The Basic Principles of a Partnership

A partnership is a form of a business entity that provides many more advantages than any other form of business entity. There are several basic principles of a partnership that once understood, the reader can use to his advantage in the small business world. Below are descriptions and an explanations of the basic principles of a partnership and the corresponding legal impact.

Historically partnerships were created due to family business operations. The typical relationship was father and son in business. It was normal in farming and in the old town business operations. As the judicial system expanded and attorneys saw opportunities in lawsuit litigation to attach to the assets of both or all partners for the negligent act of one partner, many of the traditional partnerships converted to corporation status. This is clearly the distinctive disadvantage of a partnership. If your partner is sued for a negligent act in business operations, then you are exposed to having your assets attached from a lawsuit.

Given this, why would anyone want to participate in a partnership? To explain this, you first need to understand what a partnership means.

A partnership is mutual covenant of cooperation to achieve a particular or a set of goals. The best example of a partnership is a marriage. Here the covenants are agreed to in the vows and the goals are mutual support and ultimately the continuation of a family through the raising of children. In business, the primary goal is to make money. By combining the strengths of two or more partners, the business operation’s goal is to maximize the bottom line profit of the operation. To achieve this, partners have to have a high level of understanding and mutual reliance on each other to achieve success. There are certain characteristics in a partnership that exist to assurance of this success. They include the following:

  • Trust
  • Loyalty
  • Confidence
  • Devotion to Each Other

Without these characteristics, the partnership cannot achieve full success with the business goal(s).

Now that you understand what a partnership is; you can take advantage of some of the basic principles of this relationship. Most of these principles are financial in nature, but the first is not. Below identifies the top four principles and their respective advantages of a partnership with a description and/or examples.

Mutual Reliance

As children we learned early on about the value of dependence upon our parents for food, shelter, clothing, guidance and love. This is by far the 2nd most rewarding relationship for humans. Marriage is the first and best example. Here, the process is the same; we become dependent upon each other for food, shelter, clothing, guidance, and love. There is no greater feeling than that of love and adoration from one’s spouse and children. 

A true partnership has the exact same relationship. We grow dependent on each other to achieve the same level of adoration and ultimately financial success. It is very easy to drop this mutual exchange for the protection corporation existence provides. A document of contracts and rule compliance transfers some of dependence element from trust to the assurance a contract can provide. But often this is the beginning of the breakdown between the two or more parties. That rewarding value of mutual reliance dissipates and some mistrust creeps into the relationship.

I am not advocating a partnership relationship for all business operations. The reader must understand that the partnership relationship is so effective in certain circumstances. Usually a family situation such as the examples of parent and child(ren), siblings, or expanded family are the best. The family unit provides the security of success for the partners. Long-term relationships between individuals also provide breeding grounds for partnership relationships. We all have relationships with others; some start out as teenagers or earlier and exist throughout their lifetimes. These are the relationships that offer the best combinations for successful partnerships.

No State Fees or Documentation

Every corporation or limited liability company has to register with their respective state’s corporation commission or secretary of the state. This requires an annual report in addition to a fee. A partnership doesn’t have to report or vouch its existence in most states. Therefore, this is an annual savings which ultimately ends up in the pocket of the partners. This may not seem as some financial boom, but over time it adds up. For most corporations, the minimum fee per year in most states is not less than $50, but by the time you add in legal fees to file the reports, pay the start-up fee with the state, pay the termination fee and file the termination paperwork, you could be looking at over $3,000 over 20 years of time. This is a lot of money, and this is in today’s dollars. Failure to file the reports timely is met with steep penalties or fines assessed by the state government. In addition, it’s another document that owners have to maintain from year to year.

No Taxation

Partnerships obtain an employer identification number from the Internal Revenue Service and file form 1065 each year. This is an information return that identifies the partners, how much the entity made in profit, and how much is assigned as income to each partner. The partnership doesn’t pay the taxes; the partners pay the taxes based on their personal tax rates.

Corporations pay income taxes, usually at a higher rate than individuals, so a pass through entity status is a financial advantage. However, there is one form of corporation existence that does offer pass through status and it is known as an S-Corporation. Therefore the ‘no taxation status’ is not unique to partnerships. However, S-Corporations allocate their earnings to the owners strictly based on the percentage of the stock owned.  Partnerships can take advantage of ‘special allocation’ of income to minimize overall taxation to the partners.

Special Allocation

This is by far the most financially valuable gain as a partnership entity status. The income from the business operation can be allocated to the partners based on the partnership agreement. One partner can be assigned capital gains or losses from the partnership while another is allocated earnings as earned income. Another partner can receive passive income which is taxed differently than capital gains or earned income. It is even possible to have a profit, assign more than that profit as earned income to one partner, generate a loss and assign that loss to another partner. By having a mutual understanding of each other’s situation, you can truly achieve the highest level of tax minimization for the entire group of partners. Seek advice from a Certified Public Accountant or an Enrolled Agent to stay in compliance with the IRS regulations.

This type of tax minimization is only available to a few forms of business existence under the Internal Revenue Service Code and Regulations. In a truly vibrant and lucrative enterprise, this advantage can save thousands of dollars each year in overall taxation.

It is important for partners to draft a partnership agreement. This document outlines the ‘who’, ‘what’, ‘where’, ‘when’, and ‘how’ of the business operation. It further defines the allocation of income and the investment requirements of the respective partners. This is an effective tool in managing the business because each partner is aware of their duties and potential for earnings. The document can be simply for small or single goal oriented operation, even short duration operations, or involved and complex for high end organizations such as medical partnerships or professional firms. When drafting such an agreement, seek the advice of a qualified attorney familiar with such documents.

From the above information the reader can understand the basic principles of a partnership. There are a lot of advantages and this form of entity status works well in certain business situations or circumstances. Future articles will articulate when this form of entity status is warranted. For now, understand the basic principles of the mutual covenant between the partners to appreciate this entity form. But just like a marriage, there is a strong possibility that the partnership will end in divorce. All partners must comply with the mutual reliance aspect and contribute to the relationship for it thrive and grow. Act on Knowledge.

© 2013 – 2022, David J Hoare MSA. All rights reserved.

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