It’s no wonder that when many aspiring entrepreneurs first consider being their own boss, one of the first questions they ask is whether they should engage close friends or even family in their new enterprise. Aside from the burden of personal relationships, the choice to form commercial partnerships with friends and even family is not one to be taken lightly. When opposed to incorporation, business partnerships are a more “loose” approach to establish a firm, but there are several legal factors you should be aware of before delivering your handshake to cement the transaction.
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What is the definition of a legal business partnership?
A formal business partnership is nothing more than an unincorporated commercial connection. It is still subject to taxation, regulation, and even government inspection (depending on your industry), but it can provide a less complicated way for small businesses to get started.
How can I create a legally binding business partnership?
You should register your company with state and municipal agencies, as well as the IRS. It’s also a good idea to draught a legally enforceable partnership agreement outlining each partner’s obligations and what is expected of each party. The agreement may be as loose or as extensive as you like, but it’s always a good idea to have it reviewed by an experienced small company attorney to ensure that it will stand up in court if necessary.
Partnership Advantages (over incorporation)
For starters, there are no complicated incorporation procedures or expenses, which is a big benefit for cash-strapped start-ups. Furthermore, each partner participates to all aspects of the firm, from decision-making to profit sharing to tax burden. This sharing of responsibilities may help ease some of the burden of running a company, and having a trusted compatriot to depend on in times of need can be a huge benefit. Furthermore, by forming partnerships in which the partners have complementary abilities (one is strong with facts and numbers while the other is a natural salesman), firms may benefit from a healthy working dynamic that would not be feasible if one owner attempted to do everything alone. Inclusion may also be used as a potent incentive to inspire star employees—what greater prize for loyalty and devotion than to participate in the duties and benefits as a founding member?
Partnership Types
Business partnership agreements are classified into three types:
1) General Partnerships: Profits, responsibility, and management responsibilities are divided equally or unequally among all partners by a percentage distribution (as defined in your partnership agreement).
2) Limited Partnerships: These are partnerships in which parties may opt to restrict their responsibility and influence. Businesses that are managed as silent partnerships are a typical illustration of these sorts of partnerships—one partner is the “money” behind the operation while the other accepts full responsibility for operating the firm.
3) Joint Ventures: These are basically broad partnerships that expire after a certain period of time or when a specific project or phase of development is accomplished.
Taxes and Partnership
In general, all partnerships are obliged to file with the IRS and state-level revenue services. This necessitates that the company get a tax ID number or authorization. Partnerships, on the other hand, do not pay taxes. Instead, they submit an annual information return, which details the amount of revenue earned by the company. Individual partners are responsible for reporting income and paying taxes on their individual forms. This is referred to as “pass through” profit/loss.
Individual partners may be liable for the business’s Annual Return of Income, Employment Taxes, and Excise Taxes on property bought. In addition, partners must claim Income Tax and Self-Employment Tax (on their own forms). Schedule K-1 (Form 1065 sent to all partners), which effectively replaces a W2, is one of the required forms.
Partnership disadvantages
Personal rivalry are, of course, the most significant drawback of economic relationships. When put under the burden of operating a failing company, even the best of friends may turn into the worst of adversaries. Even if all partners can put aside their personal difficulties, there are still legal drawbacks to partnerships. The most serious is liability. Because partnerships do not need incorporation papers, participants share the business’s obligation (both legal and financial). This implies that if the company defaults on debts or is sued by a client, the individual partner (and their financial assets) may be at risk. Similarly, when things are going well, everyone shares in the profits. That may not seem to be a terrible thing, but how you define profit sharing is critical for positioning your company for long-term success (which illustrates, once again, the importance of a legally binding partnership agreement).
When is it time to call it quits?
While a partnership makes perfect sense for a start-up, there may come a point when the company development you’ve seen compels the partnership’s breakup. Knowing when it’s appropriate to do so is an important skill to have if you want to prevent growing pains. Among the most important factors are:
Maintaining a moderate number of partners (avoid operating a firm “by committee”)
When a person’s responsibility risk becomes too great for him or her to bear
When you need to borrow money from a financial institution, now is the time to do it.
Walk In with an Open Hand and a Keen Mind
Partnerships should be exactly that: a collaboration between two individuals who have same aims and are of like mind. You can’t operate a company if you’re always attempting to outwit or undercut your partner’s interests, and you definitely can’t keep such a corporation viable if your partners aren’t doing their weight. These poor habits might be tough to detect while working with a buddy, but it’s critical that you maintain a professional distance. You should be prepared to participate in both the effort and the profits, but having a well-structured definition of the partnership (in legally binding language) is critical to keeping things running well. If things get too hazy, stressful, or confrontational, it may be time to terminate the partnership to preserve both your company and your relationship.