trading individually. It gives room for specialization which is advantageous.
Partners can share tasks and responsibilities, with each of them specializing in areas they are best at and enjoy most. If any partner has a financial background, such could focus on maintaining the company books, while another may have previously worked extensively in sales and focus on that aspect of the business. A sole trader has to do all these things alone or employ someone to do some of it.
Unlike a one-man business, the business benefits from the unique point of view each partner bring to the table. This is because partners jointly take decisions. In business, it is clear fact two heads really are better than one, with the combined conclusion of deliberating on a situation far better than a single-handed operation.
Unlike a limited liability company, the partners can keep their affairs confidential since it is not necessary for them to make their accounts available for public inspection.
Ownership and control are combined
The partners both own and control the business. As long as the partners are able to agree on how to operate and drive forward their entity, they are free to pursue it without interference from any shareholders. This can make a partnership business more flexible than a limited company, and they also have the ability to adapt more quickly to changes.
Ease in raising capital
Capital is obtainable more easily either to set up a business or to expand an already existing business compared to the sole proprietorship. The partners can easily raise more capital by pooling their personal resources, they can also find it easier to borrow money. this is because lenders have more confidence in a group of people than an individual. Also, a group of people may be in a better position to offer collateral security that banks require before giving out loans.
While a sole trader can employ staff, it is quite impossible to bring someone on board to manage the business alongside. Employees always believe the sole proprietor be the one running the business and good people may not get that motivation if they feel, as far as their own career is concerned, there is nowhere to go.
On the other hand, it’s usually possible to admit a new partner into a general partnership. Business with the incentive that they could become a partner attracts good staffs, either when they join or at some point in the future.
Easy access to profits
In a business partnership, they share the profits of the business between the partners and They flow directly through to the personal tax returns of each partner rather than initially retaining it within the partnership. In a limited company, the company retains the profits until they pay it out, whether as salaries under PAYE or when the shareholders approve it as dividends.
The business has a greater chance of continuity than a sole proprietorship. The death of a partner may not lead to the total dissolution or termination of the entity since other partners can still carry on. A partner can as well enjoy holidays or any form of leave such as sickness without affecting the normal course of the business. Also, while having a joint business, each partner can still run another business of his own without affecting the performance of the partnership business.
There still exists personal contact with both employees and customers. This is because the size of the business is relatively small, unlike the limited liability companies.
Disadvantages of partnership
No independent legal status
A business partnership does not have an independent legal entity separate from the partners. It can imply that unless the business puts a partnership agreement with alternative provisions in place, it may dissolve on certain conditions. These conditions may include the resignation or death of one of the partners or even an occurrence of disagreement among partners. This tendency can cause insecurity and instability as well as diverting attention from developing the business. This will mostly not be the preferable outcome for the remaining partners.
Even when a partnership agreement is in place, the remaining partners may not be in a position to buy the share of the outgoing partner of the business. In such cases, the business will likely dissolve.
The business has unlimited liability for the active partners as the case is in a sole proprietorship. Also, because the business does not have a separate legal entity, the partners are individually liable for debts and losses that the business incurs. That means if the business runs into trouble each partner’s personal assets may be at risk of loss or seizure. This would generally not be the case here if the business was a limited company.
Perceived lack of prestige
Like a sole proprietorship, the partnership business model often appears to lack the sense of prestige that mostly associates with a limited company. Especially given their lack of independence aside from the partners themselves, partnerships can appear to be temporary enterprises, even though many partnerships are very long-lasting.
The fact that this form of a business appears not to be permanent and that companies house cannot check its finances can appear to present more risk. Because of this, some clients prefer to deal with a limited liability company and even refuse to transact with partnership businesses.
Limited access to capital
The business tends to have limited access to capital. In essence, the amount of capital each partner would contribute is relatively small when we compare it to a limited liability company. It cannot raise capital by issuing shares or debentures. This can also limit the expansion of the business.
Banks may prefer the greater accounting transparency, separate legal personality, and sense of continuity that a limited liability company provides. Banks may be unwilling to render loan services to this business. Several other forms of long-term finance are not available here.
Potential for differences and conflict
Arguments and disputes may arise among partners if they feel that some members are not contributing their full quota to the business. Quarrels may lead to a total dissolution of the entity. Also, the introduction of a new partner may cause trouble especially if some partners do not accept him.
Disagreements and disputes will not only harm the business. It will also destroy the relationship that exists between the individuals involved. Conflict can be a major distraction, consuming the partners’ time, energy, and money. It is advisable for every partner to have an agreement that will reduce the adverse effect of conflicts.
Slower, more difficult decision making
Unlike the sole proprietorship, decision-making takes a longer time to arrive at. It can be slower as a partner will need to consult and discuss matters with your partners. Where there is a disagreement, they will have to spend more time negotiating to build an agreement. Sometimes this may imply loss of opportunities. This will as well frustrate a partner who is used to making all the decisions for their business individually.
Basically, while a sole trader retains all the profits of his business, the partners have to share the profit among themselves.
Sharing profits impartially can raise difficult questions. Such questions include How does the business value different partners’ skills? What happens when one partner is not contributing sufficient time and effort into the partnership, but still taking their share of the profits? Displeasure is bound to occur if there doesn’t appear to be an even balance between effort and reward.
A partnership agreement, also known as a partnership contract. You can also call it articles of partnership, or a deed. It is a written agreement between two or more parties intending to form or carry on a business for the purpose of making a profit. This document is a foundation document that is crucial for running a new document.
If you want to organize your business as a partnership, it is good to ensure that you draft out a deed and the details of how to make business decisions. You should also state clearly ways to resolve disputes and how to handle stocks and purchases.
The agreement helps to handle difficulties that normally would have been difficult to handle. This is because it is legal. The agreement is a document that contains the rules and regulations guiding the business entity. It is usually drafted by a legal practitioner.
The agreement will address the following issues;
Whether it is not necessary or two owners are to equally share ownership and authority, or however they decide it, they should make it clear in the agreement.
How they will make decisions
The partners should be able to state how they would make and implement their decisions.
How to determine purchase price when one partner withdraws
It is possible to agree on a neutral third party such as a banker or an accountant to find an appraiser to determine the partnership price’s interest.
The amount they will pay to a partner who withdraws
Based on the contract, partners can agree on the amount they want to pay to a partner who withdraws. For example, if they will pay him over three, five, or ten years with interest.
It is an unfavorable thing for a cash-flow crisis to hit a business especially when they have to pay the entire price on a spot on one lump sum.
The partnership agreement also gives some details about the business such as;
- The name of the business.
- Nature of the business the partners want to undertake.
- The amount of capital/capital resources that each partner would contribute.
- How they would share profits and losses among themselves.
- The way would dissolve the business if the need arises.
- How to share or delegate the responsibility of the management of the business.
- The method of admitting new partners.
- How to resolve disputes when they occur, etc.
Dissolution of Partnership
There are different conditions that result in the dissolution of this form of business. It can either happen voluntary or involuntary due to any of these reasons;
- Dissolution by mutual agreement or consent of the partners
- Dissolution by notice
- Insolvency of partners
- Commitment to illegal business
- Death of a partner
- Expiry of term
- Completion of work or contract
- Resignation of partner
In conclusion, to legally form a partnership involves a few steps such as choosing a structure, drafting a partnership agreement, naming the business, and submitting annual reports when necessary. Because this form of business does not do not have a separate legal entity. It does not require series of formalities like that of a limited liability company or a corporation.
Chyou is a published author who focuses on the field of international business. After an established career facilitating mergers and acquisitions for medium to large corporations, Chyou turned to writing to help students better understand international business concepts.