According to the IRS, a partnership is an unincorporated organization with two or more members who carry on a trade, business, financial operation, or venture and divide its profits. A single person cannot form a partnership. 

There are different types of partnerships, such as a Limited Partnership (LP), Limited Liability Partnership (LLP), General Partnership (GP), or Family Limited Partnership. The laws covering partnerships are covered in Internal Revenue Code Title 26, Subtitle A, Chapter 1, Subchapter K sections 701 to 777. 

Partnerships are excellent structures for entrepreneurs who bring different skill sets to the business. For example, you could form a partnership with a friend to build an apartment building where you contribute the raw land to the partnership and your friend contributes the money for the construction cost, but you decide to split the profits 50/50. This unequal ownership structure is not possible in a corporation, only a partnership could accommodate such a disproportionate ownership interest. A partnership should have a partnership agreement that outlines the key provisions of the partnership.

Types of Partnerships

General Partnership (GP)

A general partnership (GP) is the easiest partnership because when two or more people are engaged in a business for profit, it is automatically deemed a partnership by default. General partners in a partnership have unlimited personal liability for each partner. Each partner can enter into a contract on behalf of the partnership and subject the other partner to liability. Partnership agreements are highly recommended to clearly outline the roles and responsibilities of each partner. 

Limited Partnership (LP)

A Limited Partnership (LP) is a general partnership but with limited liability for one or more members. A limited partnership has at least one general partner and limited member. Like a GP, the general partner has unlimited (100%) liability whereas a limited partner is only at risk for the amount of money they have invested.

The General Partner manages the partnership while the Limited Partner(s) is simply a silent investor and does not participate in the day-to-day operations of the business. The general partner(s) have unlimited liability whereas the limited partner(s) have limited liability. 

LPs are ideal for partnerships seeking outside investors who want limited liability and do not want to participate in the daily operations of the partnership business.

Limited Liability Partnership (LLP)

Unlike a General Partnership where all the partners have unlimited liability, a Limited Liability Partnership has limited liability for all partners. As a result, the debts and liabilities of the partnership do not pass-through to the partners. Also, a partner in a LLP can play an active role in the partnership while still maintaining limited liability whereas a limited partner in a Limited Partnership must be a silent investor and cannot participate in management of the partnership. LLPs are popular among professional businesses such as CPAs, engineers, lawyers, etc.; however, individual states may have rules on who can form an LLP.

Family Limited Partnership

A Family Limited Partnership (FLP) is a partnership between family members to hold assets for estate planning, tax, creditor protection, and asset protection purposes. A FLP cannot be formed by a single individual, but can be formed by a husband and wife. An FLP is similar to a holding company that owns various assets such as closely held companies, marketable securities, real estate, and privately held companies.

The FLP has one or more general partners who are in charge of running the FLP. The Limited Partners are other family members who have limited authority. While the general partners have unlimited liability, they can shield their liability by forming an LLC to be the general partner.

A FLP is a highly effective entity structure for families with significant wealth seeking to minimize their tax liability. 

General Characteristics of all Partnerships

All partnerships are unincorporated businesses and by themselves are not taxable entities. Partnerships are considered Pass-Through-Entities (PTE) because a partnership does not pay federal income tax and files only an informational tax return using Form 1165 to report each partner’s share of profits and losses. The partnership agreement dictates how the income, losses, and expenses of the partnership are allocated among the partners. Once the partnership informational 1165 return is prepared, each partner receives a K-1 showing their proportional share in the partnership interest. 

How to form a partnership?

A partnership is formed when two or more individuals (or entities) contribute capital to form a business. The contributed capital can be either cash, property, or services in exchange for a partnership interest. A partner in a partnership can be an individual, an LLC, corporations, trusts, estates, associations, and other partnerships. Depending on the state and type of partnership, formal documents may not be required to form a partnership; however, a partnership agreement is always highly recommended.

Taxation of Partnerships

Partnerships are Pass-Through-Entities (PTE) and pay no federal income tax, unlike C-Corporations which are double taxed. Even though partnerships do not pay federal tax, they must obtain an Employer Identification Number (EIN) to file their tax returns. The federal partnership return (Form 1065) is only an informational return used to allocate income and loss to each partner through the issuance of a K-1. The K-1 is then used by each partner to file their personal income tax returns. Partnership taxation can become extremely complicated, especially if for example when a partner contributes appreciated property to the partnership; sells their partnership interest; has a foreign partner; 

Income from a partnership is taxed at the individual level. However, depending on the type of partnership, some states may impose a state or franchise tax on the partnership.

