Partnerships are a form of flow-through business entity. A partnership has to have at least two partners with any percentage of partnership interest. For example, one partner can have 99% interest and the other can have 1% or any combination that adds up to 100%. And a partnership is not limited to two partners; there can be as many as the partnership wants to have.
Once a very popular business entity, I haven’t seen many new partnerships start up lately. I think there are two reasons for this:
- Popularity of S-Corporations
- They are an unwieldy type of business entity
Formation
Ok – when I say they are unwieldy - what do I mean? The way a partnership must be run is dictated by your state statutes. Check out the business organization section of your state statutes to find the rules on how partnerships in your particular state need to operate. Following these rules, the partnership draws up an agreement and files paperwork with the secretary of state in which the partnership is going to operate. Most states have provisions for both general partnerships and limited partnerships.
With a general partnership, all partners are all personally liable for any legal action taken against the partnership and for any debts the partnership owes. And that’s jointly and severally– which means that if your partner does a boned headed thing on behalf of the partnership – even if you didn’t authorize it, you are on the hook as well for any negative repercussions.
Many states allow for limited liability partnerships, which basically means if you are a limited partner your liability is limited to your investment in the partnership. However, you won’t have any say so in how the partnership is run.
Taxation
A partnership files an informational return only. Paperwork is filed with the IRS but the partnership doesn't pay the tax. IRS Form 1065 is prepared to record all the partnership items of income and expense and these items are divvied up according to each partners ownership % and taxed on their Form 1040 at their personal tax rate. Assuming a net income is reported by the partnership, when reported on the person's personal tax return those earnings are also subject to self-employment taxes, which comes out to roughly an additional 14.9% in taxes.
Partners are taxed even if they don’t take any money out of the partnership. Of course, if the partnership has a net loss, the loss can offset other items of income on the Form 1040 like your spouses wages or interest income.
How Do Partners Get Paid?
- The partnership agreement can call for guaranteed payments. These are payments made to the partner regardless if the partnership made or lost money. So if the partnership agreement says your guaranteed payment is $1,000 per month, you get a check for $1,000 per month. Guaranteed payments are deducted as an expense of the partnership and are subject to self employment tax too.
- Distributive Share: Partners can also receive payments based on their ownership % of the profits of the partnership. These payments are not deductible as a partnership expense but are generally subject to self-employment tax.
Bottom line, I don’t recommend forming a partnership for a small arts and crafts business. You’ll have the additional expense of having an attorney draw up your partnership agreement and you’ll have to pay an accountant to prepare the tax return. There are much easier ways to run your business when you have two or more owners. Check out the info on corporations.
