Fact checked for accuracy by Janet Berry-Johnson, CPA.
A partnership is a formal arrangement between two or more parties in the management and operation of a business entity. In a partnership, business partners share profits and liability with your business partners.
Thinking about whether or not a partnership is right for your business? Below, we cover all the different types of partnerships, the pros and cons of each one, how to set them up, how taxes work, and compare them to other business structures. Let’s get started.
Types of Partners: General Partners vs. Limited Partners
A general partner has unlimited personal liability for debts in a business, while a limited partner has limited liability and is not active in the business’ operations.
Suppose you are a general partner; you are involved in the business’s day-to-day running. On the other hand, your limited partner does not partake in running the business. However, if you are a general partner, you have unlimited liability for debts. On the other hand, the liability of limited partners does not go beyond their investment.
Types of Partnerships
Overall, there are four types of partnerships. Here is an overview of each one and their advantages and disadvantages.
General Partnership (GP)
In a GP, an agreement is made between two groups to set up and run a legal entity. All the individuals or groups are responsible for managing the business, and they all have unlimited liability.
Whenever you choose a general partnership, you must be ready to share profits, losses, and debt liabilities equally. In case you plan to do this unequally, ensure you have a partnership agreement for reference.
Pros and Cons of General Partnership
Here are the advantages and disadvantages of general partnerships.
- A general partnership is straightforward and quick to establish. It is generally less expensive, simpler, and time-saving since it doesn’t need a lot of paperwork.
- Secondly, taxes for general partnerships are simplified since you are not required to pay income tax. The accrued profits and losses are passed through individual partners.
- General partnerships are easy to dissolve. If you decide to dissolve your general partnerships, you will not go through many legal issues; the process is easy and time-saving.
- Partners face potentially unlimited liability. Due to the absence of a corporate structure, GP doesn’t distinguish itself as a business entity. As a result, you have no protection from lawsuits against your business. Therefore, debtors can seize your assets in case of unpaid debts.
- Secondly, you are liable for the actions of your partner. For example, if your partner executes an agreement without your knowledge, you have an obligation to honor its terms and conditions.
Limited Partnership (LP)
Limited partners are not actively involved in the day-to-day activities of the business. However, general partners are in charge of the business’s everyday activities.
What Is a Limited Partnership?
LP is a type of partnership where one partner has unlimited liability and other partners have limited liability. If you have limited liability, you are the limited partner. The general partner has unlimited liability.
Limited partnerships have both general and limited partners. As mentioned, general partners are active managers, whereas limited partners have minimal involvement. Limited partners offer capital, but they cannot make management decisions and cannot oblige any debts beyond their investments.
Pros and Cons of Limited Partnerships
The main advantage of LP, especially for a limited partner, is the limited liability since you are only responsible for the amount invested. In addition, if you are a limited partner, you are not required to pay self-employment taxes.
However, the general partners have unlimited liability, on the downside, taking complete control of management decisions. As a result, they may choose to mishandle the business, which can disadvantage a limited partner who is not involved in making decisions.
- Limited partners have personal liability protection.
- LPS are pass-through entities for taxation; therefore, profits are taxed only once.
- A limited partnership is easy to create.
- There are no self-employment taxes for limited partners.
- There is no limitation on the number of shareholders.
- In an LP, you can utilize the managerial or financial strength of other partners.
- Extensive documentation may be required.
- The assets of general partners are not protected.
- The general partners are responsible for the actions of one another.
- Partnerships are terminated if one of the partners dies or withdraws.
Limited Liability Partnership (LLP)
LLPs are partnerships where all partners have limited liability. In contrast to Limited Partnerships, all the partners can be involved in management activities and decision-making. However, you will not be responsible for the actions, misconduct, or negligence of your partners.
LLPs are used for structuring professional service provider companies such as accounting and law firms. For you to form a limited liability partnership, ensure that you and your partners register the venture in the relevant state through the local secretary of state. Acquire all the required permits and licenses applicable to the industry and state.
Pros and Cons of LLPs
Like other forms of business arrangements, limited liability partnerships also have advantages and disadvantages.
- The limited liability protects members’ assets from most liabilities of the business.
- LLPs are flexible; a written agreement between the members dictates operations and profit-sharing.
- An LLP is like a legal person, thus can buy, lease, own property, enter a contract, employ staff, and be held accountable.
- It is corporate ownership, thus can appoint two companies as members of LLP.
- One of the disadvantages is lack of privacy. There can be public disclosure since annual reports are submitted to the relevant authority for records. Profits cannot be retained like in a company limited with shares.
- LLP must have at least two members; thus, in case one member dies, it has to be dissolved.
