Partnerships are a popular business entity in the United States, particularly for small businesses. If you are considering forming a partnership, it is important to understand the fundamentals (and consequences).
Generally, a partnership is a business relationship between two or more individuals or entities, where they share profits, losses, and management responsibilities. However, joint ownership of property is usually not enough to create a partnership for federal income tax purposes. The IRS defines a partnership as an unincorporated entity, such as a joint venture or group, that carries out a trade, business, financial operation, or venture and divide its profits.
Partnerships can be created for various purposes, including joint ventures, professional practices, and investment opportunities. This article provides a basic overview of the general process of forming a partnership, terminating a partnership, and the tax obligations of the partners in the U.S.
Forming a Partnership
The process of establishing a partnership involves multiple stages (if formed “properly”). First, partners generally select a business name and register it with the appropriate state agency. Next, the partners are wise to adopt a partnership agreement that sets out the terms and conditions for operation and management of the partnership, such as each partner’s responsibilities and rights, how the partnership will be managed, and arrangements for sharing profits and losses.
Partnerships are usually classified in two categories: general and limited. A general partnership implies that all partners are accountable for the partnership’s obligations. On the other hand, a limited partnership has one or more limited partners who are usually liable only for the amount of money they have invested, while the general partner is usually responsible for all of the partnership’s debts.
The conditions for a group to qualify as a partnership require at least two members who contribute resources and expect to share in the business’s profits and losses. However, specific organizations, such as corporations, trusts, and estates, are not regarded as partnerships for federal income tax purposes.
The partnership agreement plays an essential role in the overall health of the partnership and the investment that the partners involved may hope to protect. All contingencies should be considered—a “divorce”, profits, losses, litigation, buy-sell, etc. should be considered, even if not anticipated. If the partnership agreement does not address a particular matter, the relevant local law will fill the gaps, and that local law will not always provide a favorable (or clear) outcome.
Partnerships that are inactive in their business activities can choose to be excluded from federal income tax treatment as a complete or partial exemption. Usually, all partners must agree to this decision, and the appropriate organization must submit Form 1065 to make the election.
Partnerships that do not actively conduct business can choose exclusion from treatment as a partnership for federal income tax purposes. This exclusion can be complete or partial, but, again, generally all partners must agree to make the choice. Additionally, partners must be able to compute their own taxable income without computing the partnership’s income. An eligible organization must make the election on Form 1065 no later than the time for filing the partnership return for the first tax year for which the organization desires exclusion, including extensions.
A limited partnership is formed under a state limited partnership law and composed of at least one general partner and one or more limited partners. In this structure, a general partner is, in most circumstances, personally liable for partnership debts, while a limited partner’s liability for partnership debts is limited to the amount of money or other property that the partner contributed or is required to contribute to the partnership.
Limited Liability Company
A limited liability company (LLC) is an entity formed under state law by filing articles of organization as an LLC. In contrast to partnerships, members of an LLC are not, in most circumstances, personally accountable for the company’s financial obligations. An LLC may be treated as a partnership, corporation (including S corporation), or disregarded entity for federal income tax purposes, depending on its structure. A multi-member LLC is usually taxed as a partnership by default. However, it may choose to be taxed as a corporation by filing Form 8832 (Form 2553 for S Corporation).
Terminating a Partnership
An existing partnership is considered as continuing if it is not terminated, which means that it is still considered to be in operation. However, a partnership is usually considered terminated only when none of the partners continue to operate any aspect of the partnership’s business, financial operation, or venture.
If a partnership is terminated before the end of a tax year, it must file Form 1065 for the short period between the start of the tax year and the date of termination or change. This return must be filed by the 15th day of the third month following the termination date.
Forming a partnership can be a relatively simple process, but partners should be aware of the tax and other obligations that come with it. Partnerships must file annual tax returns and each partner must report their share of the partnership income on their individual tax returns. Ending a partnership also involves specific legal and tax requirements that partners must follow. Partners should consult with a tax advisor to ensure that they comply with all legal and tax obligations when forming or ending a partnership, to avoid unwanted surprises and to set themselves up for long-term success.
Freeman Law represents general or limited partners, LLC members, and other closely-held businesses in complex corporate and partnership litigation matters. Our attorneys are well-versed in complex breach-of-fiduciary matters, business divorce litigation, and disputes stemming from complex partnership accounting and partnership agreement provisions. Schedule a consultation or call (214) 984-3000 to discuss your partnership issues or concerns.