General Partnerships

Overview

A general partnership is a business enterprise entered into by two or more persons who do not form a corporation or any other type of business entity to operate a business.  If two or more individuals start a business together with the understanding that each will share in the profits of the enterprise, they are considered a general partnership even if they didn’t specifically intend to start a general partnership.

A general partnership does not offer the partners any limited liability protection for their personal assets. A judgment against the partnership generally allows a creditor or claimant to go after the assets of the partnership and all partners to satisfy a judgment.

Both very large and very small businesses can operate as general partnerships. It is not necessary to have a written partnership agreement to be considered a partnership (though it is often advisable in order to avoid unintended results that may occur from the application of a state’s default partnership provisions.)

For federal tax purposes, there are no restrictions on who can be a partner in a partnership.  Thus, individuals, estates, trusts, corporations, foreign persons, and tax-exempt entities can all be partners for federal tax purposes.  State law, however, may impose some limitations.  For example, state law may only recognize individuals who are licensed physicians as partners in a partnership providing medical services.

A general partnership is a pass-through tax entity. It does not pay taxes at the business level. Instead, all profits and losses are “passed through” to the partners on a pro rata basis according to their respective ownership percentages or other percentages agreed to in a partnership agreement.

Like a sole proprietorship, general partnerships usually are not required to file any certificates or other organizational documents with municipal authorities, but they usually must file a “fictitious business name” or DBA in the municipality where they are located.

Advantages

The Arrangement of Duties is Flexible

Each state has a general partnership act, but partners may generally establish arrangements according to their own agreement, which will override most of a state’s default partnership provisions.  A partnership may also have several different classes of partners, each having different economic rights in the partnership.

The Arrangement of Benefits is Flexible

In a corporation, allocation of profit and loss is proportional to the percentage of stock held by each shareholder. That is, a shareholder who owns 10% of the outstanding shares in a corporation would be entitled to receive 10% of any dividends paid by the corporation. In a partnership, distributions of profits, losses and capital gains need not be directly proportional to the percentage interests held by the partners.  This flexibility permits an individual partner to receive a disproportionately higher percentage of profits as a reward for taking special economic risks or for services provided to the partnership. It also permits a higher income partner to receive a disproportionately higher share of any loss incurred by the partnership (to offset income from other sources, thereby reducing overall personal tax liabilities).

Even though partnerships do not require the legal formality of a written agreement, one should be created to protect the partners’ interest.  Without such an agreement, the default provisions of state partnership law may cause unfavorable or unintended results, such as equal shares of profits and losses regardless of original capital contributions.

Some limitations control how a partnership can allocate profits and losses.  The federal tax code, for example, limits the ability of partners to deduct passive losses against most income.  A partner may not deduct tax losses that exceed his initial investment in the partnership plus his share of its liabilities.

A Partnership Interest May Be Transferable

Unlike a sole proprietorship, a partner’s interest in the partnership is a discrete asset. A partner may transfer his partnership interest to his heir or estate, or to another person.  Customarily, however, transfers of a partnership interest are restricted under the terms of a partnership agreement.

Transfer restrictions usually give the partnership and/or the existing partners a “right of first refusal” when a partner wants to transfer his interest in the partnership, even if the transfer is to a member of his immediate family.

One important purpose of these provisions is to prevent existing partners from allowing other individuals to become partners without their consent.

Transfers are also restricted to prevent unfavorable tax consequences that may occur if more than a certain percentage of partnership interest is sold within a certain period of time.

A partnership pays no income tax as a separate entity; profits and losses are passed through to the partners, and are reported on each partner’s individual tax return.

Disadvantages of a General Partnership

Each partner in a partnership has personal liability for the obligations of the partnership. Each partner is liable, at a minimum, for at least his proportionate share.  Under most circumstances, however, each partner may be liable for the entire amount of all partnership debts and other obligations.  This is known as “joint and several” liability. It means that each partner has 100% liability to satisfy partnership obligations to a third party, but has a corresponding right to seek reimbursement from other partners for their proportionate share of the payment made by such partner. Therefore, if the partnership becomes bankrupt or insolvent, one partner with greater assets may be required to satisfy the liabilities of the other partners even if they exceed what would ordinarily be considered that partner’s proportionate share of those liabilities.  Great care should therefore be taken in selecting partners.

Under the partnership statutes of most states, partnerships usually terminate upon the death or withdrawal of any partner unless the partners agree to continue the partnership.  The partners may include a continuation provision in the partnership agreement, or, in the event of a death or withdrawal, the remaining partners may simply agree to continue the partnership.  Usually, the agreement to continue must be made within a specified period of time.  If there is only one partner left, however, the partnership will be dissolved unless an additional partner (or partners) is admitted to the partnership within a specified period.

