Mention to colleagues that you are considering starting a business partnership, and you likely will hear countless tales of conflict, drama, and eventual splits. For many people, the dissolution of a partnership feels inevitable and unavoidable even before it starts.
Just because messy endings are possible doesn’t mean partnerships are guaranteed to end with damaged relationships and business losses. However, the difference between a successful partnership and a cautionary tale takes more than luck. Partners should carefully define the business arrangement with agreements and contracts from the start to avoid heartache at the end.
For many professionals, partnerships offer meaningful advantages and result in successful businesses not possible as solo ventures. Interestingly, sole proprietorships dominate the market in terms of numbers but lag in scale and revenue. According to the IRS, returns from the 2022 tax year indicated that 25-30 million people were working entirely for themselves, from home offices. While partnerships made up only 4.5 million returns in the 2022 tax year, non-employer partnerships averaged $160,000 compared to $40,352 for sole proprietorships.
Why Partnerships Work When Done Right
At their best, partnerships bring together shared goals and resources. Instead of one person being responsible for all of the capital and long hours, the burden is shared, reducing burnout. When selected thoughtfully, the right blend of partners also brings diverse talents and skills to the table, often making it easier to succeed than if working solo. The right partners can balance out each other’s strengths and weaknesses, such as one excelling at the financial aspects while the other is a great negotiator.
Partnerships also bring financial and tax benefits. With shared financial responsibilities, partnerships often have better access to loans and investors. Because there is built-in business continuity in case of one partner’s death or disability, financial institutions often view the investment as a lower risk than a sole proprietorship in this regard. Additionally, eligible partners can claim the qualified business income (QBI) deduction to deduct up to 20% of their share of business income.
Because the partnership does not pay taxes, both the profits and the losses are passed through to the partners and must be filed on each partner’s personal income return. In addition to avoiding double taxation faced by C corporations, partners can also use losses to offset income from other business ventures. As long as the IRS guidelines are followed, partners can also structure profits and losses in ways other than an even split.
Crafting an Agreement
The real problem isn’t partnerships, but poor preparation. The common theme among most partnership horror stories is lack of written agreement. Without these documents, even the most amicable relationships can quickly turn into heated disputes.
In many cases, the issues stem from money, including profit sharing, responsibility for bills and tax liability. Other common issues, include roles, decision making structure and dissolution of the partnership. Even when these issues were discussed and agreed upon by partners, lack of documentation lends to people changing terms and disputing conversations.
When creating a partnership, all partners should work together to create a detailed and iron-clad partnership agreement that defines all aspects of the business and relationship. By working with professionals experienced in partnerships, including tax professionals and attorneys, both partners can feel assured that their interests are represented in the agreement.
Partnership agreements should usually address the following areas:
- Goals for the partnership: By defining and discussing what each partner envisions the future of the business, the partners can refer back to the documentation when issues arise in the future in terms of direction and goals.
- Ownership percentage: Even if the agreed terms are 50/50, having this division in writing can provide a foundation for decision making and ownership considerations.
- Capital contributions: This section defines how much each partner contributes both in terms of starting capital as well as ongoing expenses, such as rent and labor.
- Profit sharing/compensation: Specify how profit and losses are shared among partners as well as any base compensation.
- Dispute resolution: Decide ahead of time and document how to handle any disputes among partners, such as mediation or arbitration.
- Buy-sell provisions: Document what will happen if one or both partners want to dissolve the partnerships. Be sure to include specific situations, including death, disability, exit and divorce.
- Non-compete terms: If one partner buys the other out, this section clarifies any non-compete terms, such as not starting a competing business for a set period of time.
Overcoming Challenges of Partnerships
Professionals considering whether to start a sole proprietorship or a partnership quickly encounter one of the biggest differences. Launching a sole proprietorship is relatively simple and typically inexpensive — there are no contracts or documents to create. Owners also do not need to file a separate corporate tax return; they just add a Schedule C to their existing personal return.
On the other hand, partnerships require start-up costs to get the legal documents that create a strong foundation. Instead of the income passing directly to the owner as in a sole proprietorship, the profits must be split between partners and separate returns filed quarterly. By taking the time to create a partnership agreement before launching the business, many partners avoid the stress and struggles often associated with partnerships.
Unlimited liability that comes with a general partnership is also often a common concern. However, partners can limit this by setting up a limited liability company (LLC) or a limited liability partnership (LLP) from the start. Both structures create the business as a separate entity from the partners’ personal assets, meaning that partners’ personal assets are protected in case the business fails or is sued.
Protecting Your Partnership Before It Starts
While having two people’s perspective to make decisions can be positive, many partnerships fail due to disagreements, especially in terms of directions and rewards. Even when two people have worked together successfully in other fashions, stress and responsibility often turn minor differences into major conflicts. Partners who start the relationship by proactively addressing potential conflicts, especially in terms of decision making, often result in a resilient and ultimately financially successful partnership.
Partnership provides a path for many professionals to achieve ambitious growth simply not possible as a solo owner. The emotional and legal drama that often keeps people from even considering partnership is not inevitable, but easily preventable. Parters that lay everything out in legal documents from the beginning turn potential conflict into the potential for significant revenue and growth.
This material has been prepared for informational purposes only, and is not intended to provide or be relied upon for legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.
