Choosing the Right Legal Entity for Your Startup - Exploring Partnerships
- Choosing the Right Legal Entity for Your Startup - Exploring Partnerships
- What Are the Best Types of Businesses to Operate as Partnerships?
- Who Is Eligible to Operate as a Partnership in the US?
- How to Register a Partnership?
- What Are the Key Advantages of Partnership?
- What Are the Key Disadvantages of Partnership?
- Partnership vs. Sole Proprietorship vs. LLC vs. Corporation
- How is a Partnership Taxed?
- Pros and Cons of Partnership Taxation
- How to Convert a Partnership?
Starting any new business is a big deal that requires enormous time and energy. Strategic planning and hard work are essential to success. One of the decisions you need to make before opening your business is to decide on your legal entity type. You have some choices available to you, such as sole proprietorship, partnership, LLC, or corporation (both S and C). A partnership is a desirable type of legal entity because you share the work and responsibilities according to your partnership agreement. It’s not all on you to do everything.
According to IRS tax return data, there are roughly 4,467,584 partnerships in the U.S., and that figure increases by 3.2% annually. Most of this growth is due to LLCs operating as partnerships. Over half (57.6%) of all partnerships have fewer than three partners. Partnerships are widespread but only comprise 7% of all business entities.
Before going into business with partners, you should compare how a partnership stacks up against an LLC, a corporation, or a sole proprietorship. The decisions you make now about your business can have long-term consequences, and you should gather as much information as possible before making your final decision. If you don’t want to assume all the risks of a new business, a partnership might be the perfect fit for you.
What is a Partnership?
A partnership is when two or more people sign a legal agreement to manage a business together and split the profits. Depending on the agreement, some partners may be involved in day-to-day operations, whereas others may remain “silent partners,” investing in the business and reaping the benefits.
There are a few different types of partnerships:
- General Partnership (GP):
A general partnership is when two or more individuals share ownership, profits, and liabilities equally.
- Limited Partnership (LP):
A limited partnership is a type of business entity that has general partners (who manage the business and share in the liability) and limited partners (who invest in the business but have limited liability). With an LP, partners share in liabilities and profits due to their percentage of ownership.
- Limited Liability Partnership (LLP):
In a limited liability partnership, all partners are protected from personal liability for certain types of business debts, legal issues, and the actions of other partners. This type of partnership works well for lawyers, accountants, and doctors.
Partnerships offer great flexibility about who can operate as one, making them a very popular option with new businesses.
Key Features of Partnership
Partnerships work very well for many businesses because individuals share the responsibilities of owning a business. Some of the key features of a partnership include the following:
What Are the Best Types of Businesses to Operate as Partnerships?
Partnerships work best for businesses with multiple people who want to work together and share in the business’s responsibilities and profits. However, partnerships are not well suited for large companies that should be incorporated. Some types of businesses that are ideal for a partnership structure include:
Professional Services:Companies that offer professional services, such as accounting, law firms, medical practices, and architectural agencies, are ideal for partnerships where individuals can offer their unique skills under the same roof.
Multiple-Owner Businesses:Partnerships work well for businesses that require more than one person to run, such as fitness gyms, small retail outlets, and juice bars.
Test-Tube Businesses:A partnership is a great way to start if two or more people have a business idea and want to test it out before going big.
Hospitality:Many hospitality businesses are partnerships. These include coffee shops, bars, pubs, restaurants, cafes, food trucks, and small hotels.
Diverse Skillset Businesses:A business that needs multiple experts is another great fit for a partnership. One example might be an IT company with web experts, security personnel, and computer technicians.
Online Businesses:Partnerships also work well for e-commerce businesses. One partner could focus on developing the product while the other focuses on the website and e-commerce functions.
Partnerships allow small businesses to offer high-quality products and services affordably by splitting the investment and work among multiple individuals. For some budding companies, this business entity structure is ideal.
Who Is Eligible to Operate as a Partnership in the US?
