A partnership is a unique type of business. It's composed of at least two owners, but it could have many owners (thousands, even). These owners share in the benefits and drawbacks of the business partnership, according to the terms of a partnership agreement that they sign when they join the partnership.
To form a partnership all that's required is (1) to register the partnership in the state where it is going to do business, and (2) to create a partnership agreement defining what each partner is responsible for, the different types of partners, how partner ownership works, and how to handle changes in the partnership.
Partnerships are formed and operate under state regulations. See your state's business division (often under the secretary of state's website) for more information on state business regulations.
Becoming a Partner in a Partnership
Partners usually join a partnership, either when it starts or when they join, by contributing money or other assets to the partnership. Another track to partnership is to be hired as an employee and after a period of time be invited to join the partnership. A law firm, for example, may have employees, called associates. At some point, an associate may be invited to "make partner" by buying into the partnership.
Two Types of Partners - General and Limited
Different types of partners in a partnership are similar because they all have made an ownership contribution.
Partner types are different in how active they are in the partnership and how much liability they have. Liability in a partnership, as in other businesses, means individual partner liability of two kinds:
- For the debts of the partners
- For actions of themselves and all other partners
General partners who actively participate in the business of the partnership have full liability in these situations. For example, this means they might have to pay debts of the partnership from their personal funds.
But a partner's liability can be limited if they are an investor who doesn't get involved in the management or activities of the partnership. Limited liability in these cases means that the person is only liable up to the amount of their investment in the business.
General Partners vs. Limited Partners
A general partner in a partnership takes part in the daily operations of the partnership and is personally responsible for the liabilities of the partnership.
A limited partner doesn't take part in the activities of the partnership (like being a CPA, for example) or managing the partnership. Limited partners have limited liability, as described above. Limited partners are sometimes called "silent partners," because they contribute but don't do anything on a day-to-day basis.
How Partners Pay Taxes
Partners can take distributions from their share of the partnership according to the terms of the partnership agreement. But they aren't taxed on these distributions; they are taxed on their share of the income or loss of the partnership each year.
Both limited partners and general partners receive a share in profits and losses of the partnership (this is called their partnership interest), based on their percentage share of ownership of the partnership, as defined in the partnership agreement.
The partnership itself isn't taxed on its income. An information return is filed for the overall business using a partnership tax return (IRS Form 1065). The partners receive a Schedule K-1 showing their share of the income or loss of the partnership, depending on the partnership agreement. The Schedule K-1 information is added to each partner's 1040/1040-SR and any profits or losses are added to the person's other income to calculate their total taxable income.
Limited Partners and Partnership Losses
Limited partners have a special tax situation when the partnership has a loss. Because they have don't participate in the partnership business, they have what the IRS calls "passive activity." In this case, their share of the partnership's loss for the year may be limited. This is a complicated tax situation, so get help from your tax professional if you find yourself in this position.
Levels of Partners in a Partnership
Levels of partners in the partnership may be senior partners, junior partners, and associate partners. Duties and responsibilities vary at different levels. At each level comes more responsibility, including the training and supervision of lower-level partners. Some partners may be responsible just for administration while others focus on gaining and maintaining clients.
Managing Partners - Duties and Responsibilities
Some partnerships have a managing partner, who is responsible for the overall running of the partnership, the day-to-day financial, legal, and human resources functions. The managing partner is given authority to act on behalf of the partnership by the partners, as spelled out in the partnership agreement.
With the increased responsibility given to a managing partner comes with increased liability. Signing legal documents, for example, carries an additional responsibility and liability.