Deciding on a legal business structure is a critical first step when starting a new company. It impacts everything – from how you report income and your level of personal liability to compliance with legal obligations at all governmental levels.
For many, forming a business partnership is a strategic move. Partnerships can offer a synergy of expertise and resources, creating a collective capability greater than the sum of its parts. Unlike an LLC, a partnership implies that the business is conducted by individuals who share the management and profits.
What is a partnership?
A partnership is when two or more people or groups agree to run a business together. Each partner shares in the profits, losses, and business decisions. Partnerships can be formed between individuals, businesses, or organizations – anyone who wants to work together to make a profit and move forward with shared goals. Simply put, it’s a team running a business, sharing the ups, downs, and responsibilities.
Once you’ve formed a partnership, it’s pivotal to clearly and legally document the understandings and expectations between partners. This step ensures a smoother business operation and helps prevent potential disputes. This brings us to another crucial term – the partnership agreement, which outlines the detailed terms and conditions among partners.
What is a partnership agreement?
A partnership agreement is a contract between business partners. It answers: Who owns what? Who does what? How will profits (and losses) be shared? It also sets the rules for solving disagreements and explains what happens if a partner leaves or passes away. It’s a safety net, ensuring everyone knows the plan and preventing future disputes.
In my nearly 30 years as an attorney, entrepreneur, and advisor, I have navigated the nuances of different business structures, often evaluating the unique benefits and challenges of forming a partnership. And as an attorney, I’ve drafted hundreds of partnership agreements for various ventures. And I was a partner in numerous legal partnerships (which historically had to be structured as partnerships). This guide is your roadmap, with practical advice, actionable tips, and best practices from mentoring hundreds of entrepreneurs and small businesses and helping thousands start and expand their ventures.
Partnerships: A Comprehensive Guide
Types of business structures
Before diving into the details, let’s look at the popular types of business structures:
Sole proprietorship: This business is owned and operated by a single individual. This person maintains complete control over the company but bears all the risk.
LLC (Limited Liability Company): This business structure merges the characteristics of corporations, partnerships, and sole proprietorships. It provides limited liability protection to its owners or members.
Corporation: A corporation is a business entity legally separate from its owners or shareholders. It can sell shares of stock to raise capital, something a sole proprietorship or partnership can’t do.
Benefits of forming a partnership
Embarking on a business journey with a partner isn’t just about having company. It’s about combining strengths, sharing responsibilities, and multiplying resources to create a resilient, resourceful, and robust venture.
Forming a partnership can weave a safety net, enabling the business to take leaps with shared risk and blend diverse skills to brew innovation and stability. From shared financial responsibilities to melding distinct skills, a partnership opens up a world where mutual benefits are not just possible but are often amplified. Here are fifteen tangible benefits for people when choosing a partnership structure:
- Shared responsibility. Partnerships often result in shared responsibility, which can lessen individual load. If one partner is adept at digital marketing, they can focus on online promotions, while the other, perhaps skilled in operations, manages order fulfillment. In a retail shop, one partner could manage in-store operations while the other takes care of supplier relationships and inventory management.
- Diverse skill set. Partners often bring varied skills and expertise, enhancing the business’s capabilities. One partner could focus on website design and UX design, while the other manages content creation and customer service. One partner could specialize in sales and customer interaction on the shop floor, while the other could focus on back-end operations and stock management.
- Enhanced creativity. With more minds at work, partnerships often foster enhanced creativity and innovation and can help you develop the best business ideas. An online design store can have one partner focused on creating unique designs while the other ensures they are showcased innovatively on the platform. While one partner brings innovative culinary ideas to a restaurant, the other might introduce fresh, customer-engaging service strategies.
- Risk mitigation. Having a partner means risks, especially financial ones, are shared. Both partners share the financial burden if an e-commerce platform fails to perform as expected. In a physical store, if a new product line doesn’t sell as projected, both partners absorb the financial impact.
- More resources. Partnerships can mean access to more resources, such as capital, clientele, and industry contacts. In an IT firm, one partner might bring in financial investments while the other brings a rich client database. In a consultancy, one partner may offer a spacious office for client meetings while the other brings in crucial industry contacts.