You must ensure you are qualified before you can set up your partnership. The U.S. has strict guidelines about what constitutes a partnership, and to be eligible, you must check off the list of requirements below:
- Unincorporated Organization:
Your business must not already be a corporation, or you cannot become a partnership.
- Two or More People:
You must have two or more people willing to enter a legal partnership agreement and share in the business’s responsibilities and profits.
- Partnership Agreement:
All parties must sign a legal document specifying the details of the partnership, including its roles, duties, responsibilities, and benefits.
How to Register a Partnership?
Partnerships are legal business entities. The steps to establishing a partnership will differ slightly depending on the type you intend to create. The good news is a partnership is easier to register than a corporation. The steps to forming a partnership are outlined below, and there are differences for each type.
You will need to choose a business name under which to operate. You can use the partners’ names (like law firms do) or choose a fictitious name and register it with the Secretary of State as a DBA (doing business as). You must check with the Secretary of State to ensure your chosen name has not already been taken. You cannot operate under a business name that is already used within the state.
It’s also essential to ensure you are not infringing upon anyone’s trademark. Check the U.S. trademarks database to see if your proposed company name is already in there. Once you have found a business name that suits your business and is available, register it through your Secretary of State’s office. You must file a DBA form if the name does not match the partners’ last names.
Although you don’t legally need to draft a formal partnership agreement, experts strongly recommend you do so to avoid any issues down the road. Partnerships exist with oral agreements, but you could end up in a legal battle due to misunderstandings if you don’t put everything down on paper.
A partnership agreement can be complex, and it’s best to hire an attorney to draft one for you. Some of the items you want to include in your agreement are as follows:
- Contributions:
Clearly spell out each party’s contributions (both financial and operational).
- Management and Control:
Specify how much control each partner will have over the business, who will manage things, and who will only be “silent” partners.
- Profits and Losses:
It’s essential to allocate in writing the percentage of the profits and losses each partner will incur.
- Distributions:
Stipulate when and how distributions of money or property will be doled out.
- Voting Rights:
Who has what voting rights, and how much are they worth? Decide how much decision-making power each partner has.
- Responsibilities/Duties:
Detail each partner’s responsibilities within the business and their duties on a day-to-day basis.
- New Partners:
Detail the process for adding new partners and when this can happen.
- Bankruptcy, Withdrawal, or Death:
If a partner files for bankruptcy, decides to withdraw from the firm, or dies, you must specify what happens to the partner’s interest in the business and the procedure for them leaving the company.
- Duration:
You should also provide details about the duration of the partnership and what to do if life events necessitate dissolving it.
- Continuation:
If an event occurs that dissolves the partnership, include a provision for continuation with the remaining partners.
- Right of First Refusal:
Add a section about the “right of first refusal” so that other partners can purchase another partner’s interest if they die or leave the company.
Many types of businesses and occupations require specific licenses before you can do business. For example, CPAs, lawyers, health-care providers, real estate agents, etc. Some types of businesses also require licenses to sell certain products like meat, alcohol, tobacco, and firearms. Contact your local town office to ask about local, state, and federal permits or licenses you must have before opening your partnership. You may even need special building permits or zoning licenses for some businesses.
The IRS requires partnerships to register for an EIN (employer identification number) regardless of whether or not they hire employees. This crucial step is easy to accomplish. Log onto the IRS.gov website, and you can register your partnership and get an EIN within a few days. You will need this EIN when you apply to open a business bank account.
If your business sells goods, you must also register with your state’s tax agency so you can pay sales tax on every product you sell. The local tax authority differs from state to state, and some states do not have a sales tax. Check with your state tax office (varies) to learn more about this step.
In a partnership, at least one person will have personal liability for the business and actions of the other partners. This leaves you vulnerable to loss if you are not protected. Find a local business insurance agent and purchase a policy that protects you against catastrophic financial loss in the event of legal issues or other problems. You will also need commercial auto insurance if you use vehicles in your business.
Since it’s not just you running the business, you must apply for a business bank account to keep all business activity in one place. It will be easier to delineate the business income and expenses at tax time and keep partners from confusing personal money with business.
