THE FISCAL BLUE PRINT
WITH COACH JEFF MONTGOMERY
Episode 29: Legal Structures for setting up your own business! Part 2- Partnerships
To continue our discussion of different legal structures for your business, today we are going to tackle partnerships. Have you ever been asked to join a business? Maybe you already have a business and are thinking about bringing on a new partner. There are a few things to consider: Taxes, liabilities, & succession. Let’s dive right in!
Disclaimer: Please do not take advice from me on this show. As a licensed Fiduciary I am only allowed to advise clients. So, unless you’re a client I can’t give you advice because I don’t know you. So, think of this as helpful hints and education only. And please before implementing any information or ideas you hear on this show always consult your legal adviser, your tax adviser, and your financial adviser…………. right? that’s just common sense.
(1:47) Practical Planning segment: As you’ll soon see, partnerships are very similar to Sole Proprietorships in many ways, beginning with how they are formed. Remember last week when we said in an SP from the Federal govt perspective you just need to start doing business?
Overview: Well, a partnership is automatically formed when 2 or more people go into business. No official documentation is needed for a partnership to be formed.
However, there is one thing you will need from the Fed govt perspective that’s different from the SP. You will need to get an EIN employer identification number commonly called a Tax ID number. As mentioned last week, obtaining an EIN is fast and free. Go to IRS.Gov and search for the EIN application.
Also, just like SP’s you will most likely face some local requirements such as licenses and DBA forms which we discussed in last week’s show. Partnerships almost always have a name that is separate from its owners
So far partnerships are simple much like SP’s. Now let’s talk about something that is not required when forming a partnership but is nonetheless recommended and very important….
(5:00)A partnership agreement. If you plan on going into business with someone, don’t you think it’s smart to have some type of agreement between the parties? I’m sure there are certain items you want to make sure are in that agreement.
This is where the help of a professional may be a good idea rather than a DIY approach. However, if you go the DIY route, at the very least you should have the following:
- How expenses will be divided
- How profits will be allocated. Many times, there are multiple partners with different ownership percentages
- How and when profits will be distributed. Sounds like item 3 but as well soon find out how profits are distributed is not always the same as how profits are allocated
- The division of tasks within the business. Who does what?
- Under what instances can one partner sell his or her interest in the partnership
- What occurs in the event of a partner’s death, disability, etc.?
- And how will major disagreements be handled and resolved
For example, let’s say we have a business with two partners and each partner is married and has a spouse. If one partner passes away most likely the deceased partner’s spouse would inherit that share of the business. Well, what if the existing partner doesn’t want to work with the spouse?
How is that potential conflict remedied? Well, it should be spelled out in the operating agreement. And how that is typically handled is a buyout from the surviving partner to the deceased partner’s spouse.
(10:45) How is that funded? Depending on the buyout amount, of course, it could come from personal assets of the surviving partner being paid to the spouse. IF we are talking about a successful business worth a lot of money that it is typically funded by a life insurance contract on each partner and a change in the operating agreement explicitly mentioning how those proceeds are to be paid to exercise the buyout provision. This is commonly called a buy/sell agreement
(12:00) Taxation: Partnerships themselves are not subject to federal income tax………instead just like SP’s they are pass-through entities. Each of the partners taxed on their share of the income. Remember, on an SP they would use schedule C to calculate profit and loss? Well, partnerships would use Form 1065.
They would list all revenues and all expenses on page 1, answers some questions on pages 2 and 3 and the 4th page of form 1065 is called a schedule K and K-1.
Schedule K breaks down all the income categories like ordinary business income, maybe some rental income on the property the business owns, interest income from savings accounts possibly, etc.
Then K-1 breaks down each partner share of that income which is then carried over to each of their 1040’s. Pretty Simple!
SE TAX of 15.3%: Just like from an SP the ordinary business income from a partnership is generally subject to SE tax when passed through as well
(14:20) Do they get that deduction we talked about for ½ of the tax paid? Yes, but remember it’s a tax deduction, not a tax credit.
And, just like an SP each partner can take an additional deduction of 20% until 2025 based on the tax cut and jobs act of 2017. Again, it’s important to talk to your tax advisor to see if the business itself qualifies for that 20% deduction and whether there are other limitations for income, etc.
So Definitely consult your tax advisor on those thresholds and to see if your business qualifies for that additional 20%
One other important note to talk about regarding taxation for partnerships is something called tax basis. Which is essentially what you invested in the business to get it started.
Often a surprising thing happens around tax time with partnerships and owners of those partnerships when first formed and they complete their first tax year…
(16:00) Partners get taxed on their share of the profits even if those profits are not distributed to them personally. Profits from the business don’t always get distributed. Sometimes they stay in the business to be used later. Well, of course, those profits don’t escape taxation.
So, as a general rule………owners get taxed on their share of the taxable income regardless of how much is distributed
However, they are not taxed by the amount of the distributions received unless those distributions are more than the tax basis mentioned earlier.
The tax basis changes based and increases on amounts invested by the partners, a partner share of taxable income and its decreased by partnership losses and distributions they receive.
(18:00) Liability: Ok well it’s probably obvious that before you form a partnership with someone, you should make sure you trust that person implicitly!
Why is this so important in a partnership? Because……… you have UNLIMITED LIABILITY EVEN FOR EACH OTHER!
In a general partnership, each partner has unlimited liability for all the partnerships debts. This is different from a limited liability partnership which we’ll discuss in a second.
It’s exactly like in an SP with one critical difference: You’re responsible for all debts of the business even if you didn’t create them
(19:14) For example; let’s say two people own a restaurant together and one of the partners decides to expand on his or her own without the other partner’s knowledge and signs a lease for a new location or worse yet buys a location with partnership assets and debt.
The partner that knew nothing about this now liable for those debts.
Partners are agents for the business. What this means is each parent can be held responsible for liabilities resulting from a lawsuit or stemming from a contract signed by one without the other’s knowledge. Another reason to have this spelled out explicitly in the partnership agreement
Usually, when someone uses the word partnership, they are talking about a general partnership. However, with a Limited Partnership, there must be at least one General Partner with Unlimited liability………. the other partners could be Limited Partners with limited liability
So, limited partners much like shareholders of a company cannot lose more than their investment in the partnership You might ask why everyone wouldn’t want to be a limited partner……. Well, one important rule with a limited partnership is you cannot participate in the day to day decisions and operations of the partnership. If they do, they will lose their limited liability status. Typically, GPs are the original founders and LPs are usually just investors.
(22:00) Coachable Segment: Let’s run through everything we just learned in a quick summary:
- If owners don’t take any action to incorporate or form an LLC, a multiple owner business will be a partnership by default
- P must obtain an EIN and usually are required to file a DBA
- It’s not required but a really good idea to create a partnership agreement
- Like SP’s, partnerships are pass-through entities for taxation purposes
- Form 1065 is used to calc profit and loss and schedule K and K1 are part of form 1065 and break down the partnership’s income and each partner share of that income
- Ordinary business income is subject to SE tax when passed through to each partner
- In a Partnership, partners are taxed upon their allocated share of taxable income even if it’s not distributed
- Partners are not taxed on the amount of the distributions received unless those distributions are more than their individual tax basis.
- In general, each partner has unlimited liability for all partnership debts
- Each partner is an agent of the partnership and has the power to bind the partnership to a contract within the scope of the business
- In an LP limited partners are essentially investors and have limited liability
- LPs must have at least one General Partner
- LP’s cannot engage in the management or day to day operations of the partnership
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