Business Numbers · Chapter 1 · Choosing a Business Entity

Partnerships

The natural extension of the one-owner business to two or more owners — half corporation, half sole proprietorship, and the whole trick is knowing which nature answers which question.

bookSHelf · Business Numbers · §1.2 · a self-paced section

Partnerships · bookSHelf Business Numbers§1.2

Outline — by the end of this section you will be able to

Learning objectives

Describe the three principal types of partnership and how personal liability differs among them Def 1.2.1 · Table 1.2.1
Explain what a partnership agreement is, why it should be in writing, and what it should contain Def 1.2.2–1.2.3
Explain how partnership income is taxed on the partners' personal returns — and how SE tax splits by partner type §1.2.3

Partnerships · bookSHelf Business Numbers§1.2

§1.2 — What the structure is

Two or more owners, one business

Definition 1.2.1 — Partnership

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.

Two natures in one business. 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.

A partnership: two or more persons carry on one business and share its profits and losses.

Figure 1.2.1: Two or more persons carry on one business and share its profits and losses.

Partnerships · bookSHelf Business Numbers§1.2

§1.2.1 — Three forms, one dimension that matters

General versus limited partnerships

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 liable for their own wrongdoing

Table 1.2.1: The liability trade-off across the three partnership forms.

Read it: more liability protection is the thing owners are usually buying when they move to a more formal structure — the recurring theme of this chapter, completed as the liability spectrum in §1.6.

Partnerships · bookSHelf Business Numbers§1.2

§1.2.1 — Worked example

Who loses what when the partnership can't pay

Example 1.2.1 — A $150,000 judgment, $60,000 of assets

A limited partnership runs an event-planning business. Mar is the general partner; Ken is a limited partner who invested $20,000 and takes no part in management. The partnership loses a lawsuit and owes $150,000, but the business's assets total only $60,000. (a) How much of the remaining $90,000 can the creditor pursue from Ken? (b) From Mar? (c) What if this had been a general partnership?

(a) Nothing beyond his investment. Ken's liability is capped at the $20,000 he invested — already inside the business's $60,000. His personal assets are not at risk.

(b) All of it. Mar is the general partner — every LP must have at least one — so their personal assets are exposed to the full unpaid $90,000, exactly as if they were a sole proprietor.

(c) Both owners exposed. In a general partnership each partner is personally liable regardless of which partner caused the debt — that is mutual agency at work.

Partnerships · bookSHelf Business Numbers§1.2

§1.2.1 — Check your understanding

Try It Now 1.2.1

Try It Now 1.2.1 — Pick the partnership form

For each business, pick the form that best fits and say why: (a) Four CPAs want protection from one another's professional mistakes while accepting responsibility for their own. (b) A restaurant needs $100,000 from an investor who 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.

(a) LLP — the classic form for licensed professionals: shielded from the other partners' malpractice, still liable for their own. (b) Limited partnership — she becomes a limited partner, capped at her $100,000, in exchange for staying out of management; the firm still needs at least one general partner. (c) General partnership — no filing is needed to create one; each friend has unlimited personal liability and can bind the other.

Partnerships · bookSHelf Business Numbers§1.2

§1.2.2 — The contract behind the handshake

Put the rules in writing

Definition 1.2.2 — Partnership Agreement

A partnership agreement is the contract governing the partners' relationship. It records the capital contributions of each partner, the allocation of profits, losses, and draws, each partner's authority and decision-making role, and the processes for a change in partners, dissolution, and settling disputes.

Skip it and the state decides. Partners with no written agreement don't get "no rules" — the state's Uniform Partnership Act fills every gap they never discussed, including how profits are split. Writing the agreement is how you opt out of the defaults.

The partnership agreement: the written rules covering contributions, allocations, authority, changes, dissolution, and disputes.

Figure 1.2.2: The written rules — contributions, allocations, authority, changes, dissolution, disputes.

Partnerships · bookSHelf Business Numbers§1.2

§1.2.2 — Why the agreement matters so much

Any partner can bind them all

Definition 1.2.3 — Mutual Agency

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.

