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What are the major characteristics of a “general partnership”?
A general partnership is the most basic form of business entity. The primary characteristics of the general partnership are as follows:
Forming a General Partnership – Creation & Maintenance
A general partnership is an agreement between two or more persons to share a common interest in a commercial endeavor and to share its profits and losses. There is no government-filing requirement to form a general partnership.
The partnership can arise by default from the actions or activities of the partners. This general partnership definition contains similar elements to the sole proprietorship, but it requires more than one person.
The agreement between the individuals does not have to be written or expressed. It can be implied from the actions of the partners. It is important to understand that a general partnership is a default entity. That is, the partners do not have to intend to create a general partnership, nor do they have to realize that a general partnership has been formed.
- Note: Under the doctrine of “partnership by estoppel”, a court may deem a relationship to be a partnership when the requisite elements are not present. This situation arises when third parties rely upon an individual representing himself as a partner or consents to another representing himself as a partner.
- Example: I learn about an opportunity to make money by raking leaves for a local business. I approach Elsa and ask her to help me rake leaves to make money. We agree to split all proceeds from raking leaves. We have formed a general partnership.
Individuals may enter into a written agreement, known as a “partnership agreement”, establishing a general partnership. A partnership agreement is the governing document for any type of partnership. Partnership agreements are not mandatory, but it is advisable for any partnership to have an agreement governing the partnership relationship.
- Note: Documenting the relationship between individuals in a business activity can serve to characterize the relationship as either a general partnership or employer-employee relationship. In the absence of a formal agreement, states have default rules governing the operations of the partnership and the relationship between the partners. While the default rules are comprehensive, they often do not always align with the specific intent of the parties. If you wish to hire an individual (not bring her on as a partner) and compensate her with a share of the profits, you will need to document the employment relationship. This may require special structuring of any profit sharing as a bonus paid to the employee, rather than as an ownership percentage in any profits.
A general partnership has no formal maintenance requirements. There are, however, default rules that provide for the rights of partners with regard to the partnership. This may include the right to vote for certain partnership decisions and a right to profits of the partnership. These rules are a form of governance requirement that may be considered maintenance of the business entity.
- Example: Dave begins scouring the neighborhood for metal items that people leave on the curb as trash to be collected by the garbage man. Dave knows that he can take the metal to a scrapyard and make some money. He asks Laura if she will take his truck and cruise her neighborhood for metal. He says that he will give her 40% of the value of any metal collected. In this case, Dave has agreed to share ownership in the business and Laura will be a partner. If Dave had said he would pay her $7.50 per hour and give her 20% of the value of any metal she collects, then Dave would still be a sole proprietor.
What does it mean to be at-will partners?
As previously noted, a general partnership may arise simply through an intent to undertake a mutual activity for a profit. That is, parties who do not intend to be partners may, nonetheless, be deemed a general partnership “at-will”. The “at-will” characteristic means that there is no formal agreement in place delineating the time during which the individuals will remain partners. Any partner may leave the partnership at any time.
In determining whether the activity of individuals forms a partnership, a court will look at the totality of the circumstances. This means that the court will examine any evidence of the activity or relationship between the individuals to see if they meet the state law characteristics or requirements of a partnership. The circumstances may obviously indicate that some other type of relationship exists, such as an employer-employee relationship exists. In this case the individuals will avoid the classification of partners and all of the default rules and obligations that accompany such designation.
Characteristics of an At-Will Partnership
Equal Ownership of Partnership – The default rule is that partners of an at-will partnership share equally in the ownership of the business. It does not matter if the partners contribute at different levels to the partnership, either through assets of labor.
Equal Authority in Management Functions – The default is that each partner has the authority to take part in the management of the firm. Likewise, the partner has the inherent authority to act on behalf and bind the firm in agreements.
Decision Making Authority – The default rule allows partners to participate in management decisions. Generally, routine, operational decisions may be made by a majority of partners. Major decisions affecting the business must achieve unanimous support of the partners.