Use the list above for general partnerships and limited partnerships, but you must also file a certificate of limited partnership with the Secretary of State when you form a limited partnership. The certificate requirements vary by state, but typically, they will detail the partnership name, address, purpose, and list of the partners and their business addresses. You must also specify a “registered agent” with the Secretary of State to receive service of process and any legal notifications.
What Are the Key Advantages of Partnership?
There are many advantages to forming a partnership. Before signing on the dotted line, you must also know all the ins and outs to make an informed decision. Review the list of key advantages below that make a partnership ideal for your situation.
What Are the Key Disadvantages of a Partnership?
Partnerships offer many great benefits; it’s the only good option for some types of businesses. However, familiarize yourself with the disadvantages so you can choose the right business entity with your eyes wide open. Some key disadvantages of a partnership include:
Partnership vs. Sole Proprietorship vs. LLC vs. Corporation
Choosing your business entity type will impact you for years. Think about your business now and what it will look like in five years or ten. Sole proprietorships and partnerships use pass-through taxation, and at least one individual is liable for the company’s debts and legal issues. LLCs or corporations protect the individuals who own the business against personal liability.
However, both can be taxed as their own entity, and the individuals must report income, profits, and losses from the business on their own personal returns. With a sole proprietorship and partnership, you will have more control over business decisions than with a corporation. LLCs fall in the middle, depending on how they are structured.
Review the chart below to learn about the different types of entities and how they compare. A partnership might be the best fit for you and your partners.
| Characteristic | Sole Proprietorship | Partnership | LLC | S-Corp | Partnership (C-Corp) |
|---|---|---|---|---|---|
| Formation | Quick and simple with no filing requirements with any government agency. | Simple to create with no legal filing requirements. | More expensive to create and requires filing with the state. | An S-Corp is more costly to establish, and it requires state filing. | It is more expensive to establish and requires filing with the state. |
| Cost of Formation | None | None | The cost of the state filing fee is usually between $100-$150. | The cost of registering an S-Corp with the state can be anywhere between $20 and $800. | The average cost to register a C-Corp in the United States is $633. |
| Business Name | Can operate under the owner’s name, or a fictitious name using a DBA. | Can operate under the owner’s name, or a fictitious name using a DBA. | Must register an official company name with the state that is established and secured. | Must register an official company name with the state that is established and secured. | Must register an official company name with the state that is established and secured. |
| Taxation | Pass-through taxation, where all everything is filed under the owner’s personal taxes. | Filed under the partnership. Each partner claims their income and losses on their personal returns based on their percentage of the business. | Pass-through taxation, where everything is filed under the owner’s personal taxes. If there are multiple owners, taxation is treated like a partnership. | Each owner declares their share of profits/losses on their personal returns. Income is allocated based on owner percentage. Owners can use corporate losses to offset other types of income. Fringe benefits are limited to owners who own more than 2% of the shares. | The C-Corp is a separate taxable entity that must file returns. Owners split profits and only declare their portion on personal income tax returns. Owners can deduct fringe benefits as business expenses. |
| Liability | The owner is personally liable for all business actions, liabilities, debts, and damages. | Owners are personally liable for all business debts. | Business is its own entity; therefore, the owner(s) are protected against personal liability. | Owners have limited liability for personal debts, and business legal issues. | Owners have limited liability for personal debts and business legal issues. |
| Operational Requirements | No operational requirements are necessary. | No operational requirements are necessary. | More formal requirements than an LLC but not as strict as a C-Corp. | Much easier to maintain than a corporation. Annual member meetings and a report are required. | Annual meetings are required, and members must vote on changes. Shares of stock must be sold to raise capital. |
| Management | Full control of all decisions, management, and operations. | Each partner has equal control and decision-making ability unless it’s a limited partnership. | An operating agreement outlines how each member can manage the company. | Managed by a group of directors that shareholders vote in. | Managed by a group of directors that shareholders vote in. |
| Raising Capital | Can be challenging and the owner often has to invest his/her own money. | Each partner can invest, and more partners can be added to raise additional capital. | Managers can sell interest in the business to raise capital based on operating agreement restrictions. | Can sell shares of stock to raise capital. | Can sell shares of stock to raise capital. |
| Transferability of Interest | No | No | Possible based on the operating agreement restrictions. | Yes, as long as IRS regulations about who can own stock are honored. | Shares of stock can be easily transferred. |
How is a Partnership Taxed?
