A partnership is a type of business structure where two or more individuals come together to carry out a business venture. The partners pool their resources, skills, and expertise to establish and operate the business. They share the responsibilities, profits, losses, and liabilities of the business according to the terms outlined in a partnership agreement.
Types of partnerships
Partnerships can take various forms:
- general partnerships
- limited partnerships
- limited liability partnerships (LLPs).
In a general partnership, all partners have equal rights and responsibilities, and they share the profits and losses equally. Each partner also has unlimited personal liability for the partnership’s debts and legal obligations.
Limited partnerships consist of at least one general partner and one or more limited partners. The general partner assumes full liability for the partnership’s obligations, while limited partners have limited liability and are typically not involved in the day-to-day operations of the business.
Limited liability partnerships (LLPs) provide liability protection to all partners. In an LLP, each partner is shielded from personal liability for the actions and debts of the other partners and the partnership itself. This type of partnership is often chosen by professionals such as lawyers, accountants, and architects.
Pros of running a business as a partnership
Easier formation than corporations and LLCs
Compared to other business structures, partnerships are relatively easy and cost-effective to establish. They require minimal legal formalities and paperwork. Partnerships can be formed by a simple agreement between the partners, outlining the terms of the partnership, profit-sharing arrangements, and decision-making processes.
Shared responsibility
Unlike a sole proprietorship, one of the biggest advantages of a partnership is the shared responsibility among partners. The workload and decision-making process are distributed, allowing partners to divide tasks based on their strengths and expertise. This shared responsibility not only reduces the burden on individual partners but also makes for better decision-making since each partner may have different perspectives.
Diverse skills and expertise
Partnerships bring together individuals with different skill sets, knowledge, and expertise. This diversity can greatly benefit the business by fostering creativity, innovation, and efficient problem-solving. The collective wisdom and varied experiences of partners can lead to more effective business strategies and successful outcomes.
Increased capital
By pooling financial resources, partners can contribute to the business’ capital requirements, providing more funds for investment, expansion, and operational needs. This increased capital can accelerate business growth and facilitate the pursuit of opportunities that might be beyond the reach of a sole proprietorship.
Shared financial burden
In a partnership, partners share the financial risks and losses of the business. Each partner contributes to the business’ liabilities and obligations, reducing the burden on individual partners. This shared financial responsibility provides a safety net and minimizes the impact of potential setbacks on any single partner.
Tax advantages
Unlike a C-corporation, partnerships are not subject to double taxation. Instead, profits and losses “pass through” to the partners’ personal tax returns. This arrangement can result in lower overall tax liabilities, as the partners are only taxed on their individual share of the partnership’s profits.
Also read: How To File Taxes as a Partnership (Forms and Deadlines)
Deduct business losses on tax return
Because the losses of a business pass through to the partners’ individual tax returns, business losses can be deducted from personal income and be used to offset profits from other income sources, like a day job.
Flexibility
Partnerships offer considerable flexibility in decision-making and business operations. Partners can establish their own rules, agreements, and operational frameworks, allowing them to tailor the business to their specific needs and goals. This flexibility enables partners to be nimble, adapt to changing market conditions, and seize opportunities more swiftly than in other business structures.
Also read: What Are The Different Types Of Business Entities?
Cons of running a business as a partnership
Unlimited liability
Similar to a sole proprietorship, one of the biggest drawbacks of a partnership is that the partners of the business have unlimited liability. In a general partnership, each partner is personally liable for the business’ debts, obligations, and legal actions. This means that if the business faces financial difficulties or legal issues, partners may be held personally responsible, risking their personal assets and financial well-being.
Disagreements and conflicts
Partnerships can face internal conflicts and disagreements due to differences in opinions, decision-making styles, and strategic visions. Disputes over business operations, profit distribution, and future directions can arise, potentially straining relationships and hindering effective decision-making.
Profit distribution disagreements
One of the most common disagreements within a partnership is around profit sharing. The distribution of earnings may not always align with each partner’s individual effort or contribution. The specific percentage of profit sharing can be agreed upon in the partnership agreement, considering each partner’s capital contribution and time commitment to the business. However, as the business evolves, some partners may feel the share agreement is unfair and become resentful or demotivated.
Shared decision-making
Partnerships require consensus and collaboration in decision-making. While shared decision-making can lead to more comprehensive perspectives and robust solutions, it can also slow down the decision-making process. If partners have differing viewpoints or struggle to reach a consensus, it may result in inefficiencies and delays in implementing crucial business strategies.
Dependency on partners
Partnerships rely heavily on the active participation, dedication, and commitment of all partners. If one partner becomes inactive, uncooperative, or decides to leave the partnership, it can significantly disrupt the business’s operations and continuity. The departure of a partner may require reevaluating the partnership agreement, redistributing responsibilities, and potentially affecting relationships with clients and stakeholders.
Limited funding options
Compared to corporations, partnerships may face limitations when it comes to raising capital. Partners typically rely on their personal funds, loans, or contributions from within the partnership. This can restrict the ability to access larger funding sources, such as issuing shares or attracting external investors, which may be available to corporations or LLCs.
