Partnership Business Structure and Taxation in the USA

Introduction to Partnership Business

A partnership business is formed when two or more people come together to operate a business venture. It represents a long-standing commitment to conduct business collectively. The individuals who own a partnership are known as partners. They do not need to be located or to work in the same place, although most do. Nonetheless, they maintain a single set of accounting records and divide the profits and losses. A well-known example of a partnership in which partners are situated not simply in different cities but in different countries is the large international accounting partnerships, some of which have offices all over the world.

The reasons why people may choose to form a partnership business include the fact that the capital needed is more than one person can provide. By having each partner contribute a certain amount of money, the total capital required to start the business can be raised within a short period of time. Secondly, the skills or abilities needed to manage the business may not be found in a single individual; since the partnership is formed by two or more persons, the skills and abilities needed to run the venture will be more readily available. Thirdly, many individuals prefer to share the management of a business venture rather than doing all the work on their own. Lastly, it is also common for partners to be members of the same family.

A partnership is not a corporate or distinct legal body. Rather, it is regarded as an extension of its owners for legal and tax purposes, even though a partnership may hold assets as a legal entity (Stephen & Daniel, 2008, p. 23). Although a partnership may be formed on a simple agreement — even a handshake between owners — a well-crafted and carefully worded partnership agreement is the best way to begin the business. In the absence of such an agreement, the standard partnership act may apply. This partnership act is a body of laws concerning partnerships that has been adopted by most countries in order to govern the business.

Generally, two kinds of partnerships exist: general partnerships and limited partnerships. In a general partnership, each partner is equally accountable for the business's outstanding liabilities. All partners are also permitted to participate in the management of the company. In the absence of a declaration to the contrary in the partnership agreement, each partner has equal rights to organize and run the business. Unanimous consent of the partners is required for all key decisions. Nonetheless, any commitment made by a single partner is legally binding on all partners, regardless of whether or not the others were informed.

Background Information on Partnership Business

In a limited partnership, one or more partners are general partners and one or more partners are limited partners. General partners are individually responsible for the business's debts and claims against the business, and they may also participate in the day-to-day running of the business. A limited partner, by contrast, is an investor — a silent partner who does not participate in the running of the business and is not personally liable beyond his or her capital contribution. The laws of a particular country determine the extent to which limited partners may be involved in daily operations without endangering their limited liability.

The partnership form of business is particularly common among real estate investors, who benefit from the tax advantages available to limited partners, such as the ability to deduct depreciation. Limited partners can lose the investment they have contributed, since their liability for the outstanding debts of the partnership is limited to that investment. They are also prohibited from withdrawing or receiving back any part of their capital contribution.

The nature of a partnership includes several defining features. First, a partnership is formed in order to make profits. Second, the partnership must comply with the Partnership Act of 1890; if there is a limited partner, the Limited Partnership Act of 1907 also applies (Geoffrey, 2006, p. 48). Third, there must be a minimum of two partners and a maximum of twenty partners, although exceptions exist — banks may not have more than ten partners, while there is no upper limit for firms of accountants, solicitors, stock exchange members, surveyors, auctioneers, or insurance brokers. Fourth, each partner — apart from limited partners — must pay his or her share of any outstanding liabilities that the partnership cannot settle, and if necessary may be required to sell personal assets to do so.

With regard to partnership agreements, written agreements are not legally required; however, it is advisable to have an appropriate written agreement drafted by a lawyer or accountant. A written agreement reduces misunderstandings and disputes among partners. The agreement may contain as much or as little as the partners wish, since the law does not prescribe its contents. Common accounting provisions include: the capital to be contributed by each partner; the rate of interest, if any, to be paid on capital before profits are divided; the ratio in which profits or losses will be shared; the rate of interest, if any, to be charged on partners' drawings; the salaries to be paid to partners; the procedures for admitting new partners; and the procedures to be followed when a partner dies or retires.

Where no partnership agreement exists, Section 24 of the Partnership Act of 1890 will govern the situation. Under that section, profits and losses are divided equally; no interest is allowed on capital; no interest is charged on drawings; no salaries are permitted; and partners who advance money to the partnership beyond their agreed capital contribution are entitled to interest at the rate of five percent per annum.

There are numerous advantages of forming a partnership. First, it allows owners to pool resources and share the expertise of co-partners. Second, partnership profits pass through to the owners, who report their share on personal tax returns; thus profits are taxed only once at the individual level, rather than twice as with corporations, which are taxed at the corporate level and again when dividends are distributed to shareholders. Third, compared to a corporation, a partnership is relatively simple to form and manage — no forms need to be filed or formal agreements drafted, though it is prudent to prepare a written agreement. Fourth, because partnership owners are generally its managers, the business is fairly straightforward to run and decisions can be made quickly without extensive procedural formality. Finally, partnerships generally have an easier time raising capital than corporations, since partners who apply for loans as individuals can often obtain favorable terms by pledging personal assets in addition to those of the partnership.

Several disadvantages of partnership businesses also exist. When major decisions must be made — for instance, whether and how to expand the business — partners frequently disagree, creating potential instability. Additionally, the personal assets of the partners are at risk because there is no separation between the owners and the business. In general partnerships, the business will typically dissolve if one partner dies, retires, or withdraws; however, in limited partnerships, the loss or withdrawal of a limited partner does not affect the stability of the partnership (Stephen, 2008, p. 18).

The term tax refers to a compulsory financial contribution made by individuals to sustain government. To be liable for taxation means to be included in an assessment levied for the purposes of taxation. The concept of taxation, both in common usage and under the laws of various states in the United States of America, has been used broadly — not merely to express the supreme authority being exercised, but to describe the application of that authority for a specific purpose: to raise revenue for the ordinary and necessary expenditures of government, whether at the state, regional, municipal, or metropolitan level.

Taxation normally operates on a society or on groups of people within a society, and it functions through various rules of apportionment. Taxes are levied as a portion of the output of productive activities and services generated by the population. In doing so, the state exercises its sovereign constitutional authority, and the taxes collected are used to sustain government, administer the law, and maintain the diverse legal functions of the nation (Alan & James, 2005, p. 7).

Taxation of Partnerships

For many small business enterprises, remitting income tax involves mastering double-entry bookkeeping while identifying every available business deduction. For partnerships, paying taxes also requires understanding complex terms such as distributive share, special allocation, and substantial economic effect. Generally, the Internal Revenue Service (IRS) — the institution responsible for tax collection in the USA — does not treat partnerships as separate from their owners for tax purposes. Instead, they are treated as pass-through entities. This means that all earnings and losses of the partnership flow through to the partners, who pay taxes on their share of the profits on their personal income tax returns. Each partner's share of profits and losses is normally specified in a written partnership agreement.

Although the partnership itself does not pay income taxes, it is required to file Form 1065 with the Internal Revenue Service. This is an informational return that the IRS reviews to determine whether the partners are correctly reporting their income. The partnership must also provide a Schedule K-1 to the IRS and to each partner. The Schedule K-1 breaks down each partner's share of the business's earnings and losses. Each partner then reports this profit and loss information on his or her personal tax return — Form 1040, with Schedule E attached (Jeffrey, 2008, p. 12).