Unlimited Personal Liability – As in any general partnership, partners in an at-will arrangement have unlimited personal liability in tort for the actions of other partners. Likewise, the partners are personally liable for the debts or obligations of the partnership. This may include situations where other partners bind the partnership without the actual authority to do so.
Fiduciary Duty – Partners share a common fiduciary duty to act in the best interest of the partnership. At times, this duty has been construed as a duty to act in the best interest of other partners. The fiduciary duty is generally to avoid self-dealing and not appropriate business opportunity for one’s personal benefit or to the exclusion of other partners.
What is a GP agreement and What Should it Include?
A partnership agreement is the governing document for any type of partnership. Partnership agreements are not mandatory, but it is advisable for any partnership to have an agreement governing the partnership relationship. In the absence of a formal agreement, states have default rules governing the operations of the partnership and the relationship between the partners. While the default rules are comprehensive, they often do not always align with the specific intent of the parties.
- Note: Most states have adopted the Uniform Partnership Act as the rules governing partnerships. Some states, however, have unique common law rules (such as rules affecting the duties between partners) that apply to the partnership relationship.
A partnership agreement, like other business entity governance documents, should be drafted to address the specific concerns of the business and the partners. Below are some of the major considerations to address within any partnership agreement.
- Partnership Name: Make certain that you check the availability of the name with the Secretary of State’s office. Further, if you are going to operate under a name other than that of the partners, you should make a fictitious name filing or “doing-business-as” filing with the Secretary of State or local authorities.
- Ownership Interest: What will the allocation of ownership interest be? What will be each partner’s contribution to the partnership in exchange for her share of partnership interest?
- Entitlements of Partners: The default rule for partnerships is that each partner is entitled to an equal portion of profits and losses of the business. If the parties wish for an alternative allocation of ownership or entitlements, then the partnership agreement should address the allocation. One unique aspect about a partnership is that, with certain exceptions, partnerships can allocate profits and losses in a different percentage than the ownership structure. Further, the agreement should address the timing and amount of any distribution of partnership profits or assets. This is an extremely important provision, as the partners may have varying ideas regarding when and how much they are able to draw from partnership profits.
- Authority of Partners: Who will have decision-making authority within the partnership? Will one party have authority over certain decisions? Will certain decisions require consensus? Which partners have authority to bind the business in contract? Authority is important, as the default rules provide each partner the authority to act on behalf of the business and bind the partnership (and all partners) in contract.
- Management Responsibilities: It may be a good idea to designate primary responsibilities to certain partners. Often partners have conflicting ideas over who should be in charge of which business activities. While these provisions do not have to be concrete, they provide some guidance as to the responsibilities of each partner.
- Addition of New Partners: What is the process of bringing on new partners? What is the required consent from the parties? Does it require unanimous consent or simply a majority? How is the allocation of any new partnership interest determined?
- Continuity of the Partnership: What happens if a partner dissociates or is expelled? What is the procedure for the partner leaving or exiting? How is the partner’s interest handled? Does the partnership continue on or must the business be wound up? Is the result different if the dissociation is not voluntary? What if a partner passes away? Who bears responsibility in any of these situations?
- Partnership Disputes: How will partnership disputes be resolved? Will there be a formal process for mediating disputes? Will the partners use a third-party arbitrator? If so, what are the rules surrounding it?
What is a buy-sell agreement and why is it important?
A buy-sell agreement outlines the procedures for a partner leaving the GP. It can be included within the partnership agreement or it can be separate. Generally, it outlines the procedures for dissolving or continuing the business if a partner dissociates. It can outline procedures for both voluntary and mandatory dissociation. It will address the following issues:
- Can a partner be involuntarily expelled?
- When is the GP required to buy out or liquidate a partner’s interest?
- What is the process of dividing and liquidating each or all of the partner’s interests?
- What method will be used for valuing the business and the dissociating partner’s interest?
- Is a dissociating partner able to transfer her GP interest to third parties or is she required to sell her interest back to the GP?
- Is the result different if a party dies? Loses mental capacity? Retires? Involved in a property dispute (such as a divorce), bankruptcy, etc.?
What other steps should I follow in forming the GP?