- Networking opportunities. More partners typically equate to a wider network, which can be leveraged for business growth. An online advertising agency can benefit from one partner’s digital influencer contacts while utilizing the other’s connection with ad platforms. In a real estate business, one partner’s connections with property dealers and the other’s links with advertising agencies can be beneficial.
- Improved decision-making. Different perspectives often lead to well-rounded decision-making. In a digital magazine, editorial and technical decisions can be balanced between partners with expertise in each field. In a bookstore, one partner might select the inventory based on literary knowledge, while the other ensures technological tools (like point-of-sale [POS] systems) are updated and efficient.
- Flexibility. Partnerships often provide flexibility in management and operations. In an e-learning platform, partners can manage course updates and student interactions alternately, ensuring continual operation even during vacations. In a clinic, partners can alternate their duty hours to provide consistent services without burnout.
- Tax benefits. Partnerships can offer various tax benefits, depending on jurisdiction. An online consultancy might benefit from tax deductions available for partnerships in its operational domain. A manufacturing unit run as a partnership may avail of certain tax credits available in its location.
- Easier to form. Forming a partnership can often be less complex and requires fewer formalities, paperwork, and expenses. Two freelancers might combine services and form a partnership firm with minimal documentation. Two artisans might join to create and sell products in a shared physical space with less bureaucratic involvement.
- Boosted financial capability. A partnership can amplify a business’s financial prowess by pooling all partners’ monetary resources and creditworthiness. In a SaaS business, while one partner might inject direct capital, the other might facilitate a loan due to their robust credit history. A coffee shop partnership might see one partner contributing more towards initial capital while the other agrees to a higher profit-sharing ratio to balance the scales.
- Companionship and moral support. A partner can offer emotional and moral support, making the entrepreneurial journey less isolating. When running an online retail store, partners can buoy each other during slow sales, brainstorm new strategies, and provide moral support. In a physical fitness center, when one partner feels disheartened due to challenging situations, the other can provide encouragement and shared resolve to navigate through.
- Client satisfaction. With multiple partners, client needs can be addressed more comprehensively and responsively. A digital marketing firm can provide client services across varied time zones, with partners strategically located in different regions. A consulting firm with partners specialized in various domains can offer clients a one-stop solution, enhancing client satisfaction and retention.
- Flexibility in ownership transfer. Partnerships generally facilitate smoother transitions in ownership compared to other business structures. In an online tutoring platform, a partner wishing to exit can transfer their ownership stake to the remaining partner or a new entity more fluidly. In a law firm, a retiring partner might transfer their stake to an existing partner or a new entrant, ensuring continued business operations without complex restructuring.
- Greater borrowing capacity. Partnerships often have a larger borrowing capacity than sole proprietorships due to combined assets and credit. An e-commerce partnership might secure a more substantial loan to scale operations, utilizing the combined assets and collateral of the partners. A manufacturing business partnership could leverage partners’ combined creditworthiness to secure better borrowing terms for expansion or upgrading machinery.
Will your business idea succeed?
Disadvantages of partnerships
Being tethered to another person or entity in business could mean conflicts, liability, and intricate financial management. Here are ten potential drawbacks of partnerships:
- Conflict in decision making. Decisions might be contested when more than one person is involved, and conflicts can arise. Two partners in an e-commerce platform might disagree on inventory purchasing decisions. Partners in a bookstore might have conflicts over which books to stock and promote. This is common in other types of entities, too. Over the years, I’ve had many conflicts with partners in partnerships, LLCs, and corporations. However, this is often legally more complicated in partnerships because they are often equal, and it’s not always clear who makes the final decision.
- Joint liability. All partners share the burden of business debts and liabilities. All partners in a digital marketing agency may be liable for a debt incurred due to a failed campaign. In a restaurant business, partners are responsible for any debts accrued due to a failed event or investment.
- Profit sharing. All profits have to be shared among partners, sometimes leading to discontent. Profits from a thriving online coaching platform must be distributed among all partners, potentially sparking disputes. Profits from a successful promotional event at a retail shop must be shared among partners, possibly igniting conflicts.
