This is the second in a continuing series of articles on business entities. In this article, we address the basics of the partnership form of business.
The decision to enter into a partnership should not be taken lightly. Before entering into a partnership, you should be able to answer several questions. Why is there a need for a partner or partners? Does the prospective partner share your goals for the business? Will the prospective partner be willing to make the investment of money, time and effort that is necessary? Does the prospective partner share your sense of ethics?
In its most basic form, a partnership involves an agreement between two or more persons who agree to share the profits and losses of a business; however, this often involves sharing control of the business as well. Partnerships also have the advantage of having more than one person who can contribute capital, effort and ideas to the business.
Partnerships usually come with an increased administrative burden as compared to a sole proprietorship. While not legally required, a partnership agreement is a document that forms the rules for the operation of the partnership. There inevitably will be differences of opinions between partners, and without a partnership agreement the path for resolving differences will be more difficult. At a minimum, issues such as capital investment, division of profits, control, admission and removal of partners and termination of the partnership should be addressed in the agreement. These issues can be addressed in a variety of ways so it is advisable to seek advice from a knowledgeable professional when entering into a partnership.
A general partner can be personally liable for the actions of the partnership. If one partner takes an action for the business that results in liability, other partners can be held liable even in cases where the other partners were not directly involved in the action. Consequently, partnerships need to be well insured in order to protect the partners’ personal assets.
Partnerships are considered “pass-through” entities for federal income tax purposes which means that the profits and losses of the partnership flow through to the partners and the partnership does not directly pay income tax. Instead, the individual partners pay personal income tax on the profits that flow through to them. Unlike a sole proprietorship, a partnership must file a federal tax return which is an informational return. Thus, tax compliance costs are usually greater for a partnership than a sole proprietorship. Pennsylvania also requires partnerships to file an informational income tax return even though the profits pass through to the partners. Pennsylvania currently taxes these profits as personal income at the rate of 3.07%.
Under federal tax law, there can be issues as to whether partners are treated as employees of the partnership or whether they are subject to the self-employment tax. This is a complicated issue that will be dependent on circumstances so legal advice may be necessary to resolve this issue.