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Partnerships and Law

What Is a Partnership?

Definition of Partnership

A partnership is formed by two or more persons carrying on a profit-oriented business as co-owners.

When two or more people voluntarily agree to operate a business for profit as co-owners, a partnership is formed. The partnership agreement is an agreement that governs the partnership and establishes the rights and obligations of the partners; the agreement is not required to be in writing, but a written agreement is often used to tailor business relationships to the specific needs of the partnership, rather than relying solely on state statutes. For example, Mark and Austin enter into an agreement to operate a construction company. Their intention is to do commercial construction work, including building new commercial buildings for specific clients and remodeling existing commercial buildings to meet the needs of new tenants. Their agreement is that Mark's responsibilities will include finding new clients and cultivating existing clients and that Austin's responsibilities will include preparing bids for construction jobs and overseeing the accounting for individual construction projects. Mark and Austin will share the responsibilities for managing the jobs that the business undertakes and will share equally in the profits and losses generated by the business. To begin the business, Mark and Austin each contribute $5,000 to the business to purchase their ownership interests in the business. They name their business AustinMark Construction Company.

The agreement that Mark and Austin have entered into is a partnership agreement. The business that this partnership will conduct is intended to be a profit-making business.

It is important for business leaders to understand the terms used in the definition of partnership. There are several forms of business that anyone considering starting a business can select, and though the terms used to describe those businesses are similar, the consequences of each form of business can be different and significant. For instance, a partnership is often considered to be an appropriate choice when two or more individuals want to participate in the operation of the business, primarily because of the tax consequences involved, but the unlimited liability that is characteristic of partnerships can be a reason not to form a partnership if the business that is to be conducted involves activities that may damage property or injure others. Unlimited liability is the concept that partners are personally responsible for paying partnership debts, even if they must use personal assets to do so.

Formation of a Partnership

A partnership is formed when two or more entities agree to form that partnership, contribute assets to the partnership, and receive interests in the partnership.
The people who agree to form a partnership become a partner in the business. Those partners can be individuals, unincorporated associations (including other partnerships), corporations, or any combination of these.

After forming a partnership, the partners must agree to operate the partnership as a business for profit, an organization whose primary goal is making money in a recognized trade, occupation, or profession. If the business does not make a profit, it is still a partnership because it has the intention to make a profit. The business that the partners agree to operate must be legal, and it must be an actual business, such as a trade, occupation, or profession.

The requirement that each partner is a co-owner is satisfied when there is an agreement for the partners to share, on some basis, the profits and losses from the partnership business and for the partners to share management responsibilities of the partnership business.

A partnership has a name that differs from the names of the individual partners, though the partnership name may include their names.

The partnership is not always considered to be a separate legal entity that is different from the partners. In some situations a partnership is considered an aggregate, or combination, of the individual partners. For instance, for federal income tax purposes, a partnership is not considered to be an entity. For this reason it does not pay any federal income taxes. Instead, the profits (or losses) of the partnership "pass through" to the individual partners. Those partners are responsible for paying the federal income taxes owed on their portion of the partnership profits, whether or not the profits are actually paid out to the partners.

In other situations the partnership is considered to be a legal entity with certain legal rights. For instance, a partnership can file a civil lawsuit (one based on noncriminal statutes, such as disputes involving contracts) and can be sued under the partnership name. Also, the partnership (rather than the individual partners) can own titles to real and personal property in the name of the partnership.

Duties Imposed upon Partners by Law

Partners owe one another fiduciary duties of loyalty, good faith, honesty, confidentiality, and the highest standard of care.

Partnerships create a special form of agency—a relationship in which one party represents another party and is authorized to act on behalf of that other party. Therefore, much of agency law applies to partnerships. Unless the partnership agreement imposes specific limitations, each partner is an agent of the partnership. The other partners authorize them to do whatever is necessary to carry out the partnership business on behalf of the other partners. Each partner is assumed to have knowledge of and responsibility for everything that each other partner does on behalf of the partnership in carrying out the partnership business.

An agent's fiduciary duty includes legal obligations that partners owe each other: to act loyally, in good faith, honestly, confidentially, and with the highest standard of care when making decisions requiring business judgment. As an agent of the partnership and the other partners, each partner has specific fiduciary duties to the partnership and other partners that include the duties of loyalty and care.

The duty of loyalty means that a partner cannot compete with the partnership business or take partnership opportunities for themselves and has several applications in the context of partnerships. First, a partner must disclose to the other partners anything of value that comes into the partner's possession as a result of their activities on behalf of the partnership. That duty to disclose includes the requirement to reveal any information that a partner acquires that is relevant to the partnership.

The duty of care means that a partner must act as a reasonably prudent person would act in the circumstances. The partner has an obligation to keep proper business records and perform audits and must not engage in gross negligence, reckless conduct, or violations of criminal law in representing the partnership so as to make the partners and the partnership liable. A partner who breaches the duty of loyalty, the duty of care, or both may face a civil lawsuit—from one or more of the partners or from the entire partnership.

How Partnership Profits and Losses Are Shared

Partnership agreements spell out how partnership profits and losses are to be shared. If there is no partnership agreement, or if it is silent on the allocation of profits or losses, then the default position is that all partners equally share profits and losses.

One of the characteristics of a partnership is that it is formed to operate a business that is intended to make a profit. Of course, there may be times when a partnership business loses money. For example, the partnership that Mark and Austin formed, AustinMark Construction Company, negotiated a contract to build a new commercial building for a new client for $100,000. In negotiating that contract, Austin prepared a bid that indicated that the partnership would spend a total of $85,000 in materials and labor to build the new building, so the partnership expected to make a profit of $15,000 on that contract. However, because the cost of steel that would be used in the building increased because a tariff that was not expected was imposed on imported steel, the cost of building the building was actually $110,000, and the partnership lost $10,000 on the contact. If that were the only contract in the first year after the partnership was formed, the $10,000 loss would be shared by the partners, Mark and Austin.

Another characteristic of a partnership is that the partners have agreed to share profits earned, losses taken, and costs paid to vendors. That agreement does not have to provide that the partners will share the profits and losses equally. It does not even have to provide that profits will be shared on the same basis as losses—although the partnership that does this may face questions from the Internal Revenue Service (IRS), the bureau of the Department of Treasury tasked with enforcing income tax laws.

A partnership agreement does not have to be in writing. However, if profits and losses are to be shared in any way other than equally, then the allocation of profits and losses are detailed in the written partnership agreement. If there is no agreement about how profits and losses will be shared, then the partners share profits and losses equally.

For example, in a two-person partnership, one partner may contribute more money or assets to the partnership than the other partner. In a case such as this, the partnership agreement might provide that the partner contributing more receives a larger percentage of profits.

Partnership Profits and Losses

Partnerships calculate their profits or losses for the year and report the profit or loss to the IRS. Then the partnership allocates the profit or loss to the partners, who are responsible for paying the taxes on their allocated portion of that profit or loss.
Losses in a partnership are "passed through" to partners so that the partners can use those losses to offset income from other sources. So a partner with substantial income from other sources—and therefore the need for losses to offset against that income—might receive a larger percentage of losses from the partnership. However, the IRS requires all allocations to meet an economic substance test. In other words, the taxpayer has to have a business purpose for the allocation. It cannot be done just to avoid taxes.

Partnerships do not pay federal income taxes. Instead, a partnership computes the amount of taxable income it has earned for the year. Then, according to the partners' agreement on sharing of profits and losses, the partnership allocates the profits or losses of the partnership for that year to the partners. Each partner includes the profit or loss allocated to them by the partnership in their own income tax return and personally pays the resulting federal income tax.