- Limited capital. Raising funds can be limited to the personal funds or creditworthiness of the partners. An app development partnership may find difficulty scaling due to limited capital investment. Due to constrained capital, a dental practice partnership may struggle to expand to new locations.
- Business continuity. Partnerships may face continuity issues due to the withdrawal or death of a partner. An online consultancy may face disruptions if a key partner departs unexpectedly. A partner’s sudden exit from a law firm could potentially destabilize client relationships and ongoing cases. I’ve seen this happen often at law firms and other professional partnerships.
- Diverse risk appetite. Partners might have different thresholds for risk, which can influence business strategies. A partner in a FinTech startup might be reluctant to explore a new, innovative, but risky feature, contrary to the other’s willingness. Partners in a construction business might disagree on taking up a large, potentially lucrative, but risky project.
- Limited expertise. Limited to the partners’ skills and knowledge, some areas may lack expertise. A blogging platform run by content creators might lack technical optimization due to limited IT knowledge. A physiotherapy clinic may not optimize its marketing strategies due to a lack of marketing expertise among the partners.
- Shared losses. All partners have to bear losses, which can impact personal finances. If an online retail business incurs losses, the personal savings of all partners may be impacted. In an event management partnership, a failed event could dent the personal financial health of all partners.
- Complicated exit strategy. Exiting or dissolving a partnership can be complex and may affect business operations. Leaving or dissolving a partnership in a web development business might disrupt ongoing projects. A partner’s exit from a salon business might involve intricate valuation and division of assets.
- Customer trust. When a partner leaves, or a partnership dissolves, it might erode customer trust and loyalty. In a SaaS business, customers might feel uncertain about the continuity and reliability of the service upon changes in partnership. Patrons of a local cafe might be skeptical about quality consistency if a well-known partner departs.
Recognizing these potential challenges allows prospective partners to tread wisely, crafting strategies that mitigate these risks and leveraging the benefits to navigate the potential hurdles of partnership businesses.
Types of partnerships
Partnerships are not a one-size-fits-all model. There are various forms, each bearing its distinct set of rules, liabilities, and operational methods:
General Partnership (GP)
All partners share equal rights, responsibilities, and liabilities in a general partnership.
Best for: Consulting firms, law practices, small retail businesses, and local service providers.
Not ideal for: Ventures with unequal investment or involvement, high-risk businesses, and tech startups with substantial liability.
Limited Partnership (LP)
Some partners enjoy limited liability and are not involved in management, while others have unlimited liability and manage the business.
Best for: Real estate investment groups, film production companies, family businesses wanting to involve silent members, and venture capital firms.
Not ideal for: Small businesses with active partners, technology companies, and businesses that require all partners to be involved in management.
Limited Liability Partnership (LLP)
All partners have limited liability and can be involved in business management.
Best for: Professional practices like law and accountancy firms (my law firms started as partnerships and converted to LLPs when state laws permitted this conversion), consulting businesses, medical practices, and design agencies.
Not ideal for: Businesses desiring simplicity in structure, sole proprietorships, manufacturing businesses with high liability.
Two entities come together for a specific project or a specified period.
Best for: Construction companies on a specific project, tech companies collaborating on a product, multinational business expansions, and research and development projects.
Not ideal for: Ongoing, long-term businesses, small local businesses, independent entrepreneurs, and ventures requiring a singular brand identity.
Businesses collaborate for mutual benefit without forming a new entity.
Best for: Airlines sharing certain routes, e-commerce, and retail collaborations, tech companies sharing technology, and cross-promotional marketing campaigns.
Not ideal for: Businesses desiring shared liability and responsibility, ventures that need a unified brand, and small businesses with limited resources.
Limited Liability Limited Partnership (LLLP)
A variation of the LP where even general partners can have limited liability.
Best for: Large investment projects, family estate planning, agricultural operations, and certain real estate investments.
Not ideal for: Small scale businesses, tech startups, businesses with straightforward operational needs, and single-location service providers.
