1.2 Partnerships
SLO 1
Describe the legal and administrative steps required to start a small business (business name registration, EIN, licenses/permits, business bank account), implement a basic recordkeeping system, and compare sole proprietorships, partnerships, LLCs, S-corporations, and C-corporations in terms of liability exposure, tax treatment, and formation/compliance requirements in order to recommend an appropriate entity structure for a given business scenario.
This section adds the second pillar of the entity comparison this outcome asks you to make: the partnership, in its general, limited, and LLP forms. You learn to place each form on the liability spectrum — a general partner stands exposed like a sole proprietor, while limited and LLP partners buy real protection — and to follow partnership income along its pass-through path from Form 1065 and Schedule K-1 onto each partner's personal return. The section also shows what a written partnership agreement must contain and why mutual agency makes one essential, so that when a scenario involves two or more owners, you can weigh liability, taxation, and formation requirements and defend a recommendation.
Learning Objectives
By the end of this section, you will be able to:
- describe the three principal types of partnership and explain how personal liability differs among them and from a sole proprietorship or corporation;
- explain what a partnership agreement is, why it should be in writing, and what it should contain;
- explain how partnership income is taxed on the partners' personal returns, and how self-employment tax applies to general versus limited partners.
A partnership is what you get when two or more people join up to carry on a trade or business together. Each partner puts something in — money, property, labor, or skill — and each expects to share in the profits and losses of the business. Where the sole proprietorship of §1.1 is the natural structure for one owner, the partnership is its natural extension to two or more owners who do not want the formality of a corporation.
Think of a partnership as half corporation, half sole proprietorship. Like a corporation, it is a real legal "person" — it can own property and be sued in its own name. But like a sole proprietorship, the tax bill and (for general partners) the debts land on the owners personally. Knowing which nature answers which question is the whole trick of this section.
The partnership occupies an interesting middle ground between the structures on either side of it. On one hand, like a corporation, a partnership is a legal entity: it can own property in its own name, it can be held legally liable for its actions, and it is a separate entity from its owners, the partners. On the other hand, like a sole proprietorship, its income is not taxed at the entity level — the tax characteristics "flow through" to the individual partners — and, for general partners, the owners remain personally liable for the business's debts. Understanding the partnership means understanding which of these two natures applies to which question.
Weighing the partnership form. When choosing a structure, partnerships offer several benefits over other entities — and those advantages are balanced by real drawbacks. The table below sets the two sides of the ledger side by side:
| Advantages | Disadvantages |
|---|---|
| No taxation at the partnership level. The partnership as a business unit is not subject to income tax; its tax characteristics flow through to the partners, avoiding the double taxation of a C corporation. | Unlimited liability. General partners answer personally for the business's debts (developed in §1.2.1). |
| Ease and lower cost of formation. Most business regulations are written with corporations in mind. Partnerships face fewer regulations and reporting requirements, involve less formation paperwork, and are simpler to form, alter, and terminate. | Mutual agency. Any partner can bind the whole partnership to a contract, so each partner's decisions expose the others. |
| Combined skills and financial resources. Pooling two or more owners' business acumen, contacts, and capital gives a partnership an advantage over a one-person sole proprietorship. | Limited life. The partnership generally ends when a partner joins, withdraws, or dies, making the business less permanent than a corporation. |
| Management flexibility. With no board of directors overseeing operations, partners who agree can make quick decisions and adapt the business rapidly. | Difficulty transferring ownership. Because a change in partners can dissolve the partnership, selling an interest is complicated and usually requires valuation and renegotiation. |
| Easily changed structure. A partnership can be converted to a corporation relatively easily in the future, since — with no shareholders to consider — its capital can be converted to shares of common stock. | Limited ability to raise capital. Unlike a corporation, a partnership cannot issue stock; it raises money only by taking on debt or by the partners contributing more of their own assets. |
The three subsections that follow examine the types of partnership and their liability, the agreement that governs the partners' relationship, and the taxation of partnership income.
A partnership is the relationship existing between two or more persons who join to carry on a trade or business, with each person contributing money, property, labor, or skill, and each expecting to share in the profits and losses of the business.
