Partnership: Definition, How It Works, Taxation, and Types

By CAROL M. KOPP Updated March 28, 2023

Reviewed by MARGARET JAMES

Fact checked by KATRINA MUNICHIELLO

What Is a Partnership?

A partnership is a formal arrangement by two or more parties to manage and operate a business and
share its profits.

There are several types of partnership arrangements. In particular, in a partnership business, all partners
share liabilities and profits equally, while in others, partners may have limited liability. There also is the
so-called "silent partner," in which one party is not involved in the day-to-day operations of the business.

KEY TAKEAWAYS

A partnership is an arrangement between two or more people to oversee business operations and share
its profits and liabilities.

In a general partnership company, all members share both profits and liabilities.

Professionals like doctors and lawyers often form a limited liability partnership.

There may be tax benefits to a partnership compared to a corporation.

Partnership

Investopedia / Matthew Collins

Types of Partnerships

In a broad sense, a partnership can be any endeavor undertaken jointly by multiple parties. The parties
may be governments, nonprofits enterprises, businesses, or private individuals. The goals of a
partnership also vary widely.

Within the narrow sense of a for-profit venture undertaken by two or more individuals, there are three
main categories of partnership: general partnership, limited partnership, and limited liability
partnership.
General Partnership

In a general partnership, all parties share legal and financial liability equally. The individuals are
personally responsible for the debts the partnership takes on. Profits are also shared equally. The
specifics of profit sharing will almost certainly be laid out in writing in a partnership agreement.

When drafting a partnership agreement, an expulsion clause should be included, detailing what events
are grounds for expelling a partner.

Limited Liability Partnership

Limited liability partnerships (LLPs) are a common structure for professionals, such as accountants,
lawyers, and architects. This arrangement limits partners' personal liability so that, for example, if one
partner is sued for malpractice, the assets of other partners are not at risk.

Some law and accounting firms make a further distinction between equity partners and salaried
partners. The latter is more senior than associates but does not have an ownership stake. They are
generally paid bonuses based on the firm's profits.

Limited Partnership

Limited partnerships are a hybrid of general partnerships and limited liability partnerships. At least one
partner must be a general partner, with full personal liability for the partnership's debts. At least one
other is a silent partner whose liability is limited to the amount invested. This silent partner generally
does not participate in the management or day-to-day operation of the partnership.1

Finally, the awkwardly-named limited liability limited partnership is a new and relatively uncommon
variety. This is a limited partnership that provides a greater shield from liability for its general partners.2

Taxes and Partnerships

There is no federal statute defining partnerships, but nevertheless, the Internal Revenue Code (Chapter
1, Subchapter K) includes detailed rules on their federal tax treatment.3

Partnerships do not pay income tax. The tax responsibility passes through to the partners, who are not
considered employees for tax purposes.3

Individuals in partnerships may receive more favorable tax treatment than if they founded a corporation.
That is, corporate profits are taxed, as are the dividends paid to owners or shareholders. Partnerships'
profits, on the other hand, are not double-taxed in this way.3

Advantages and Disadvantages of Partnerships

A successful partnership can help a business thrive by allowing the partners to pool their labor and
resources. Most sole proprietors do not have the time or resources to run a successful business alone,
and the startup stage can be the most time-consuming.

Creating a partnership allows the partners to benefit from one another's labor, time, and expertise.
Moreover, a shrewd partner can also provide additional perspectives and insights that can help the
business grow.

But there is also an additional risk in joining a partnership. In addition to sharing profits, the partners
may also assume responsibility for any losses or debts from the other partners. There is also a higher
chance of conflict or mismanagement. When the time comes to exit, it may be harder to reach an
agreement about selling the business.

Pros and Cons of Partnership

Pros

Partners can pool their labor, capital and expertise.

Partners can share tasks, allowing greater work-life balance.

More partners can bring their experience and new perspectives to the firm.
Cons

Partners may bring additional debts or liabilities.

There is a greater chance of disagreement or mismanagement.

It may become harder to sell the business.

Partnerships by Country

The basic varieties of partnerships can be found throughout common law jurisdictions, such as the
United States, the U.K., and the Commonwealth nations. There are, however, differences in the laws
governing them in each jurisdiction.

The U.S. has no federal statute that defines the various forms of partnership. However, every state
except Louisiana has adopted one form or another of the Uniform Partnership Act; so, the laws are
similar from state to state.

The standard version of the act defines the partnership as a separate legal entity from its partners,
which is a departure from the previous legal treatment of partnerships.

Other common law jurisdictions, including England, do not consider partnerships to be independent
legal entities.

How Does a Partnership Differ From Other Forms of Business Organization?

A partnership is a way of structuring a business that involves two or more individuals (the partners). It
involves a contractual agreement (the partnership agreement) between all of the partners that set the
terms and conditions of their business relationship, including the distribution of ownership,
responsibilities, and profits and losses. Partnerships outline and clearly define a business relationship
and responsibility.

Unlike LLCs or corporations, however, partners are personally held liable for any business debts of the
partnership, which means that creditors or other claimants can go after the partners' personal assets.
Because of this, individuals who wish to form a partnership should be extremely selective when choosing
partners.

If Partners Don't Have Limited Liability Why Set Up a Partnership?