Taxes and partnerships
Depending on different businesses’ unique financial and operational configurations, partnership taxes could be either an ally or an adversary. While a partnership as a business entity does not pay taxes, the profits pass through to partners who report this income on their personal tax returns.
Businesses that benefit from partnership taxation
- Consulting firms. Shifting income among partners can optimize individual tax scenarios.
- Real estate investment groups. Using pass-through taxation to manage investment gains and losses effectively.
- Small local retailers. Capitalizing on simplicity and avoiding double taxation.
- Family businesses. Managing estate planning and wealth transfer with a flexible partnership structure.
- Law practices. Mitigating liability and enjoying the flexibility of distributing profits.
- Freelance and creative agencies. Navigating varying incomes through beneficial income-splitting among partners.
- Joint ventures in research and development. Appropriating expenses and research credits optimally among entities.
- Professional practices (e.g., doctors, architects). Managing professional income with flexibility among partners.
- Craftsmanship businesses (e.g., boutique craft shops). Handling often fluctuating incomes and expenditures in a straightforward manner.
- Educational services. Distributing educational revenue and operating expenses effectively among partners.
Businesses potentially disadvantaged by partnership taxation
- High-tech startups. Potential challenges with investment funding and allocation of losses.
- Large-scale manufacturing businesses. The complexity in managing and allocating large expenses and revenues.
- Corporations with international operations. Navigating through international tax law and potential double taxation issues.
- Venture capital firms. Managing investor returns and extensive financial portfolios.
- E-commerce giants. Handling extensive online transactions, international sales, and VAT.
- Robust franchise operations. Distributing income and managing expenses across various entities.
- Large agricultural businesses. Allocating extensive operational costs and managing international trade.
- Biotech companies. Allocating extensive R&D expenses and managing investor relations.
- High-risk businesses (e.g., adventure tourism). Balancing high liability with the fiscal flexibility of a partnership.
- Companies with high capital expenditure (CAPEX). Managing the allocation of significant CAPEX and related depreciation.
How to start a partnership
1. Choose a business name
Your partnership’s business name must embody your brand while adhering to your state’s regulations. Typically, it should be unique and not misleadingly imply that you’re a government agency or an unauthorized industry.
Brainstorm potential names and ensure they align with your brand message. Run a name check to confirm that no business in your state has claimed it. Also, check for available domain names to create a business website with the same name.
2. Draft a partnership agreement
This crucial document outlines how your partnership will function. Though not legally required in all jurisdictions, a partnership agreement can prevent future disputes.
Consider hiring a business attorney to draft the agreement. This document should cover, at minimum, the following topics:
- The distribution of profits and losses
- The roles and responsibilities of each partner
- The procedures for adding or removing partners
- The procedures for dispute resolution
- The protocol in the event of dissolution of the partnership
We go into more detail below on the key terms of a partnership agreement and the pitfalls you should avoid.
3. Register your partnership
Your partnership must be registered with the appropriate state agency, often the Secretary of State.
Check with your state’s Secretary of State office or a legal advisor for the specifics in your area. In most cases, you’ll need to file a document known as a “Statement of Partnership Authority.” This document generally includes details about your business name, purpose, duration of the partnership, and information about each partner.
4. Obtain an EIN
An Employer Identification Number (EIN) is your partnership’s Social Security number. The IRS uses it to track your business’s tax obligations. Even if you don’t have employees, an EIN is usually necessary.
Apply for an EIN through the IRS website—it’s free and straightforward. After submitting your application, you will immediately receive your EIN. The IRS has a helpful checklist to help you decide whether you need an EIN to run your business.
5. Open a business bank account
A separate business bank account helps you keep your business finances separate from your personal finances, making tax time much easier. It also lends credibility to your business.
When opening a bank account, choose a bank that caters to small businesses. Prepare to provide your partnership agreement, EIN, and business registration documents.
6. Register to do business in other states (if necessary)
If your partnership will do business in states other than where you registered, you’ll likely need to register your business there.
Each state has different rules regarding what constitutes “doing business” in their jurisdiction. Consult with a legal advisor to understand whether this step is necessary. Registration usually involves filing a similar form to the one you filed with your home state and paying an additional fee.