Definition 1.2.1 — A partnership: two or more persons carry on one business and share its profits and losses.
1.2.1 General versus limited partnerships
Partnerships come in three principal forms. They differ mainly in one dimension that this course cares about above all: how much personal liability each partner bears.
- General partnership. The basic form, in which each partner is personally liable to the partnership's creditors if the partnership itself has insufficient assets to pay them. These owners are called general partners, and — exactly like the sole proprietor of §1.1 — their personal assets are exposed to the full debts of the business. Because of mutual agency (developed in §1.2.2), a general partner is liable for partnership debts regardless of which partner actually incurred them.
- Limited partnership (LP). An association with at least one general partner, while the remaining partners may be limited partners. A limited partner's liability is capped at their own investment in the firm — their personal assets are not at risk if the partnership cannot pay its creditors. In exchange for this protection, limited partners are traditionally passive investors who do not manage the business. Every LP must still have at least one general partner who bears unlimited liability.
- Limited liability partnership (LLP). A form that gives all partners limited personal liability against another partner's obligations — so one partner's malpractice or wrongdoing does not put the others' personal assets at risk. LLPs are typically formed by licensed professional groups such as lawyers and accountants. The protection is not absolute: each partner remains personally responsible for their own negligence and wrongdoing and for that of anyone under their direct control or supervision.
Summary of the three partnership forms. The table below collects the liability trade-off — the recurring theme that more liability protection is the thing owners are usually buying when they move to a more formal structure.
| Type of partnership | Advantage | Disadvantage |
|---|---|---|
| General partnership | Simple and inexpensive to form | All partners have unlimited personal liability |
| Limited partnership (LP) | Limited partners' liability is capped at their investment | At least one general partner is still personally liable |
| Limited liability partnership (LLP) | Partners are shielded from other partners' malpractice | Each partner remains personally liable for their own wrongdoing |
Reading across §1.1 and this subsection establishes the liability spectrum you will complete in §1.6: a sole proprietor and a general partner have unlimited personal liability; limited partners, LLP partners, LLC members, and corporate shareholders have limited liability. Where a business falls on that spectrum is one of the two or three questions that decide its entity choice.
A limited partnership runs a small event-planning business. Mar Delgado is the general partner — they run the day-to-day operations alongside their wife, who works the events. Ken is a limited partner who invested $20,000 and takes no part in management. The partnership loses a lawsuit and owes a $150,000 judgment, but the business's assets total only $60,000.
a) How much of the remaining $90,000 can the creditor pursue from Ken? b) How much can the creditor pursue from Mar? c) How would the answer change if the business had been a general partnership?
Solution
a) Nothing beyond his investment. Ken is a limited partner, so his liability is capped at the $20,000 he invested — and that money is already inside the business (part of the $60,000 of business assets the creditor can reach). His personal assets — home, savings, car — are not at risk.
b) All of it. Mar is the general partner, and every limited partnership must have at least one. Their personal assets are exposed to the full unpaid $90,000, exactly as if they were a sole proprietor.
c) Both owners would be exposed. In a general partnership there are no limited partners: each partner is personally liable for the partnership's debts, regardless of which partner caused them (that is mutual agency at work). The creditor could pursue the unpaid $90,000 from either owner's personal assets.
Answer: Ken risks only his $20,000 investment; Mar's personal assets cover the shortfall. In a general partnership, both partners' personal assets would be exposed.
For each business, pick the partnership form that best fits and say why:
a) Four CPAs form a firm and want protection from one another's professional mistakes, while accepting responsibility for their own. b) A restaurant needs $100,000 from an investor, Mai Vang — who runs a catering side business with her wife — and she wants a share of profits but no role in operations and no risk beyond her investment. c) Two friends start a lawn-care business with a handshake and no filings of any kind.
Solution
a) Limited liability partnership (LLP). LLPs are the classic form for licensed professionals (lawyers, accountants): each partner is shielded from the other partners' malpractice but remains personally responsible for their own negligence and for people under their direct supervision.
b) Limited partnership (LP). Mai becomes a limited partner: her liability is capped at the $100,000 investment, in exchange for staying out of management. Note that the restaurant still needs at least one general partner who bears unlimited liability.
c) General partnership. No filing is needed to create one — carrying on a business together as co-owners is enough. Each friend is a general partner with unlimited personal liability, and each can bind the other through mutual agency.
