Fact checked for accuracy by Billie Anne Grigg, a bookkeeper and Mastery Level Certified Profit First Professional.
If you’ve decided that a general partnership seems like a good fit for your business, you likely have some questions about how to go about forming one. It’s not a purely straightforward process, and there is a big difference between technically meeting the definition of a general partnership and being a successful one.
Preparing ahead for the intricacies of starting a general partnership is a smart move that will hopefully set you up for success. You will find the requirements for setting up a general partnership, the tax implications, and big-picture factors to consider before starting the process covered below.
Steps to Form a General Partnership
Forming a general partnership is easier than you might think in some respects. A business entity only needs two components to be considered a general partnership:
- Be comprised of two or more partners who have a written or oral partnership agreement
- Sell services or products
That said, although your business may technically fit the definition of a partnership, there are finer details at play when it comes to going about forming one wisely.
You will want to be sure that you understand why a general partnership is advantageous for your business before you get too far along. General partnerships are popular because they’re relatively easy to form; you may notice as you read the required steps that few of them are unique to this business structure.
However, you must also be prepared to accept personal and shared responsibility for the partnership. A major potential downside to this responsibility is unlimited liability in a general partnership, i.e., you and any partner(s) are at risk of being personally sued if the partnership amasses debt that it cannot repay.
Another potential source of trouble in a general partnership is shared decision-making. If one of your partners makes a decision on behalf of the partnership, it applies to all partners. A carefully crafted partnership agreement can mitigate the associated risk.
As mentioned previously, the agreement can be as simple as an oral agreement. But it’s a good idea to formalize a contract in writing to avoid potentially messy disagreements later.
It could be worth consulting an attorney for this process; you will need to agree on topics like each partner’s responsibilities and how much capital each partner is to contribute.
The regulatory components necessary to form a general partnership remain with these crucial first steps complete.
Depending on the type of business your general partnership is, you may need to acquire business licenses early on. A convenient list of federally required licenses can be a good place to start. However, there are many more requirements at the state and local level; even home-based businesses are subject to some.
It is also important to obtain Employer Identification Numbers (EINs) early on. There are both federal and state tiers, but note that most state tax ID number applications will require a federal EIN, so it’s best to apply for the federal number first.
The last couple of regulatory steps to take are to obtain an unemployment insurance account number (only required if the partnership will have employees) and register the business name. Both of these steps are at the state level and, in all likelihood, can be performed online, depending on your state.
How Taxes Work for a General Partnership
On a federal level, the Internal Revenue Service (IRS) considers a general partnership a “pass-through” entity. This means that a partnership “does not pay income tax” as an entity, but rather individual partners report their shares of profits and losses on their personal income tax returns.
However, the complete picture gets more complicated. For one, it is still mandatory for partnerships to file an informational return (Form 1065) with the IRS. Other taxes may be applicable if the partnership has employees, though the partners themselves are not considered employees.
There are also state tax implications for partnerships. Most states abide by federal regulations and require income from general partnerships to be reported on personal income returns, but a 2017 state and local tax (SALT) deduction cap on personal income tax returns has led some states to introduce a workaround: an option to file for partnerships as an entity.
Notably, filing as an entity is only required for a partnership in Connecticut. In the following states, Pass-Through Entity Taxes (PTETs) are voluntary (as of January 2022):
- Alabama
- Arizona
- Arkansas
- California
- Colorado
- Georgia
- Idaho
- Illinois
- Louisiana
- Maryland
- Massachusetts
- Minnesota
- New Jersey
- New York
- North Carolina
- Oklahoma
- Oregon
- Rhode Island
- South Carolina
- Wisconsin
Remember, if your state is listed above, you can file taxes for your partnership as an entity rather than as personal income, thus avoiding the $10,000 SALT deduction cap. Only in Connecticut must you consider a partnership an entity for tax purposes, and in every unlisted state, you have no option but to file partnership income as personal income, leaving you subject to the deduction cap.
More states will likely follow suit in this workaround in the future. Bear in mind, too, that if it seems beneficial to file state taxes for your partnership as an entity (and your state of residency is listed above), every state has its policies for how that income is then taxed.
For instance, in Minnesota, PTE tax is “calculated by multiplying the entity’s Minnesota source income by the highest Minnesota individual income tax rate, which is currently 9.85%.”
It is possible, then, that you may not find pass-through entity tax beneficial for your partnership at all; it is simply an additional option to consider.
Considerations Before Forming a General Partnership
This is perhaps a great deal of information to take in all at once. Bottom line–is a general partnership right for your business?
First and foremost, you might ask yourself to what degree you trust your partner(s) and how carefully you have drawn up a partnership agreement. General partnerships are relatively simple constructions, but they leave you and your partner(s) subject to unlimited liability. Simply sharing responsibility also requires sharing any debt your partnership may incur.
Therefore, you might also consider whether another type of business entity would better suit your needs. The unlimited liability of a general partnership is not always desirable, and virtually any other business structure (save sole proprietorship) eliminates that burden.
Another major factor in deciding your business structure is what sort of tax you will be subject to. A smaller corporation might meet the requirements of an S-corporation and thus pay personal tax, for instance, while a C-corporation would pay corporate tax.
It will take some calculation specific to your business to determine whether personal, “pass-through” taxes or corporate taxes are preferable. As discussed earlier, it is not always a simple decision to make when there are complications such as the SALT deduction cap and its state-level workaround for partnerships to accept tax liabilities as entities.
The Last Word
Ultimately, with enough preparation and a solid partnership agreement with trustworthy partners, a general partnership can be an excellent way to structure your business. Although there is much to consider regarding the finer details, forming a general partnership is a surprisingly achievable task. If you’re interested in how to form other types of partnerships, read our guide on how to form a limited partnership as well.
Filed under: Advice Columns
