Business Entity: Partnership

Often, two or more individuals decide to open a business. They believe that they have the talents and experience to operate a successful business. In these cases, the individuals form a partnership.

A partnership is simply two or more individuals who desire to open a business. It is very similar to a sole proprietorship in many respects.

Most partnerships are formed “on a handshake and a promise.” While these ventures have occasionally worked, most fail due to misunderstandings between the partners. It has been our experience that partnerships formed without a formal partnership agreement are doomed to have severe problems, most of which lead to the dissolution of the partnership.

As such, it is highly recommended that the partners contract an attorney to draft a formal partnership agreement. This agreement should address at a minimum the following concerns.

  1. CONTRIBUTION PERCENTAGES
  2. PROFIT SHARING PERCENTAGES
  3. LOSS SHARING PERCENTAGES
  4. GUARANTEE PAYMENTS TO PARTNERS FOR HOURS WORKED OR CAPITAL CONTRIBUTED
  5. RESPONSIBILITES OF EACH PARTNER
  6. PROCEDURES FOR THE ADDITION OF PARTNERS
  7. PROCEDURES FOR THE WITHDRAWAL OF PARTNERS
  8. WHAT HAPPENS WHEN A PARTNER DIES OR IS INCAPACITATED
  9. HOW DISPUTES ARE MEDIATED
  10. 1PROCEDURES FOR THE DISOLUTION OF THE PARTNERSHIP

(NOTE: MULTIPLE OWNERS OF REAL ESTATE PROPERTY DO NOT HAVE TO FORM A FORMAL PARTNERSHIP. THE INTERNAL REVENUE CODE HAS PROVISIONS RELATED TO SPLIT INTEREST REAL ESTATE. THIS ELIMINATES A LOT OF CONCERNS REGARDING REAL ESTATE OWNERSHIP BY MULTIPLE OWNERS.)

Advantages of a Partnership:

  1. A partnership has all the advantages of a sole proprietorship excluding the ease of formation and no special return required. (A formal partnership agreement should always be prepared and a partnership is required to file a Form 1065 each year). However it requires more than one individual as opposed to other non-Sole Proprietorship Entities.
  2. It is relatively simple to add new partners and to “cash out” withdrawing partners.
  3. Profit or Loss distribution percentages are easily changed via “guaranteed payments to partners.”

    For example, assume a partnership was formed and one individual contributed $50,000 but does limited work for the firm, while the other partner works full time for the partnership but has no capital contributed. The following illustrates how guaranteed payments to partners may be included in the partnership agreement in order to “equalize” the profit distributions.

    Working capital will earn a fixed rate of 7% and is guaranteed to Partner A,

    $15/hour is guaranteed to both partners for hours worked and all remaining profits and losses will be divided evenly. The following occurs:

    Partner A Capital Contribution: $50,000
    Partner A Hours Worked: 10 hours
    Partner B Hours Worked: 1,500 hours
    Profit before Guaranteed Payments to Partners: $35,150
    The partnership agreement would yield the following results:
    Partner A:
    Capital Contribution $ 50,000 x .07 = $3, 500.00
    Hours Worked 10 x 15 = 150.00
    TOTAL: $3,650.00 (A)
    Partner B
    Hours Worked 1,000 x 15 = 22,500.00 (B)
    Total Guaranteed Payments to Partners: $26,150.00
    Total Income: $36,150.00
    Less Guaranteed Payment: ($26,150.00)
    Income after guaranteed payment: $10,000.00 (C) 50% each
    Total Income Partner A
    Guaranteed Payment: $3,650.00 (A)
    Profit Distribution: $5,000.00 (C)
    Total: $8,500.00
    Total Income Partner B
    Guaranteed Payment: $22,500.00 (B)
    Profit Distribution: $5,000.00 (C)
    Total: $27,500.00
    Total Both: $36,150.00


    As you can see, there is tremendous flexibility in adjusting profit distributions.


Disadvantages of a Partnership:

  1. Partnerships have all the disadvantages of sole proprietorships, plus
  2. Each partner is jointly (taken together) or severally (each individually) liable for all claims against the partnership. This basically means if the partnership is sued and a judgment is entered, the litigant can collect the full amount from one partner or from all partners. Each partner is NOT limited to their percentage of ownership.
  3. If the partnership agreement is poorly drafted, numerous problems can occur during the operation or dissolution of the partnership.
  4. When starting a partnership, most individuals are convinced that the other partners are equally concerned for the success of the partnership. As time passes, petty grievances and self interests have a tendency of undermining even the best business partnership.