1.2.2 Partnership agreements
There is no legal requirement that a partnership agreement be in writing. In fact, a partnership can be formed entirely by accident — by a mere handshake or informal understanding — and people have ended up in court after forming a partnership without ever intending to. Precisely because the relationship can arise so casually, it is strongly advised that any partnership be governed by a written contract.
A partnership agreement is the contract governing the partners' relationship. It records the partners' roles, how profits and losses are shared, and the contributions each partner makes, along with the basic facts of the business — its name, location, purpose, the partners' names, and the date of inception.
If partners never write an agreement, they don't get "no rules" — they get the state's rules. A state's Uniform Partnership Act (or Revised Uniform Partnership Act) fills every gap the partners never discussed, meaning the state, not the partners, decides key questions like how profits are split. Writing the agreement is how you opt out of the defaults.
Beyond those basics, a well-drafted agreement should spell out the following:
- the capital contributions of each partner (cash, property, or services), how each is recorded, and how it affects each partner's ownership share;
- the allocation of profits, losses, and draws (withdrawals), including whether any partner receives a guaranteed payment (in effect, a salary) and how much;
- each partner's authority and decision-making role — who is responsible for what, how decisions are made, and the thresholds at which all partners must be involved;
- the process for a change in partners — how a partner may be added or may withdraw;
- the process for dissolution; and
- the process for settling disputes — often the most important provision of all, because disagreement among partners is inevitable and a clear dispute-resolution mechanism keeps a conflict from interrupting the business.
Why does documenting each partner's authority matter so much? Because in a partnership, each partner is an agent of the business — someone whose actions legally commit it.
Definition 1.2.2 — The partnership agreement: the written rules covering contributions, allocations, authority, changes, dissolution, and disputes.
Mutual agency is the power of every partner to bind the partnership in dealings with outside parties, such as vendors and lenders. The partnership — and therefore the other partners — is bound by any partner's business actions, whether or not the other partners agreed to them.
Documenting each partner's authority in the agreement is the main way partners protect themselves from being committed to obligations they never approved. It cannot stop an outside vendor from enforcing a contract one partner signed, but it gives the other partners recourse against the partner who exceeded their authority — and, just as importantly, it forces the partners to decide in advance who may sign for what.
Steps to establish the business. Once the agreement is complete, a few practical steps remain to bring the partnership into operation:
- Select the state in which to operate. Partnerships usually choose the state where they are located. Because the partnership pays no entity-level income tax and faces limited regulation, the choice of state matters far less than it does for a corporation.
- Register the name with the authorities required by that state (in California, a Fictitious Business Name / DBA filing where an invented name is used). Registration lets the partnership use the name and prevents others from taking it.
- Obtain the required business licenses — including a seller's permit if the partnership will sell taxable goods, and any professional licenses required of the field (attorneys, physicians, and CPAs are especially subject to licensing).
Definition 1.2.3 — Mutual agency: any partner's contract binds the partnership, and through it every other partner.
Lupe and Sol — a married couple who co-own the business — run a general partnership that sells garden supplies. Without telling Lupe, Sol signs a $12,000 contract with a fertilizer supplier. Lupe thinks the purchase is a terrible idea, and they argue about it that night.
a) Is the partnership bound by the contract? b) Is Lupe personally exposed if the partnership can't pay the $12,000? c) Which provision of a written partnership agreement is designed to prevent exactly this situation?
Solution
a) Yes. Under mutual agency, every partner has the power to bind the partnership in ordinary business dealings. The supplier can enforce the contract against the partnership even though Lupe never agreed to it.
b) Yes. In a general partnership each partner is personally liable for partnership debts, regardless of which partner incurred them. If the business can't pay, the supplier can pursue Lupe's personal assets as well as Sol's.
c) The authority and decision-making provision. A well-drafted agreement spells out each partner's authority and sets dollar thresholds above which all partners must approve a commitment. It can't undo the supplier's contract, but it gives Lupe recourse against Sol for exceeding their authority — and, used properly, it prevents the surprise in the first place.