7. Obtain necessary permits and licenses
Depending on your industry and location, your partnership may need specific business licenses or permits to operate legally.
Research federal, state, and local requirements and apply for necessary permits and licenses. You can use the U.S. Small Business Administration’s license and permits tool as a starting point.
By following these steps, you’ll ensure your partnership has a solid legal foundation, giving you peace of mind to focus on growing your business.
Partnership agreement: everything you need to know
Embarking on a business journey with a partner requires trust, mutual goals, and a robust partnership agreement that stands the test of time and tribulations. Here are the vital components and the actionable strategies to bolster each item in a partnership agreement.
Clearly outline the specific percentages owned by each partner, avoiding generalized statements. Employ precise language and formulas to describe how ownership percentages might change in various scenarios.
Protect against: Discrepancies or disagreements about ownership due to vagueness or oversights in the document—lack of clear procedures for recalculating ownership percentages in the event of capital changes.
Profit and loss allocation
Define explicit mechanisms or formulas for allocating profits and losses among partners. Include clauses for exceptional circumstances, such as unexpected losses or extraordinary profits.
Protect against: Conflict arising from perceived unfair distribution, especially in scenarios not covered in the agreement—legal challenges due to ambiguous or non-compliant profit and loss allocation methods.
Roles and responsibilities
Detail each partner’s duties, powers, and limitations, ensuring clarity and specificity. Establish mechanisms for adjusting roles and responsibilities as the business evolves.
Protect against: Conflicts or inefficiencies due to overlapping or unclear roles. Legal or operational issues arising from failure to adhere to documented responsibilities.
Specify a detailed, step-by-step process for resolving internal disputes to avoid court battles. Incorporate a clause mandating mediation or arbitration before any legal action.
Protect against: Ignoring minor disputes that could escalate into larger, more damaging conflicts—encountering a stalemate situation if the agreement is too vague or doesn’t cover a particular dispute.
Clarify the initial contributions and any additional contributions required from partners. Outline procedures and conditions for raising additional capital in the future.
Protect against: Financial stress due to unclear or insufficient capital contribution arrangements. Disagreements about valuation and equity when accepting additional capital contributions.
Enumerate key decisions that require unanimous consent and those that can be made individually. Develop a system or voting mechanism for making collective decisions.
Protect against: Experiencing delays or disruptions due to a lack of decision-making structures. Encountering dissension from partners who feel sidelined or overruled in the decision-making process.
Partner exit and succession planning
Define clear exit strategies, including buyout clauses and valuation methods. Implement a structured succession plan for seamless transitions during partner exits.
Protect against: Fumbling business continuity during an unexpected exit or transition. Engaging in legal battles over partner exits due to poorly defined exit clauses.
Death or incapacity of a partner
Establish guidelines and procedures for managing the business interest of a partner who becomes incapacitated or passes away. Specify the rights of heirs or successors to a partner’s business interest.
Protect against: Enduring business disruption and potential discord with heirs due to the absence of a clear plan. Navigating through legal complexity regarding inheritance and stakeholder rights without clear direction.
Non-compete and confidentiality clauses
Draft precise non-compete clauses defining the scope, duration, and geography to protect the business. Incorporate strict confidentiality clauses safeguarding business secrets and proprietary information.
Protect against: Experiencing damage from a partner who engages in competing ventures or leaks sensitive information—facing legal challenges for enforcing overly restrictive or vague non-compete clauses.
Amendments to the agreement
Specify the process and any necessary approvals for amendments to the partnership agreement. Ensure flexibility while maintaining a structure that prevents arbitrary changes.
Protect against: Encountering disagreements or legal issues due to inadequate procedures for making amendments and limiting the business’s adaptive capability by making the amendment process overly rigid or cumbersome.
Business sales and transfers
Define the conditions under which business assets or the entire business can be sold. Specify the partners’ rights, such as the right of first refusal, in the event of a proposed sale.
Protect against: Engaging in disputes over the validity of a sale or transfer of business shares. Encountering unexpected exits or entries of partners due to unscheduled sales or transfers.