Potential for legal issues
Partnerships can be vulnerable to legal disputes amongst partners, particularly if there is no formal partnership agreement or if disagreements arise regarding profit sharing, decision-making, or the exit of a partner. Without clear contractual guidelines, legal issues can become complex and costly, potentially leading to damage to the business’ reputation and financial stability.
Lack of continuity
Partnerships are generally characterized by limited continuity, meaning the partnership dissolves upon the departure, death, or bankruptcy of a partner unless otherwise stated in a formal partnership agreement. This lack of continuity can disrupt business operations, relationships with clients and suppliers, and require restructuring or reformation of the partnership to continue operating.
Partnership vs sole proprietorship
Sole proprietorships and partnerships have some similarities, such as ease of formation and simplicity of business structure. However, there are some distinctions to consider.
- Ownership: In a sole proprietorship, the business is owned and operated by a single individual, known as the sole proprietor. On the other hand, a partnership involves two or more individuals who come together to own and operate the business collectively.
- Decision-making: In a sole proprietorship, the sole proprietor has complete autonomy and authority to make all business decisions. In a partnership, decision-making is shared among the partners, and major decisions are usually made through consensus or as outlined in the partnership agreement.
- Liability: In a sole proprietorship, the sole proprietor bears unlimited personal liability for the business’ debts and legal obligations. This means that the sole proprietor’s personal assets are at risk. In a partnership, general partners also have unlimited personal liability for the partnership’s debts, while limited partners (in a limited partnership) have limited liability up to their investment in the partnership.
- Shared profits and losses: In a sole proprietorship, the sole proprietor exclusively enjoys all the profits generated by the business. In a partnership, profits and losses are shared among the partners according to the terms outlined in the partnership agreement. Profit distribution in a partnership can be based on various factors, such as capital contribution, agreed-upon percentages, or a combination of factors.
- Legal entity: A sole proprietorship is not considered a separate legal entity from its owner. The business and the owner are treated as one for legal and tax purposes. In contrast, depending on the jurisdiction and type of partnership, a partnership may be recognized as a separate legal entity from its partners. This distinction can have implications for issues such as contracts, taxes, and legal liability.
- Formation: Establishing a sole proprietorship is relatively straightforward. It typically requires minimal legal formalities, such as obtaining necessary licenses and permits. In contrast, forming a partnership often involves drafting a partnership agreement that outlines the terms and conditions of the partnership, profit-sharing arrangements, decision-making processes, and other important details.
- Continuity: Sole proprietorships lack continuity beyond the life of the sole proprietor. If the sole proprietor retires, becomes incapacitated, or passes away, the business generally ceases to exist. Partnerships, depending on the type and provisions in the partnership agreement, may continue even if one partner withdraws or passes away, ensuring greater continuity of the business.
Partnership vs LLC
- Liability: In a partnership, the partners have unlimited personal liability for the debts and obligations of the business. In comparison, an LLC provides limited liability protection to its owners, known as members. Members’ personal assets are typically shielded from business liabilities, and their liability is generally limited to their investment in the LLC.
- Structure: Partnerships are typically formed by an agreement between two or more individuals who come together to establish and operate a business. The partnership can be a general partnership, limited partnership, or limited liability partnership (LLP). On the other hand, an LLC is a separate legal entity that is formed by filing articles of organization with the appropriate state agency. LLCs can have one or more members, and the ownership structure and management are outlined in the LLC’s operating agreement.
- Ownership and management: Partnerships are owned and managed by the partners who actively participate in the business. Each partner typically has an equal say in decision-making, unless otherwise specified in the partnership agreement. In an LLC, ownership is divided into membership interests, and members can have different ownership percentages. LLCs can be member-managed, where all members are involved in the day-to-day operations, or manager-managed, where members appoint one or more managers to handle the business operations.
- Formalities and compliance: Partnerships generally have fewer formalities and regulatory requirements compared to LLCs. While partnerships may benefit from having a written partnership agreement, they are not always legally required. On the other hand, LLCs are subject to more formalities, such as filing articles of organization, creating an operating agreement, holding regular meetings, maintaining proper records, and complying with state regulations.
- Taxation: Partnerships are pass-through entities for tax purposes. This means that the partnership itself does not pay taxes on its profits. Instead, profits and losses are “passed through” to the partners, and each partner reports their share of the partnership’s income or loss on their individual tax returns. LLCs have flexibility in their tax treatment. By default, LLCs with multiple members are taxed as partnerships. However, LLCs can also choose to be taxed as a corporation by filing an election with the IRS.
- Continuity: Partnerships may face continuity challenges, particularly in the event of a partner’s withdrawal, retirement, death, or bankruptcy, unless otherwise specified in the partnership agreement. An LLC, on the other hand, can have perpetual existence, meaning it can continue to operate regardless of changes in membership. This allows for greater stability and continuity in the business.