1.2.3 Tax treatment of partnership income
A partnership is a pass-through (flow-through) entity, in exactly the sense §1.1 defined for the sole proprietorship: it pays no income tax at the partnership level. This is the same single layer of taxation as a sole proprietorship, and the reason partnerships, like sole proprietorships, avoid the double taxation that burdens C corporations.
How partnership income is reported. All businesses except partnerships file an annual income tax return; a partnership instead files an information return — Form 1065, U.S. Return of Partnership Income — to report the business's income and expenses. The partnership then reports each partner's share of income, credits, and deductions on a Schedule K-1. Each partner takes the figures from their K-1 onto their personal Form 1040 (via Schedule E) and pays tax at their individual rate. Follow the paper trail and you can see the "pass-through" happening: the income is reported at the partnership level but taxed at the partner level.
A subtle but important point follows from this design: partners are taxed on their allocated share of partnership income, whether or not that income is actually distributed to them. If the partnership earns income but reinvests it rather than paying it out, the partners still owe tax on their share. (A draw, or withdrawal, is not itself taxable income; it simply reduces the partner's capital account.)
No withholding, so estimated payments apply. Because partners are not employees of the partnership, no tax is withheld from their distributions. Like sole proprietors, partners therefore generally make quarterly estimated tax payments on Form 1040-ES if they expect a profit — generally required when a partner expects to owe $1,000 or more for the year.
Self-employment tax differs by partner type. How SE tax applies depends on whether a partner is general or limited:
- General partners pay self-employment tax on their net earnings from self-employment — their distributive share of the trade or business income, whether or not it is distributed.
- Limited partners are subject to self-employment tax only on guaranteed payments, such as professional fees for services actually rendered — reflecting their passive, investor-like role.
Dalisay and her brother Marco are equal (50/50) general partners in a landscaping partnership that earns $80,000 of net income for the year. The partnership decides to keep $30,000 in the business for new equipment and distributes only $50,000. How much does each partner report and pay tax on, and on which forms does the income travel?
Solution
Step 1 — The partnership reports, but does not pay. The partnership files Form 1065 (an information return — no tax due with it) and issues each partner a Schedule K-1 showing $40,000, their 50% share of the full $80,000.
Step 2 — The partners pay tax on the allocation, not the cash. Dalisay and Marco each report $40,000 on their personal returns (Form 1040, via Schedule E) and pay income tax at their individual rates — on the full $40,000, even though each received only $25,000 in cash. Her tax bill, like his, follows the allocation, not the distribution.
Step 3 — SE tax and estimated payments. As general partners, each also owes self-employment tax on that $40,000 distributive share, and each should have made quarterly estimated payments during the year to cover both taxes.
Answer: Each partner reports and pays income tax (plus SE tax) on $40,000 — their allocated share — regardless of the $25,000 actually distributed to each.
A partnership earns $90,000 of net income. Jo owns 40% as a limited partner (with no guaranteed payment); Sam owns 60% as the general partner. The partnership distributes no cash this year.
a) How much taxable income does each partner report, and on what schedule does it arrive? b) Who owes self-employment tax, and on what amount? c) Why does Jo owe income tax at all, given that she received no cash?
Solution
a) Jo reports $36,000 (40% of $90,000); Sam reports $54,000 (60%). Each receives a Schedule K-1 from the partnership's Form 1065 and carries the figures to their personal Form 1040 via Schedule E.
b) Only Sam. As a general partner, Sam owes SE tax on his full $54,000 distributive share, distributed or not. Jo is a limited partner with no guaranteed payments, so her share is investor-like income not subject to SE tax.
c) Because taxation follows the allocation, not the distribution. The partnership is a pass-through entity: income is taxed to the partners when it is earned and allocated, even if the business reinvests every dollar. Jo's $36,000 share is taxable now; the eventual cash distribution, when it comes, will not be taxed again.
