Forming a business partnership can be a great move since it opens the door to shared skills and additional capital and gives you a built-in sounding board. However, many first-time partners don’t anticipate the legal, financial, and communication challenges that come with it. Here are the top things to consider before forming a business partnership.
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Tax implications of different partnership structures
When you form a business partnership, the profits and losses pass through to each partner’s personal tax returns. However, the partnership structure can affect your liability, payroll obligations, and self-employment taxes in different ways:
- General partnership (GP): A general partnership is the default option when two or more people go into business without filing formal paperwork. All partners have unlimited personal liability, and each pays income tax and the self-employment tax on their share of earnings.
- Limited partnership (LP): In a limited partnership, one partner runs the business and takes on full liability. The other partners are usually passive investors whose personal risk is limited to the money they put in. These limited partners still report their share of profits on their taxes, but they usually don’t have to pay self-employment tax. However, they also have less say in how the business is run.
- Limited liability partnership (LLP): Limited liability partnerships (LLPs) are common for law, accounting, and consulting firms. They protect each partner’s personal assets from the actions of the others. Partners still pay self-employment tax, and some states charge extra fees to keep an LLP status. Since liability rules vary by state, it’s important to check local laws for details.
- Limited liability company (LLC) taxed as a partnership: A multimember LLC can choose to be taxed like a partnership, which lets profits pass through to the owners while still protecting their personal assets. Some states charge extra fees each year, so the cost of this protection can vary depending on where you live.
No matter which structure you choose, both partners need to make quarterly tax payments, keep track of their shares in the business, and follow the profit-sharing rules in the agreement. A certified public accountant can help you plan ahead and avoid tax surprises by walking you through different options, like taking a salary or reinvesting profits.
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Every partnership needs a clear, written agreement that lays out the rules and protects everyone if things change.
Common partnership disputes and how to resolve them
Even partners with a shared vision can find themselves clashing over one of the following four scenarios:
- Unequal effort or contribution: One partner may feel overworked and/or under-compensated. The best way to avoid this problem is by setting clear goals and checking in on them every few months. If one partner is doing more than the other, consider adjusting pay or ownership to keep things fair.
- Financial disagreements: Partners may also disagree about whether to reinvest in the business, take on debt, or pay themselves. You can handle this by creating a written plan for your finances — for example, stating you’ll have a minimum amount of cash on hand before taking out profits.
- Strategic disagreements: Sometimes partners can’t agree on big decisions, like changing the business direction or expanding into a new market. To avoid getting stuck, try bringing in a neutral third party to help you come to a decision.
- Exit or ownership change: If a partner wants to leave, goes through a divorce, or passes away, the other partner might end up working with someone they didn’t choose. To prevent this, include a buy-sell clause in your partnership agreement that explains how the business will be valued, how the departing partner will be paid, and when the clause applies.
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Partnership agreement templates: What to include
Every partnership needs a clear, written agreement that lays out the rules and protects everyone if things change. You can start with a partnership agreement template from the U.S. Small Business Administration or NOLO, then work with a lawyer to include the following points:
- Capital contributions: Spell out how much money, equipment, or intellectual property each partner is putting in and how future cash calls will work.
- Ownership and profit split: State who owns what percentage and whether profits follow those percentages or use a different formula.
- Roles and decision-making: Define each partner’s daily duties, voting rights, and how tie-breakers will be handled.
- Compensation: Clearly outline who receives guaranteed payments, how much, and how profits will be divided when there’s money left over.
- Buy-sell terms: Lay out how the business will be valued and paid for if a partner dies, becomes disabled, retires, or simply wants out.
- Dissolution plan: Explain how assets and debts will be divided if the partnership ends.
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