Form 8825

Form 8825 is used by partnerships and S-Corporations to report rental real estate activities. The purpose of reporting rental activities on Form 8825 is because rental real estate is a passive activity and is not subject to self-employment tax.      

What is an Partnership Agreement

A partnership agreement is an important document, usually created by an attorney, that outlines the key provisions of the partnership and governs the operations of the partnership. Not all states require partnerships to have partnership agreements, but it is highly recommended to protect partners and also helps their CPA know how to allocate income/losses among partners. 

What is included in a partnership agreement? 

A well written partnership agreement will cover:

• Who will make decisions on behalf of the partnership?
• Who has voting rights?
• How will profits and losses be allocated among partners?
• How will disputes be resolved?
• How the partnership will add / remove partners.
• Reimbursed expenses: what expenses are paid by the partnership on behalf of the partners?
• Unreimbursed expenses: what expenses are not paid by the partnership on behalf of the partners?
• Since the operating agreement is a binding contract, it will also include details of who has the authority to make changes to the agreement. 
• Document oral agreements among partners. 
• Partnership address and location of partnership documents.

Partnership Capital Accounts

A partnership capital account shows each partner’s equity (capital or economic interest) they have in the partnership and is tracked on a partner by partner basis. 

A partner’s capital account is increased by cash and property contributions to the partnership, and net income of the partnership. A partner’s capital account is decreased by distributions and net losses of the partnership. Each partner’s capital account is tracked on their individual K-1.

The aggregate partnership capital account is tracked on the partnership return 1065 Schedule M-2. However, not all partnerships have to complete Schedule M-2. Small partnerships with less than $250,000 in income and less than $1 million of assets are not required to complete Schedule M-2. 

A partner’s capital account does not equal a partner’s outside basis in the partnership.

Partnership Inside vs Outside Basis

Partnership basis is very important because it is used to calculate the taxation of distributions from the partnership to a partner. 

A partner in a partnership has both inside and outside. Inside basis is the partnership’s basis in the assets of the partnership whereas outside basis is the individual partner’s basis in the partnership. Sometimes the inside and outside basis are the same, but there are times when they differ. 

Assume partners A & B each contribute $100 cash to form a partnership and are 50/50 owners. In this example, both partners have an inside/outside basis of $100. 

Now assume partner A contributed equipment with a fair market value of $100 for which he paid $75 (his cost basis) to the partnership and partner B contributed $100 cash to form the partnership. In this example, the inside basis for each partner is $100, but the outside basis for partner A is $75 because his basis in the contributed equipment is $75. 

Benefits of a partnership:

• Expanding knowledge base by partnering with other experts.
• Access to more capital than just a single person.
• Share the expenses with other partners to lessen the financial burden.
• Easy to form because there are no state filing requirements.
• Allow partners split profits and losses in any manner they choose regardless of a partner’s contributed capital. 
• Limited partners have limited personal liability which means that they are not personally liable for the debts of the partnership.
• Limited partners are not subject to self-employment taxes.

Disadvantages of a partnership

• Possible disagreements among partners.
• Loss of decision making power.
• Transfer of ownership may be difficult.
• A partner’s losses are limited to their adjusted basis.
• General partners in a partnership have unlimited personal liability.
• General partners are subject to self-employment taxes.

Frequently Asked Questions on Partnerships

Q: What tax return do partnerships file?

A: A partnership files IRS form 1065 which generates a K-1 for each partner.

Q: What is the difference between a 1065 and 1120 and 1120S?

A: A 1065 is filed by a partnership; an 1120 is filed by a C-Corporation, and an 1120S is filed by an S-Corporation.

Q: What is the difference between a partnership agreement and an operating agreement?

A: A partnership agreement is for a partnership whereas an operating agreement is for an LLC. 

Q: What is the difference between an LLP and an LP?

A: LLPs and LPs are very similar except for one key difference: an LLP must have at least one general partner, but an LLP can have all limited partners.

Q: What is the difference between an LLC and an LLP?

A: LLCs and LLPs have the following key differences: 

• An LLC is a hybrid entity that can choose to be taxed as either a partnership, S-Corporation, C-Corporation, or a Single Member LLC. An LLP can only be taxed as a partnership. 

• An LLC is a Limited Liability Company whereas an LLP is a Limited Liability Partnership. 
• LLC owners are members whereas LLP owners are partners. 
• Unlike an LLC where all members have limited liability, an LLP has at least one General Partner with unlimited liability.
• LLPs are taxed as partnerships and must file a partnership (Form 1065) return.
• An LLC can be owned by one person: Single Member LLC (SMLLC), but an LLP must have at least two partners.

Q: What are the owners called in a partnership?

A: An LLC has members whereas a partnership has partners and a corporation has shareholders.