Summary of who files what. The table below shows which federal forms each party files — a quick reference you will use again when comparing entities in §1.6.
| If you are a… | You may owe… | File form… |
|---|---|---|
| Sole proprietor | Income tax; self-employment tax; estimated tax | 1040 (+ Schedule C / F); Schedule SE; 1040-ES |
| Partnership | Annual return of income (information return) | 1065 |
| Partner in a partnership (individual) | Income tax; self-employment tax; estimated tax | 1040 (+ Schedule E); Schedule SE; 1040-ES |
| C corporation / S corporation | Income tax; estimated tax | 1120 (C) / 1120-S (S); 1120-W (C only) |
| S corporation shareholder | Income tax; estimated tax | 1040 (+ Schedule E); 1040-ES |
Problem Set 1.2
Problem 1. A classmate says, "A partnership is basically just a sole proprietorship with two owners." In what sense is this right, and in what sense is it wrong? Name one way a partnership resembles a corporation and one way it resembles a sole proprietorship.
Solution
Where the classmate is right: on taxation and liability, a general partnership works just like a sole proprietorship scaled to two owners. Income passes through to the owners' personal returns with no entity-level tax, and general partners bear unlimited personal liability, exactly as a sole proprietor does.
Where the classmate is wrong: unlike a sole proprietorship, a partnership is a legal entity — it can own property in its own name and be held legally liable for its actions, and it files its own (information) return. A sole proprietorship is legally inseparable from its owner; a partnership is not.
Answer: Resembles a corporation: it is a separate legal entity that can own property and be sued in its own name. Resembles a sole proprietorship: its income is not taxed at the entity level, and its general partners are personally liable for business debts.
Problem 2. For each partner below, state whether their personal assets are at risk for the partnership's debts, and why:
a) A general partner in a general partnership.
b) A limited partner in a limited partnership.
c) A partner in an LLP, for a malpractice judgment caused entirely by a different partner.
d) A partner in an LLP, for their own negligence.
Solution
a) Yes — at risk. A general partner is personally liable to the partnership's creditors whenever the business itself cannot pay. Because of mutual agency, this liability applies regardless of which partner incurred the debt.
b) No — not at risk. A limited partner's liability is capped at their investment in the firm. The most they can lose is what they put in; personal assets stay out of reach.
c) No — not at risk. The LLP form exists precisely to shield each partner from another partner's malpractice or wrongdoing. The wrongdoing partner's own assets are exposed, but the innocent partners' are not.
d) Yes — at risk. The LLP shield is not absolute: each partner remains personally responsible for their own negligence and wrongdoing, and for that of anyone under their direct control or supervision.
Answer: a) at risk (unlimited liability); b) protected (capped at investment); c) protected (shielded from others' malpractice); d) at risk (own wrongdoing is never shielded).
Problem 3. Every limited partnership must have at least one general partner. Explain why this requirement means an LP can never fully eliminate unlimited personal liability — someone always bears it.
Solution
Step 1 — What the rule says: an LP is an association with at least one general partner; only the remaining partners may be limited partners.
Step 2 — Why that matters: a limited partner's protection (liability capped at their investment) exists only in exchange for staying out of management. Someone must actually run the business and answer to its creditors — and that someone is the general partner, who bears unlimited personal liability just like a sole proprietor.
Answer: Because the law requires at least one general partner, the LP form can reallocate unlimited liability onto one owner but never eliminate it — the creditors always have at least one person whose personal assets stand behind the business's debts.
Problem 4. Marcus and his husband, Dana, form a general partnership with a handshake and no written agreement. They later disagree about how profits should be split. What body of law decides the question, and what is the lesson about partnership agreements?
Solution
Step 1 — The partnership exists even with no writing: there is no legal requirement that a partnership agreement be in writing. By carrying on a business together as co-owners, Marcus and Dana formed a general partnership with the handshake alone.
Step 2 — Who fills the gap: because they never agreed on a profit split, the state's Uniform Partnership Act (or Revised Uniform Partnership Act) supplies the answer — the default rules of state law govern every question the partners never settled.
Answer: The state's UPA/RUPA decides the profit split, not the partners. The lesson: put the agreement in writing before a dispute — otherwise the state, not you, decides the key questions of your own business.
Problem 5. Explain mutual agency in your own words, and describe one provision of a written partnership agreement that helps partners manage the risk it creates.