Partnerships have several benefits. They are often easier to set up than LLCs or corporations and do not
involve a formal incorporation process through a government. This has the added benefit of not being
subject to the same rules and regulations that apply to corporations and LLCs. Partnerships also tend to
be more tax-friendly.

What About Limited Partnerships?

In limited partnerships (LPs), there are general partners who maintain operations of the firm and have
full liability, whereas limited (silent) partners, who are often passive investors or otherwise not involved
in day-to-day operations, enjoy limited liability. A limited liability partnership (LLP) is different from an LP.
In an LLP, partners are not exempt from liability for the debts of the partnership, but they may be exempt
from liability for the actions of other partners. A limited liability limited partnership (LLLP) is a relatively
new business form that combines aspects of LPs and LLPs.1

Do Partnerships Pay Taxes?

The partnership itself does not pay business taxes. Instead, taxes are passed through to the individual
partners to file on their own tax returns, often via a Schedule K.7

What Types of Businesses Are Best-Suited for Partnerships?

Partnerships are often best for a group of professionals in the same line of work where each partner has
an active role in running the business. These often include medical professionals, lawyers, accountants,
consultants, finance & investing, and architects.
The Bottom Line

A partnership is a legal arrangement that allows two or more people to share responsibility for a
business. Those partners share the ownership and profits, but they also share the work, responsibility,
and potential losses. A successful partnership can give a new business more opportunities to succeed,
but a poorly-thought out one can cause mismanagement and disagreements.

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5 Alternatives to Starting Your Own Business

By ANDREW BEATTIE Updated January 30, 2023

Reviewed by ERIKA RASURE

Trending Videos

The dream of being an entrepreneur appeals to many people, but starting your own business from the
bottom up can be daunting. Some alternatives deliver many benefits of being a business owner while
avoiding some of the drawbacks to starting a business.

By exploring some alternatives, you may be able to find one that will give you the experience you are
looking for while minimizing the difficulties of entrepreneurship. If none of them scratch that itch, maybe
it is time to roll up your sleeves and build a business from the ground up.

Understanding Alternatives to Starting Your Own Business

Invest in Other People's Startups

Although it may not carry the same attraction, investing in startups and established businesses can be as
profitable as running them. Publicly traded venture capital funds scout and invest in startups, creating a
portfolio of businesses that might make it big. With a single investment, you can get access to a wide
portfolio of businesses that have passed the venture capital firm's tests.
KEY TAKEAWAYS

Active alternatives to starting your own business—those that require some sweat equity from you, but
far less startup effort—include intraprenuership, finding partnerships, or purchasing a franchise.

More passive alternatives to starting your own business—those in which you own a business through
investment—include investing your capital in existing businesses, startups, or venture capital firms that
finance those startups.

On a local level, there are often opportunities to make direct investments in a business about which you
have some knowledge, either in your area or your personal network, that could exchange an equity stake
for your investment.

Both types of investments carry a level of risk that matches the potential rewards if a business is
successful, so it is important to research these opportunities thoroughly. Investing through a venture
capital fund is the most hands-off of these alternatives. You don't have to quit your job, open an office or
hire employees—you just buy shares.

Partnership

Instead of investing in a business in exchange for an equity stake, you can look into becoming a partner
in an existing business. This can mean doing day-to-day work in the business—focusing on something the
founder doesn't have time for, such as marketing or finance—or it can be a more hands-off role.

This can give you the entrepreneurial experience, minus the start-up phase, and allow you to choose the
type of work you want to do. Even if you are absolutely set on starting your own business, the right
partner can make the start-up phase go more smoothly, depending on the experience and skills they
bring to the table.

Intrapreneurship

Another option is to become an entrepreneur within a larger organization. Some companies have
structures encouraging employees to pioneer new business lines in return for equity or bonuses. If you
can find a company with a strong culture of innovation, you can build your own business within it, with
the advantage of having start-up capital from the beginning and less personal risk.
You may even be able to kick-start an intrapreneurship program by asking to spend a percentage of your
time working on pet projects with bonus structures. To bolster your argument, you can point to
companies like 3M, Intel, and Lockheed Martin. These companies saw some of their biggest growth
when intrapreneurship defined the corporate culture. Intrapreneurship can offer some of the same
benefits as entrepreneurship without forcing you to give up the security of a day job.

Buy a Franchise

A business in a box is one way to avoid many of the hassles involved with starting from scratch.
Essentially, a franchise owner is following a script proven to be successful in other locations. Benefits of a
franchise include a recognized brand, resources to draw from, and economies of scale the franchise
network creates.

The drawback to franchise ownership is primarily the cost of the initial purchase and the royalties, which
can be expensive. People who want a true entrepreneur experience will also have issues with the
limitations the franchise office imposes as far as creative control. That said, franchises have a stronger
support network and generally have a better success rate compared with the vast majority of start-ups.

Buy an Existing Business

Buying a business that is already in operation and profitable is another shortcut. There are some obvious
benefits, like less time spent in the planning and creation stage, infrastructure such as supplies already in
place, and existing customers who recognize the brand.

The major downside is that the cost of acquiring a profitable business is usually much higher than the
start-up costs of the same type of business. This cost reflects the efforts of the person who started it,
plus an additional premium charged for the business having proven its viability.

If you choose this route, it is important to perform due diligence, such as confirming all the revenue
figures and finding out why ownership is selling a seemingly successful business.

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