Undertaking business activity as a default GP is only part of the process in forming a GP. Other (optional or mandatory) considerations include: reserving and filing a business name with the state or local government (known as a “Doing-Business-As” filing), drafting a partnership agreement, obtaining a business license, registering for a federal EIN and state taxpayer identification number, and obtaining any federal, state or local permits or licenses.
- Note: Each state and locality will have specific requirements for businesses carrying on activity in its jurisdiction. Failing to adhere to these requirements can lead to criminal and civil penalties.
Continuity of the General Partnership
The duration of a partnership is determined by the intent of the parties. An “at-will” partnership has no stated date. The partnership will continue until the partners dissolve the business. The partners can designate a time period for the general partnership, after which the partnership dissolves. This is known as a “term partnership”. This means that the parties may have some duty to the partnership to remain partners for the pendency of the state time period. If the parties do not designate a specific purpose or time for the partnership’s existence, it is considered an at-will partnership. This means that partners can dissociate from the partnership at any time.
- Note: If there is a dispute between parties over assets or income at the time of dissolution, each partner is entitled to an “accounting” of partnership assets. This is an equity action used to determine the partner’s rights to partnership assets. This right is important, as partners are generally not allowed to sue each other in court over dollar damages as a result of dissolution.
- Example: I form a partnership with Maria. We specifically state that the partnership will last until the current work project is complete. We have a term partnership and we have a duty to the partnership to remain partners until the completion of the project. If we do specifically state that the partnership ends at the conclusion of our project, our general partnership is an at-will partnership. We can both leave the partnership at any time without violating any duties to the partnership.
Terminating a Partnership
In the absence of a written agreement, a partnership ends when a partner gives notice of his express will to leave (dissociate). When there’s a written agreement, the partnership ends when an event outlined by the agreement occurs or when a majority of the partners decide to end the partnership after a single partner dissociates. Written agreements can be very useful in the termination of a partnership, because they can outline a process to be followed. For example, the partnership can allow remaining partners to continue the business if they agree to do so.
Whether there is a written agreement or not, it’s fairly easy to leave a partnership, though you’ll still be responsible for obligations that the partnership incurred while you were there. Terminating a partnership is more of a process than a single moment in time because there generally remains business that needs to be wound down (i.e., debts to be paid, obligations to be fulfilled).
Partnerships have the advantage of easily flowing profits into personal income and very easy formation, but also have the disadvantage of personal liability for business obligations. As a business owner, you’ll have to weigh these factors and determine whether forming a partnership is right for you.
Any partner in a partnership may dissociate at any time. This, and certain other actions by partners, may give rise to dissolution. Absent an agreement otherwise, the following activities generally give rise to dissolution of the partnership: change in partners; winding-up process; expulsion of partner that is breach of partnership agreement; it becomes impossible to continue business; or the partnership activity becomes illegal; death or bankruptcy of a partner; or pursuant to a court order for gross misconduct or willful breach of partnership agreement.
- Note: If partnership wrongfully dissolved, the remaining partner may continue. Must settle up with withdrawing partner.
Continuity of the partnership is determined by the partnership agreement. If the partners do not have a partnership agreement stating otherwise, the partnership does not have continuity. That is, the default rule in many states is that a general partnership dissolves when a member dissociates. As such, a partnership interest cannot be transferred or passed along to one’s heirs. Most states, however, allow the remaining partners to take steps to reform the general partnership and continue in business after cashing out the dissociating party’s interest.
- Note: The transfer of a general partner’s interest, death or incapacity, may give rise to a right of dissociation by other partners. An exception to the default dissolution rule is when a partner passes away or dissociates by reason of incapacity. In such a case the general partner does not automatically dissolve.
- Example: I form a partnership with Cliff. We state in the partnership agreement that either party may leave at any time. We include provisions for the continuation of the business and the obligation of the partnership to purchase the leaving partner’s business interest. Without this agreement, the partnership would dissolve upon Cliff or me leaving.
As stated above, partners can change the default rules governing the general partnership by entering into a partnership agreement. The agreement may also designate the procedures for winding down the business or allowing the remaining partners to continue the business. It can further allocate responsibility for debts of the general partnership or allocate the proceeds upon continuation or dissolution. These types of agreements are known as “buy-sell agreements”.