- Since the income is personal, it must be taxed accordingly.
Limited Liability Limited Partnership (LLLP)
LLLP is a new entity or modification of a limited partnership.
What Is LLLP?
An LLLPs is a type of limited partnership that consists of one or more general partners liable to obligations of the entity and one or more liability protected limited partners.
General partners actively manage LLLP, while a limited partners’ main interest is purely financial. Therefore, the primary purpose of LLLP is a financial investment. In LLLP, both you and your partners are protected from personal liability in case of legal actions or debts against the business.
An LLLP offers its partners comparable liability protection as with LLP or LP. An LLLP mostly has one or more general partners; therefore, it is primarily limited partners.
Pros of LLLP
The main advantage of LLLP is that it has limited liability protection for the general partners. Therefore, if a lawsuit is filed against the company, their general partner does not carry a personal responsibility. Furthermore, if one of the general partners misbehaves, the other general partners will not be responsible.
An LLLP has the right to sell or buy stock, bonds, mutual bonds, and more.
Although LLLPs are advantageous, they do not offer comprehensive liability protection as compared to LLCs and corporations. Further still, you have to inquire if your state has recognized it as a viable option for establishing a business.
Partnership vs. LLC
An LLC is a legal business form with many similarities to a partnership. However, there are differences between LLC and Partnership.
An LLC combines the liability protection of a corporation with the operations of a partnership. An LLC may have one or more owners with a certain percentage of ownership. Operations of LLC depend on the operating agreement.
However, the members can opt out of day-to-day management by hiring a manager. Hiring a manager is not a must since the members can choose to manage the business by themselves.
On the other hand, partnerships are business relationships between people who have contributed and have a certain percentage of business equity. Partnerships work under partnership agreements. The day-to-day activities are handled by one or more of the partners.
How Taxes Work as a Partnership
Partnerships are considered pass-through entities; therefore, all the profits and losses pass through its members, who then pay taxes on the share of profits they receive on their income tax return. Although they do not pay income taxes, partnerships are required to file tax returns.
Because there are no employers to compute and hold taxes, every partner has to set aside enough money to pay taxes on their share of yearly profits. As a partner, make appropriate estimates on the amount you expect to owe at the end of the year and make payments when required.
If you actively run the partnership entity, you need to pay self-employment taxes on your partnership profits. That contributes to medicare and social security. Self-employment tax is similar to payroll taxes that employees are required to pay.
How to Form a Partnership
Here are the general steps to establish a partnership business as per the specific applicable laws.
Step 1: Make Partner Decisions
Partnerships can involve more than two individuals. Thus, it would be best if you made decisions on them. For example, you can make decisions on:
- Partner contributions.
- Types of partners, i.e., a general or limited partner?
- Partner shares on both profits and losses.
Step 2: Decide on the Type of Partnership
Choosing the type of partnership mainly depends on the decisions the members make in step one. There are several options to choose from:
- General Partnership, which has one partner type and all are involved in the activities of the business. Read our entire column on forming a general partnership for more information.
- Limited partnership, in which there are two types of partners: general and limited partners. Read our entire column on forming a limited partnership for more steps and considerations.
- Limited liability partnership, where members are protected from liabilities against the business.
Step 3: Choose the Name of the Business Partnership
The name of a partnership depends on the type of partnership you choose. It is good to have the designation of the partnership in the name. For instance, if you choose a limited liability, you should have the designation in your name. A name is critical, and it is difficult and expensive to change.
Step 4: State Registration
After completing step three, go to the secretary of state’s website, look for the business or corporation section, and register your business partnership. If you intend to operate in more than one state, register in each of them.
Step 5: Getting an Employer Identification Number
You acquire an employer ID number online.
Step 6: Creating an Agreement
A partnership agreement states in writing all the processes and decisions that members have agreed to follow. In addition, an agreement must address all the “what if questions” that may arise in the future. For information on what to include, head over to our partnership agreement template.
Step 7: Acquiring Licenses, Permits, and Other Registrations
There are some regulatory and legal tasks you must do before you successively set up your partnership:
- Register to pay sales tax in your state’s taxing authority if you sell taxable products or services.
- You must also register to pay federal taxes.
- File a fictitious name registration with your county or city.
- Depending on the partnership, register with your locality to get business licenses or permits.
The Last Word
Partnerships are a great structure for business owners who want to split stake and the responsibility in the business. There are a bunch of different partnership types to choose from, so hopefully the information above helped you clear your head on which partnership setup might be right for you (or if an LLC may be better).
Regardless of which structure you choose, good luck in your journey and let us know if you have any questions.
Filed under: Advice Columns