Partnership

A partnership is a form of business organization in which two or more persons or entities carry on a business together as co-owners, sharing its profits and losses. Partnerships can be created by a formal written partnership agreement or simply by the conduct of people who go into business together. They are common among professional firms, such as law and accounting practices, in real estate and investment funds, and in small family businesses.

In the United States, partnerships are governed by state law, much of it based on the Uniform Partnership Act. For federal income tax purposes, a partnership is a pass-through entity: it files an information return but generally pays no income tax itself, and its income is taxed directly to the partners. Unlike shareholders in a corporation, general partners do not have limited liability.

• General partnership: all partners manage the business and each is personally liable for its debts. Liability is usually joint and several, so a creditor can pursue any one partner for the full amount.
• Limited partnership (LP): at least one general partner manages the business and bears unlimited liability, while limited partners invest money, take no part in management and risk only their investment. Private equity and venture capital funds are usually organized this way.
• Limited liability partnership (LLP): partners are protected from personal liability for other partners' negligence or misconduct. It is widely used by professional firms.
• Limited liability companies with two or more members are, by default, taxed as partnerships, although they are a separate legal form.

A partnership files Form 1065 with the Internal Revenue Service and gives each partner a Schedule K-1 showing their share of income, deductions and credits. Partners pay tax on their share whether or not they withdraw any cash, which avoids the double taxation of C corporation profits but can leave partners owing tax on income they have not received. General partners also usually owe self-employment tax on their share of trading income. Since 2018, the IRS has audited large partnerships at the entity level under the centralized partnership audit regime.

A partnership keeps its own books as a separate accounting entity. Instead of common stock and retained earnings, its equity consists of a capital account for each partner, increased by contributions and the partner's share of profit and reduced by withdrawals and losses. Withdrawals during the year are usually recorded in a drawing account and closed to capital at year end. Partners' salaries and interest on capital, if the agreement provides for them, are not expenses of the partnership; they are part of how profit is divided.

Suppose partners A and B have opening capital of $100,000 and $60,000. Their agreement gives A a salary allowance of $40,000 and B $30,000, interest of 10 percent on opening capital, and splits any remainder equally. Net income is $120,000. The allowances total $70,000, and interest is $10,000 for A and $6,000 for B, leaving $34,000 to be split $17,000 each. A's share is $40,000 plus $10,000 plus $17,000, or $67,000, and B's is $30,000 plus $6,000 plus $17,000, or $53,000. If net income were lower than the allowances and interest, the shortfall would be shared as a loss in the same ratio.

Partnerships are easy and inexpensive to form, flexible in how they divide profit and control, and taxed only once. Their drawbacks include unlimited liability for general partners, the risk that one partner's decisions bind all the others, possible disputes, and limited ability to raise capital compared with a corporation. Under older law, a partnership was dissolved whenever a partner left or died, so well-drafted agreements set out buy-sell arrangements, valuation methods and admission rules for new partners. The economic entity assumption still requires partnership records to be kept separate from partners' personal finances.