Are you thinking about starting a General Partnership? Are you involved in a General Partnership and have questions about your taxes?
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If these questions apply to you, I have created a eBook on Amazon that is free for Prime members.
This book is designed to help those just starting out. See below for Chapter 2 of my book:
Chapter 2 Forming a General Partnership
Agreement
A partnership agreement can be written, oral or implied. That means a partnership could exist without the partners ever intending to start a partnership. In reading this book, I assume you did intend on creating a partnership and recommend a written agreement, which will be covered in the next chapter. You do not need to file a general partnership with your Secretary of State.
The written partnership agreement outlines the individual partner’s responsibilities, contributions and rights. The written agreement is also important to establish assets in the partnership instead of individual partners. Banks will most likely require before opening a business account in a partnership name. Having assets in the partnership name is not required as in other entity types, but gives the partner holding the assets more power than may have been intended. They could sell what is considered partnership assets, or distribute earnings in a manner not agreed upon.
The agreement should outline that partners only receive distributions from the partnership. If anything is contributed to the partnership, there should not be a recovery of the assets contributed without a specified agreement or consent of the other partners.
Duration
A partnership can be for a specified period of time, which is common with joint venture agreements, or be perpetual. If a perpetual agreement, when a partner leaves the partnership, they are entitled to fair value of their interests. The fair value needs to be outlined in an agreement (i.e. buy/sell agreement) or mediation/court proceedings will determine the value. If a stated period of time, partners are not entitled fair value of interests if they leave, and the remaining parties are probably entitled to damages if the leaving partner had obligations to fulfill.
Contributions of Capital and Interests
The partners need to describe their initial contributions and come up with an agreed upon amount if not cash contributions (i.e. Equipment or service in the partnership.) This is used to establish interests in the voting rights (if not agreed in advance, it’s equal no matter the contribution) and assets in dissolution.
For example:
Mark and Allen are starting M & A Painters. Allen contributes $40,000 cash and Mark contributes $60,000 in a vehicle and painting equipment, all unencumbered by debt. Both will work full time in the business. Mark is entitled to 60% of partnership interests.
Partnerships typically split gains and losses equally, unless specified in the partnership agreement. In the example above, in most cases Mark would be entitled to more of the assets if dissolving the partnership, but both would earn 50% of the profits, or owe 50% of losses, especially since they work full time in the business.
This may become a point of contention if one partner works considerably more in the partnership or contributed more assets, which is why a written agreement should be created to cover the partners’ share of profits and losses in a manner consistent with their contributions or service within the partnership.
Voting
Unless the partnership agreement specifies otherwise, the partners have equal voting rights. The amount contributed to the partnership would not matter, unless the partnership agreement allocates voting rights based on the contributions.
This is different than with corporations that have shareholders versus partners; however, a partnership has more leeway to structure in the way you and the partners choose. Thus you could structure that partners that have contributed more capital, assets or service to the organization have more rights to the partnership decisions.
Tax and Distributions
Each partner pays income tax based on the income attributable to them, regardless of whether they received distributions from the partnership. The partnership files with the IRS on Form 1065, which flows to the individual partner’s 1040. The partnership will send each partner a K-1, in which the income and losses are recorded on Schedule E of the 1040.
Interest, dividends, capital gains/losses, charitable deductions, etc. are recorded elsewhere on the partner’s personal tax return (Form 1040.)
The partner will also be required to pay self-employment taxes (SE Taxes) on their share of income from the partnership. The SE Tax rate is 15.3% of income, but you get a 50% credit of taxes paid. Your partnership income will most likely also be eligible for the 20% Qualified Business Income (QBI) deduction.
Going back to the above statement that partners owe taxes, even if they do not take distributions, it is common for most partnerships in the startup stage to distribute at least enough to the partners to pay the SE Tax liability.
For instance, say the partnership from the example above only made $8,000 net income the first year. Each partner would be entitled to 50%, or $4,000. They want to leave the capital in after the first year to continue to grow, but each partner would be liable to pay $612 in SE Taxes before 50% credit and QBI deduction. They elect to distribute $612 each and leave $6,776 in the partnership bank accounts to use toward growth.
Taxes will be discussed in later chapters.
Partner Withdrawal
A partner withdrawing is considered dissociation from a partnership. If a partner dissociates, the partnership must purchase the dissociating partner’s interest at fair value or “Wind up (Terminate)” the partnership. Winding up the partnership entails selling the assets, paying the creditors and distributing whatever is left to the partners.
If the surviving partners want to maintain the partnership, they must purchase the dissociating partner’s interest at fair value. Agreeing on fair value is rarely agreed on between partners, thus a mediator or court judgment may be required. That can be expensive, so it’s important to have a buy-sell agreement in place in the partnership agreement. You can structure the buy-sell agreement based on a flat amount or other methodology, such as percentage of revenue multiple, etc.
This is also important to address in case a partner were to die or become mentally unable to participate in the partnership. Without an agreement, the partnership will terminate.
If the partnership is a two person partnership and one partner dissociates, but has his/her interests purchased at fair value, the partnership will still cease to exist. At that point, the business becomes a sole proprietorship, but still is a viable business.
Partner’s Transfer of Interests
Partners can transfer their economic interests (profit distributions and asset values), but not the voting rights, management participation and ability to review partnership financial records. Those rights still remain with the transferring partner.
The new partner may have different goals from the existing partners, so this could cause problems. It’s common for the partnership agreement to have a clause that states that transfers must be offered to the existing partners first and have a value for the purchase of interests.
Miscellaneous
The partnership must be transparent to the partners, so all partners, no matter how small their interests, have the right to inspect the books and records of the partnership.
The partners owe a fiduciary duty to the partnership and each other. That means they must act in the best interest of the partnership, not necessarily in their personal best interest. Individual partners have the right to bind the partnership, but if they violate the fiduciary duty, the other partners may have legal recourse.
End of Chapter 2.
Chapter 1 talks about the advantages and disadvantages. Chapter 3 discusses the partnership agreement. Chapters 4 through 9 discuss partnership taxation.
This is my second book, my first is for nonresident alien tax returns, 1040NR.
If you need help preparing your Form 1065 and K-1s, let me know.
