What Is a Partnership? How Does It Work?

Image by Daniel Fishel. © The Balance 2019

A partnership in a business is similar to a personal partnership. Both business and personal partnerships involve: 

  • Pooling money toward a common purpose
  • Sharing individual skills and resources, and
  • Sharing in the ups and downs of profit and loss.

A business partnership is a specific kind of legal relationship formed by the agreement between two or more individuals to carry on a business as co-owners. The partners in a business partnership invest in the business, and each investor/partner has a share in the profits and losses.

The partnership as a business must register with all states where it does business. Each state his several different kinds of partnerships that you can form, so it's important to know the possibilities (explained below) before you register.

Some partnerships include individuals who work in the business, while other partnerships may include partners who have limited participation and also limited liability for the debts and lawsuits against the business.  

A partnership, as different from a corporation, is not a separate entity from the individual owners. A partnership is similar to a sole proprietor or independent contractor business because in both of these businesses the business isn't separate from the owners, for liability purposes.

The partnership income tax is paid by the partnership, but the profits and losses are divided among the partners, and paid by the partners, based on their agreement.

A limited liability company (LLC) with two or more members (owners) is treated as a partnership for income tax purposes. Read more about the differences between LLCs and partnerships

Types of Partners in a Partnership

Depending on the type of partnership and the levels of partnership hierarchy, a partnership can have several different types of partners. This article on different types of partners explains the difference between: 

  • General partners and limited partners. General partners participate in managing the partnership and have liability for partnership debts. Limited partners invest but do not participate in management. 
  • Equity partners and salaried partners. Some partners may be paid as employees, while others have only a share in ownership. 
  • The different levels of partners in the partnership. For example, there may be junior and senior partners. These partnership types may have different duties, responsibilities, and levels of input and investment requirements. 

    Types of Partnerships

     Before you start a partnership, you will need to decide what type of partnership you want. You may have heard the terms:

    • A general partnership is composed of partners who participate in the day-to-day operations of the partnership are who have liability as owners for debts and lawsuits. There may also be limited partners
    • A limited partnership has one general partner who manages the business and one or more limited partners who don't participate in the operations of the partnership and who don't have liability.
    • A limited liability partnership (LLP) is similar to the limited partnership, but it may have several general partners. An LLP is formed by partners in the same professional category (accountants, architects, etc.) and the partnership protects partners from liability from the actions of other partners. Each state has different categories of professionals that it allows to form an LLP.

      How Partners are Paid

      Partners are owners, not employees, so they don't get a paycheck. Each partner receives a distributive share of the profits and losses of the business each year. Payments are made based on the partnership agreement, and the partners are taxed individually on these payments.

      In addition, some partners may receive a guaranteed payment which isn't tied to their partnership share. This payment is usually for services like management duties.

      A partnership, like a sole proprietorship, is a pass-through business, meaning that the profits and losses of the business pass through to the owners. 

      Forming a Partnership

      Partnerships are usually registered with the state in which they do business, but the requirement to register and the types of partnerships available vary from state to state. Partnerships use a partnership agreement to clarify the relationship between the partners, the roles and responsibilities of the partners, and their respective shares in the profits or losses of the partnership. This agreement is just between the partners; it's not registered with a state.

      It is relatively easy to form a partnership, but, as noted above, the business must be registered with the state where the partners do business. Depending on the state, you may have the choice of one or more of the types of partnerships mentioned above.

      Once you have registered with your state, you can then proceed to the other typical tasks in starting a business.

      Requirements for Joining a Partnership

      An individual can join a partnership at the beginning or after the partnership has been operating. The incoming partner must invest in the partnership, bringing capital (usually money) into the business and creating a capital account. The amount of the investment and other factors, like the amount of liability the partner is willing to take on, determine the new partner's investment and share of the profits (and losses) of the business each year. 

      The Importance of a Partnership Agreement

      When a partnership is formed, one of the first acts of the partners should be to prepare and sign a partnership agreement. This agreement describes all the responsibilities of the partners, sets out each partner's distributive share in profits and losses, and answers all the "what if" questions about what happens in a number of typical situations. 

      One good example of how a partnership agreement is important involves the situation when a partner leaves the partnership. If there is no partnership agreement to spell out how to handle everything, state law determines everything.

      The partnership agreement should include:

      • Details on the duties and responsibilities of each active partner,
      • Roles of specific partners who have day-to-day management,
      • How and when contributions must be made, and
      • How distributions are set.

      The state law default for certain situations is used if there is no partnership agreement. This may not be what the partners want, but without a different agreement, they have no way to run their business as they wish.

      How a Partnership Pays Income Taxes

      As noted above, the partnership business doesn't pay any income tax; the partners pay the taxes of the business, based on their share of the profits for a specific year, as spelled out in the partnership agreement.

      The partners are taxed from the income (or loss) of the partnership on their personal income tax return, and the partnership files an information return (Form 1065) with the IRS.

      Check with your state's secretary of state to determine the requirements for registering your partnership in your state. Some states allow different types of partnerships, and there are different types of partners, based on their participation in the business and the type of partnership.