Advantages and Disadvantages of a Partnership
Advantages of a Partnership
Starting a business may require more capital than you alone can afford. Or, your business may require some particular expertise that you don't possess and can't afford to pay for by hiring someone.
A partnership offers you a broader range of possibilities for raising capital and expanding your business than a sole proprietorship. Such capital may be in the form of money, services, or both.
No Double Taxation
A partnership is a pass-through entity (a conduit). This means all items of income, deductions, gains, losses, and credits flow through the business entity directly to its owners (partners) who report these items on their own personal tax return.
It is this pass-through feature that allows a partnership to avoid double taxation because there is no tax at the entity level only at the individual level.
Schedule K-1 is issued annually by the partnership to each partner to report the partner's share of income, deductions, gains, losses, and credits. Each partner is responsible for reporting his share of these items his own individual income tax return.
Each item reported on Schedule K-1 retains its tax character after being passed through to the partners. For example, charitable contributions made by the partnership remain charitable contributions when passed through to each partner. Each partner reports such charitable contributions on his Schedule A of Form 1040 ( assuming the partner itemizes deductions).
Flexibility to Allocate Income
Partners may agree to allocate income disproportionately to the their percentage interest in the partnership.
For example, if Joe owns a 40% interest in partnership capital and Mary owns a 60% interest, they may agree to pay Joe 70% of the profits and Mary 30% of the profits. This may be justified if Joe has a critical skill needed by the business.
In contrast, if the partners were S corporation shareholders with the same percentage ownership, they would not be permitted to make a disproportionate allocation of profits.
S corporation profits are required to be allocated to shareholders according to their percentage of ownership. Therefore, Joe and Mary would receive 40% and 60%, respectively, of the profits if they were S corporation shareholders.
Disadvantages of a Partnership
A major downside of the partnership form of organization is the extent to which each partner is liable for partnership debts. A general partner's legal responsibility is broad, extending beyond just his own actions. In addition, each partner's personal assets may also be at risk.
General partners are jointly and severally liable for partnership debts. This means, each general partner may be personally liable for all the debts of the partnership if the other partners are unable to satisfy the debts of the business.
In addition to being liable for the debts of the business, each general partner may also be liable for the negligent and wrongful acts (torts) committed by employees and partners in the scope of partnership business.
Observation: There are two types of partners: (1) general partners and (2) limited partners.
General partners are involved in the everyday activities of the business and are jointly and severally liable for partnership liabilities. A general partner's personal assets may even be at risk..
A limited partner is only liable up to amount of his or her investment in the partnership. A limited partner's personal assets are off limits.
Limited partners are not permitted to be involved in the management of the business or in its daily activities. In fact, getting involved in the operation of the business can result in the loss of the limited partner's limited liability protection.
Accounting and Legal Costs
The accounting function for a partnership can be complex. For example, when the partnership is created, each partner's interest and tax basis in the partnership must be established and recorded in the books of the business.
Then, each partner's interest and tax basis must be updated periodically to reflect changes resulting from profits, losses, loans, and distributions from the partnership.
Legal costs may have to be incurred to create a partnership agreement. In addition, if a partner sells his interest in the partnership or dies, an attorney may be needed to ensure that legal-related issues are handled properly.
Cost of a Professional Recruitment Service
Because of the broad liability of each partner, a more judicious approach in the selection process of additional partners and employees may be necessary. A professional recruitment service may have to be retained to perform an objective investigation into the background (criminal and financial) of potential employees or partners.
Continuity of Life Not Assured
A partnership may be dissolved by the acts of the partners. For example, if a partner sells his interest, or dies, the partnership generally ceases to exist. When a partnership ceases to exist, it must go through a winding up process. This could involve both accounting and legal fees.
If a new partnership is established, new business bank accounts will have to opened, a new set of books created, and promotional materials and business stationery may have to be changed.
- Return to the Tax Basics for Startups Table of Contents to find related links.