Partnerships use the pass-through taxation method like sole proprietorships. That means that each partner will include their income, expenses, profits, and losses that the business incurred, based on their percentage of ownership. So, if the business earned a total of $100,000 in a year and the expenses were $45,000, the remaining profit is $55,000. With a two-person partnership, each owner would enter a profit of $27,500 on their individual tax return. The split is 50/50.
With LLCs and corporations, the IRS views the business as its own entity (LLCs can go either way) and must file its own tax return. The owners of those entities then enter only the income they received from the business and any deductions related to the business on their individual tax returns. Pass-through taxation avoids double taxation, which is a benefit of sole proprietorships and partnerships.
At the end of each year, partnerships file an IRS Form 1065, which details the total income, expenses, profits, losses, and any deductions. Two additional pages contain many questions about the partnership business, along with numbers about the business. Partners also fill out and file a Schedule K, which categorizes the income into brackets such as ordinary business income, rental income, and interest income.
Each partner will complete a Schedule K-1, which carries over all the information from the Schedule K into their personal tax return detailing their portion (based on ownership percentage) of the income, credits, expenses, and deductions from the whole.
Federal income taxes are not withheld from partnership distributions. Therefore, each partner is solely responsible for paying their own taxes. They can use quarterly estimated taxes based on the 1040-ES worksheet to calculate the total and pay some each quarter, so they don’t owe at the end of the year.
Employees pay Social Security and Medicare taxes through their paychecks. They pay half, and the employer pays the other half. Partners are not paid as employees and must pay their own self-employment taxes like sole proprietorships. The self-employment tax rate in the U.S. is 15.3% of net earnings (profit) of $400 or more. That total includes Social Security (12.4%) and Medicare (2.9%). Even though you are responsible for paying 100% of those taxes yourself, you can deduct 50% of them when you have a partnership. Partners file these taxes through Form Schedule SE along with their Form 1040.
Unlike most business entities, partnerships must file their taxes by March 15th instead of April 15th.
Partnerships allow some special deductions that may not apply to other business entities. These are as follows:
- Start-Up Costs:
The costs of setting up your partnership (including legal fees, accounting, supplies, and equipment) can be deducted from your taxes.
- Operating Expenses:
The expenses associated with operating your business may also be deducted from your taxes.
- Travel:
If you travel for business, you can deduct hotels, meals, laundry service, taxi or other car services, and mileage (according to IRS rules) from driving your car from your income taxes.
- Advertising and Marketing:
Deduct the cost of marketing your business, including business cards, signage, radio, TV, or magazine ads, and internet marketing.
- Meals and Entertainment:
If you wine and dine your clients, you may also deduct a portion of those expenses when doing your taxes.
- Home Office Deduction:
If a partner works out of a home office, they can take the home office deduction, which allows them to take a portion of their home expenses for business.
Pros and Cons of Partnership Taxation
Partnerships use pass-through taxation, which is good because it means your money is only taxed once, not doubly taxed. The partnership itself is not taxed as an entity, but each partner must claim a portion of the income, expenses, profits, and losses on their own taxes. Even though it works to avoid double taxation, each partner may pay more in taxes, and it may raise their tax bracket to a higher percentage than they would like.
Filing taxes for a partnership is more complex than with a sole proprietorship; it requires additional forms but is still less complicated than if it were an LLC or corporation.
Use this table below from the IRS to be sure you are filing the correct forms:
How to Convert a Partnership?