Solution
Mutual agency in plain terms: every partner is an agent of the business, so any partner can bind the whole partnership — sign contracts, order goods, borrow money — and the partnership (and therefore the other partners) is stuck with the result, whether or not the others agreed.
A provision that manages the risk: the agreement's authority and decision-making provision — spelling out who is responsible for what, how decisions are made, and the dollar thresholds above which all partners must approve a commitment. It cannot undo a contract an outside vendor enforces, but it defines each partner's authority in advance and gives the others recourse against a partner who exceeds it.
Answer: Mutual agency = each partner's power to commit the partnership to outside obligations. A written authority/decision-making provision (with approval thresholds) is the standard protection.
Problem 6. A partnership earns $120,000 of net income and distributes $40,000 in total to its two equal general partners, keeping the rest for expansion.
a) How much income does each partner report on their personal return, and via which forms does that number travel from the business to the partner?
b) Does either partner owe self-employment tax, and on what amount?
c) Explain why the partners' taxable income differs from the cash they received.
Solution
a) $60,000 each. The partnership files Form 1065 (an information return) and issues each partner a Schedule K-1 for 50% of the $120,000 of net income. Each partner carries that $60,000 to their personal Form 1040 via Schedule E and pays income tax at their individual rate.
b) Yes — both do. They are general partners, so each owes self-employment tax on their full $60,000 distributive share of the trade or business income, whether or not it was distributed (computed on Schedule SE).
c) Taxation follows the allocation, not the cash. Each partner received only $20,000 in cash (half of the $40,000 distributed), but each is taxed on the full $60,000 allocated share. The reinvested $80,000 is still the partners' income for tax purposes; a distribution (draw) is not itself taxable and merely reduces the partner's capital account.
Answer: a) $60,000 each, via Form 1065 → Schedule K-1 → Form 1040 (Schedule E); b) yes, SE tax on $60,000 each; c) partners are taxed on allocated income, not distributed cash.
Problem 7. Compare how a partnership and a C corporation are taxed on $100,000 of business income that is fully paid out to the owners. Use the phrases "pass-through" and "double taxation" in your answer.
Solution
Step 1 — The partnership (pass-through): the partnership pays no income tax at the entity level. The full $100,000 passes through to the partners' personal returns via Schedule K-1, and it is taxed once, at each partner's individual rate. Total layers of tax: one.
Step 2 — The C corporation (double taxation): the corporation first pays corporate income tax on the $100,000 (Form 1120). When it then pays the remaining amount out to the owners as dividends, the shareholders pay personal income tax on the dividends as well. The same earnings are taxed twice — once at the entity level, once at the owner level.
Answer: The partnership's $100,000 is taxed once on the partners' returns (pass-through); the C corporation's $100,000 is taxed at the corporate level and again when distributed as dividends (double taxation).
Key Terms
partnership — the relationship between two or more persons who join to carry on a trade or business, each contributing money, property, labor, or skill and sharing in profits and losses.
general partner — a partner who is personally liable to the partnership's creditors if the business cannot pay its debts.
general partnership — the basic partnership form, in which all partners are general partners with unlimited personal liability.
limited partnership (LP) — a partnership with at least one general partner, in which the remaining (limited) partners' liability is capped at their investment.
limited partner — a passive-investor partner whose liability is limited to their investment and whose personal assets are not at risk for partnership debts.
limited liability partnership (LLP) — a form, typical of licensed professionals, in which every partner is shielded from other partners' obligations but remains liable for their own wrongdoing.
mutual agency — the power of each partner to bind the partnership (and therefore the other partners) in dealings with outside parties.
partnership agreement — the (ideally written) contract recording the partners' contributions, profit and loss allocation, authority, and procedures for changes, dissolution, and disputes.
guaranteed payment — a fixed, salary-like payment to a partner, and the portion of a limited partner's income that is subject to self-employment tax.
draw — a partner's withdrawal of cash from the partnership; not itself taxable income, it simply reduces the partner's capital account.
Form 1065 — the partnership's annual information return, reporting the business's income and expenses without paying tax at the entity level.
Schedule K-1 — the statement a partnership issues to each partner reporting that partner's share of income, credits, and deductions.