Unlike a sole proprietor, general partners may not act unilaterally in making partnership decisions.  However, partnership agreements often give designated partners the authority to make specific kinds of decisions.

 
General partnerships are limited in their ability to obtain financing other than debt financing.  Unlike sole proprietorships, partnerships may raise capital by selling equity interests in the partnership, but the sale of such interests on a large scale is very difficult because of the prospect of potential personal liability and the usually limited market for resale of the interest.

Management

A general partnership is managed by the partners, but the management rights are not required to be equal. The partners are free to enter into a written agreement specifying the duties, responsibilities, rights, powers and limitations of each partner. In the absence of a written agreement, however, all partners have equal rights to manage the business of the partnership and to enter into agreements, incur obligations, or conduct other activities on behalf of the partnership business.

Partners may be individuals, trusts, estates, or limited liability entities such as a corporation or LLC.

There is no limit on the number of partners, but at least 2 are required.

How Its Taxed

One of the advantages of a general partnership is that, like a sole proprietorship, the business is not taxed.  Instead, income, losses, and gains are passed through to the general partners in accordance with the allocations provided in the partnership agreement (or proportionately to the interests held by each partner, in the absence of a formal agreement).  The partners then report the amount allocated on their own income tax returns and pay tax accordingly.

For example, let’s assume that Peter and Paul are partners in a printing business called PrintMasters. Each is a 50% partner. If PrintMasters has a profit of $100,000 at the end of the year, the partnership as an entity pays no federal or state income tax. Rather, both Paul and Peter will receive a Schedule K-1 from the partnership indicating that each has a $50,000 share of the $100,000 profits generated from the business. Paul and Peter will each report this $50,000 as income on his personal tax return and pay the taxes on this income individually. The net income from the partnership is taxed only once.

It is also important to understand that profits are automatically passed through to Peter and Paul whether or not they actually distribute the profits to themselves. Let’s assume that they have the business retain $30,000 in the business account instead of distributing it to themselves in order to expand the business the following year. For tax purposes, they will each still report $50,000 of the profits on their personal tax return and pay the taxes due even though $30,000 of the profit was not distributed to them.

FAQs

How is a general partnership formed?

There is no formal requirement for forming a general partnership. When two or more people engage in a business venture with the understanding that they will share profits and losses, they are automatically a general partnership if a different business type is not selected.

Do I need to file any document with my state to form a general partnership?

No. However, if you will be engaging in any real estate transactions, you may be required to file a Statement of Partnership at the state level and record it in the county where the property is located. A third party may also request a Statement of Partnership to confirm the names of the partners and who is authorized to act on behalf of the partnership.

Do I need to have a written partnership agreement?

No. A verbal agreement or understanding that the partners will share profits and losses creates a general partnership. However, state partnership laws will regulate a partnership in the absence of an agreement and these statutes may not cover all situations that could arise or provide a solution that you would desire if an agreement were prepared. It is always advisable to have an important agreement in writing.

Do all partners have equal authority and power?

Yes, unless a written partnership agreement provides otherwise. An agreement may give one or more partners specific powers or authority to act on behalf of the partnership. This additional power and authority may be all-inclusive or limited to certain specific situations.

Do all partners share equally in profits and losses?

A partnership agreement will specify each partner’s percentage share of profits and losses. A partner may have one percentage interest for voting purposes, a different percentage interest for profit distributions, and yet another percentage interest for loss allocations. However, unless these percentages are described in an agreement, the partners are considered equal for all purposes.

Do all partners have unlimited personal liability? Can this be altered?

By definition, all partners have unlimited personal liability for the debts and obligations of the partnership’s business. A creditor or claimant is free to seek damages from any partner to obtain full compensation for any loss or damage. A creditor is not limited to recovering only a partner’s percentage share of such damages. However, the partners can agree among themselves to change the percentage of liability of any partner. This is not binding on a creditor but will give any partner who pays more than an agreed percentage to seek contribution from the other partners for this overpayment.

Does a general partnership pay federal or state income tax?

No. A general partnership is not a tax-paying entity. It is a “pass-through” tax entity where profits and losses are allocated to each partner on a pro rata basis. Each partner then reports his or her share of profits on a personal 1040 tax return and pays income tax at the individual level. The partnership files an “information” return at the federal and state level indicating the profit or loss allocations made to each partner.

Does a partner have to pay income tax on profits if they’re not distributed?

Yes. Since a general partnership is not a tax-paying entity, the IRS will treat a partner’s share of profits as if it had been distributed in full for tax purposes whether or not the partner actually received any or all of the profit.