Financial management and distribution
Clarify protocols for financial management, including budget approvals and financial reporting. Detail the procedures and schedules for distributing profits among partners.
Protect against: Mismanagement of finances or inequitable distribution leading to internal conflicts—legal scrutiny or penalties due to non-compliance with financial management norms.
Admission of new partners
Describe the process, conditions, and any restrictions for admitting new partners. Specify any changes to existing partners’ equity, roles, and responsibilities when a new partner is admitted.
Protect against: Disrupting business harmony due to the unsystematic admission of new partners and altering the equilibrium of control and influence among existing partners.
Resolution of violations
Develop a mechanism to handle violations of the agreement by partners. Include provisions for penalties, reparations, or corrective actions in the event of a violation.
Protect against: Fostering a toxic environment by neglecting or ineffectively handling violations and engaging in legal battles stemming from unaddressed or improperly handled violations.
Establish clear conditions under which the partnership can be dissolved. Detail the process for asset liquidation and debt clearance upon dissolution.
Protect against: Encountering legal issues and conflicts during dissolution due to vague or incomplete procedures. Financial losses due to an unstructured or hurried dissolution process.
Remember, these items provide a comprehensive guide, but every business is unique. Tailor your partnership agreement to your specific needs, considering all possible future scenarios, and always consult a legal expert to ensure its solidity and enforceability.
Frequently asked questions about partnerships
How is a partnership formed?
A partnership is typically formed through a partnership agreement, which lays out all the partners’ terms, responsibilities, and profit-sharing. It isn’t mandatory by law but is crucial to avoid future disputes. Key steps include deciding on a business name, registering the business, obtaining necessary licenses and permits, and crafting a comprehensive partnership agreement.
What are the main types of partnerships?
Primarily, there are three types of partnerships: general partnerships, limited partnerships, and limited liability partnerships, each differing in terms of liability and management structure. A business might choose a type based on its operational, financial, and legal needs and objectives.
Are partners personally liable for business debts and obligations?
In general partnerships, partners are usually personally liable for business debts and obligations. However, in limited and limited liability partnerships, partners can limit their liability to the amount they have invested in the business.
How are partnerships taxed?
Partnerships themselves are not subject to income tax. Instead, their profits are passed to the partners, who report the business income or loss on their personal tax returns. Each partner’s share of profits and losses, usually outlined in the partnership agreement, is reported to the IRS on a Schedule K-1.
How does a partnership agreement protect the partners?
A partnership agreement provides a clear framework regarding each partner’s contributions, profit and loss distribution, and rules for resolving disputes, adding or changing partners, and dissolving the partnership. It is a safeguard, providing solutions and predetermined courses of action for various scenarios.
What happens if a partner wants to leave the partnership?
Departure scenarios should ideally be addressed in the partnership agreement. Depending on the terms, the leaving partner may sell their share to the remaining partners, to an outside party, or trigger the dissolution of the partnership. The specific processes and implications may vary based on the agreed-upon terms and type of partnership.
Can partnerships be formed without a written agreement?
Yes, partnerships can technically be formed without a written agreement through verbal agreements or the actions of a business’s operators. However, a written partnership agreement is crucial to avoid potential disputes and clearly understand all partners’ roles, responsibilities, and profit-sharing.
How are decision-making powers typically shared in a partnership?
Decision-making powers are usually shared based on the terms set in the partnership agreement. This can range from equal power for all partners to specified authority areas for each individual. Clearly defined roles and responsibilities can help streamline decision-making processes and prevent conflicts.
How is profit typically shared in a partnership?
The partnership agreement generally determines profit-sharing in a partnership. It could be shared equally or in proportion to each partner’s investment in the business. Without an agreement, profits are shared equally among partners despite the level of investment or effort put into the business.
These questions serve as a starting point, providing a foundational understanding of partnerships and their nuances. Always seek advice from a professional specializing in business structures and partnerships for specific advice and strategic guidance.
Choosing a partnership can be an excellent decision for many entrepreneurs. Each business type has unique pros and cons. Therefore, evaluate your needs, seek professional advice, and make an informed decision.