The defense is the agreement. Documenting each partner's authority can't stop a vendor from enforcing a signed contract — but it gives the other partners recourse against the partner who exceeded their authority, and forces everyone to decide in advance who may sign for what.

Mutual agency: any partner's contract binds the partnership, and through it every other partner.

Figure 1.2.3: Any partner's contract binds the partnership — and through it, every other partner.

Partnerships · bookSHelf Business Numbers§1.2

§1.2.2 — Check your understanding

Try It Now 1.2.2

Try It Now 1.2.2 — The $12,000 fertilizer contract

Lupe and Sol 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. (a) Is the partnership bound by the contract? (b) Is Lupe personally exposed if the partnership can't pay? (c) Which provision of a written agreement is designed to prevent exactly this?

(a) Yes — under mutual agency, every partner can bind the partnership in ordinary business dealings; the supplier can enforce the contract even though Lupe never agreed. (b) Yes — in a general partnership each partner is personally liable for partnership debts, regardless of who incurred them. (c) The authority and decision-making provision — dollar thresholds above which all partners must approve a commitment, giving Lupe recourse against Sol for exceeding their authority.

Partnerships · bookSHelf Business Numbers§1.2

§1.2.3 — Worked example

Taxed on the allocation, not the cash

Example 1.2.2 — Passing income (and tax) through to the partners

Dalisay and her brother Marco are equal (50/50) general partners in a landscaping partnership that earns $80,000 of net income. The partnership keeps $30,000 for new equipment and distributes only $50,000. How much does each partner report, and on which forms does the income travel?

The partnership reports, but does not pay. It files Form 1065 (an information return) and issues each partner a Schedule K-1 for their half of the full $80,000:

0.50 \times \$80{,}000 = \$40{,}000 \text{ per partner}

The partners pay tax on the allocation, not the cash. Each reports $40,000 on Form 1040 (via Schedule E) — even though each received only $25,000 in cash — and, as general partners, each also owes self-employment tax on that share, covered by quarterly estimated payments.

Partnerships · bookSHelf Business Numbers§1.2

§1.2.3 — Check your understanding

Try It Now 1.2.3

Try It Now 1.2.3 — $90,000 earned, nothing distributed

A partnership earns $90,000 of net income. Jo owns 40% as a limited partner (no guaranteed payment); Sam owns 60% as the general partner. No cash is distributed this year. (a) How much taxable income does each partner report, and on what schedule? (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?

(a) Jo reports $36,000 (40%), Sam $54,000 (60%) — each via a Schedule K-1 carried to Form 1040 on Schedule E. (b) Only Sam — a general partner owes SE tax on his full distributive share, distributed or not; Jo's share is investor-like income. (c) Because taxation follows the allocation, not the distribution — income is taxed when earned and allocated, even if every dollar is reinvested. The eventual cash distribution will not be taxed again.

Partnerships · bookSHelf Business Numbers§1.2

The headline result

Taxed on the allocation, not the cash

Partnership income lands on each partner's Form 1040 in the year it is earned and allocated — whether or not a single dollar is distributed.

The partnership itself pays no income tax: Form 1065 reports, Schedule K-1 carries each partner's share, and Schedule E delivers it to the 1040.

† Self-employment tax follows the same logic but splits by partner type: a general partner owes SE tax on the full distributive share; a limited partner's share is investor-like income, free of SE tax.

1.2

Partnerships · bookSHelf Business Numbers§1.2

§1.2 — Conclusions

What to carry forward

The one idea

A partnership is a real legal entity that pays no entity-level tax: income passes through Form 1065 and Schedule K-1 onto each partner's Form 1040, taxed on the allocated share — whether or not the cash is distributed.

The trade-off

Mutual agency lets any partner bind them all, and general partners carry unlimited personal liability. Limited and LLP partners buy real protection — but every LP still needs one general partner whose personal assets stand behind the debts.

Next: §1.3 Limited Liability Companies — the form that caps every owner's liability. Back to start.