If you established a partnership when you first started the business, you may switch to another type of business entity to increase your liability protection, take advantage of tax breaks, or increase your investment opportunities. As the business grows, the entity type may no longer fit your business goals and needs.
The good news is you can convert your business from a partnership to other forms. However, the complexity depends on what you switch to. Some of the reasons you may want to convert include:
- Business Growth/Credibility:
As your business grows and you take on more sophisticated clients, you should incorporate it to lend more credibility or legitimacy to your company. A different structure may help if the business itself is getting more complex and challenging to manage.
- Merging:
If you decide to merge with another company or a more prominent firm offers to buy you out, they may need you to convert the entity type first.
- Capital:
Raising capital can be challenging for some business types. Converting to a different entity could attract more desirable investors.
- Simplify Management:
An LLC could offer simplified management that a partnership cannot.
- Tax Advantages:
You can convert your partnership to another entity type to lessen the tax burden and improve your financial situation.
Partnership to Sole Proprietorship
If your partner(s) want to leave the business but you want to keep it going, you might decide to convert it to a sole proprietorship. Doing this will put you in the driver’s seat. You will have complete control and full liability. But the company will be all yours. Making this move requires that you completely dissolve the partnership first. To convert from a partnership to a sole proprietorship, you need to:
- Review your partnership agreement to see what steps you need to take.
- Research the legal ramifications and abide by any local, state, or federal rules when dissolving the partnership.
- Notify all partners.
- Buy out partners who want to leave.
- Resolve any remaining partnership issues.
- After dissolving the partnership, you must apply for a new EIN with the IRS for your sole proprietorship and register the new business name through the Secretary of State’s office.
- Obtain any licenses and permits under your name.
- Notify your customers and clients that your company has changed.
- Update your bank records.
- Notify the IRS of the change using Form 8832.
Partnership to LLC
You can convert the business to an LLC for added legal protection or easier management as the company grows. Follow the steps below to switch your partnership to an LLC business entity:
- You must have a unanimous agreement with all partners about converting.
- Sign an agreement attesting to the change.
- Develop a plan for conversion and decide how the LLC will be structured, owner percentages, management, and how assets and liabilities will be transferred.
- File the Articles of Incorporation with the Secretary of State.
- Draft an Operating Agreement detailing all the organization’s ins and outs.
- Legally transfer all the assets and liabilities to the LLC.
- Obtain a new EIN from the IRS.
- You may have to file Form 8832 with the IRS to notify them of the change.
- Check to see if the LLC’s new name is available and register it with the state through the Secretary of State.
- Designate a registered agent to be your receiver for legal documents.
Consider hiring a professional attorney to handle these steps, as it can become complex.
Partnership to S-Corp or C-Corp
When switching from a partnership to a corporation (S or C), you have some options available to you. You can convert it according to state laws, merge the partnership into an existing corporation (it can be new), transfer the assets to the new corporation, or change your tax status to be taxed as a corporation. The steps to accomplish this are:
- Some states allow you to convert the partnership to a corporation directly through legal paperwork.
- You can also merge your partnership with a newly formed corporation.
- Some states may require you to dissolve the partnership and start a new corporation.
- Either way, all partners must approve the change.
- Develop a conversion plan outlining the switch’s terms and conditions.
- File the changes with the Secretary of State.
- Report the change to the IRS.
Since these are the most complicated options, consider consulting an attorney to help you convert quickly and affordably and make the right decisions about your options. Check with your state office to review the specifics of corporate law and how to change your partnership into a new business entity.
- Choosing the Right Legal Entity for Your Startup - Exploring Partnerships
- What Are the Best Types of Businesses to Operate as Partnerships?
- Who Is Eligible to Operate as a Partnership in the US?
- How to Register a Partnership?
- What Are the Key Advantages of Partnership?
- What Are the Key Disadvantages of Partnership?
- Partnership vs. Sole Proprietorship vs. LLC vs. Corporation
- How is a Partnership Taxed?
- Pros and Cons of Partnership Taxation
- How to Convert a Partnership?