Ownership of a General Partnership
General partners are the sole owners of the general partnership. The parties may agree on each partner’s percentage of ownership. In the absence of a partnership agreement, default partnership rules govern the relationship. By default, partners are entitled to equal ownership rights. This means that the partners share equally in profits or losses, unless the parties specifically agree to some other allocation of profits and losses. Further, the default rule is that ownership interests cannot be transferred to third parties without the consent of the existing partners. Attempting an unapproved transfer of an ownership interest is grounds for dissolution of the partnership.
- Example: Katie and I form a partnership. We do not have a partnership agreement. As such, by default, Katie and I are equal owners of the partnership. We later enter into a partnership agreement that establishes me as 70% owner and Katie as 30% owner. This will replace the default rule that we are equal owners.
- Example: Wayne and Mariah are partners in a dog walking business. Mariah does all of the paperwork and Wayne walks the dogs. Mariah’s responsibilities are limited and she only spends about 5 hours per week on the paperwork. Wayne, on the other hand, spends nearly 50 hours per week walking the dogs. The parties have not created a partnership agreement. Under this situation Wayne and Mariah would be default 50/50 owners of the GP. Further, each would be entitled to a 50% interests in all business profits. To change this scenario the parties will need to enter into a partnership agreement either changing the ownership percentage or establishing some special allocation of profits to Wayne.
Control of a General Partnership
The general partners have complete control over the partnership. This means that partners have decision-making authority with regard to the governance and strategy of the partnership, as well as authority to act on behalf of the partnership as a general agent. The partners may establish a partnership agreement that changes or limits any partner’s right of control or voice in the management of the partnership. This does not, however, limit the authority of a partner to obligate the partnership by entering into transactions or relationships with third parties, such as loan or sales agreements. The partnership can limit the authority of a partner to act on behalf of the partnership by specifically giving any third party notice that the partner’s authority is limited.
- Note: Some partnership decisions require the consent of both partners.
- Example: Terry and I form a partnership. Terry and I have equal ability to make a decision for the partnership. If Terry wants to enter into a purchase contract, she has the authority to do so. If we decide to limit Terry’s authority in a partnership agreement, this does not limit her authority with respect to third parties. I will need to provide notice of that agreement to any third parties who may interact with the partnership through Terry.
What are the partners’ duties to the GP?
Partners have default obligations to the GP. As an agent of the GP, these duties are fiduciary in nature. Specifically, a partner has duties of care and loyalty to the GP. The duty of care requires that the partner use reasonable care in carrying out GP business. The duty of loyalty requires that the partner act in the best interest of the GP. This means that the partner cannot usurp any personal benefit that is intended for the GP.
- Example: Sally and John are both financial advisors and open a firm together. An investor, Bill, comes in one day and talks to John about serving as his financial advisor and broker. Bill explains that he wants higher returns than the market generally delivers and he wants to know if John is up to the challenge. Further, Bill does not like Sally and does not want any of his funds to be invested by Sally or any percentage of the profits to go to benefit Sally. Bill asks if John can handle his account on the side and not as part of the GP. John, fully aware of his fiduciary duties to the GP, explains to Bill that he cannot usurp a GP business opportunity for his personal gain. Further, he explains that, as partner, he owes a fiduciary duty of care to the GP in carrying out his duties. He cannot make reckless investments in hopes of gaining a higher return, which could subject the GP to disrepute or tort liability.
- Note: Partners owe fiduciary duties to the GP. There is generally no duty between partners; however, many courts hold that self-serving conduct at the expense of other parties could violate a partner’s duties to the GP.
Of course, partners can change the default rules governing the GP by entering into a partnership agreement. For example, the partners can designate a time period for the GP, after which, the GP dissolves. The agreement may also designate the procedures for winding down the business or allowing the remaining partners to continue the business. It can further allocate responsibility for debts of the GP or allocate the proceeds upon dissolution.
- Note: Carrying on business as a GP allows for ease of operations, but it is always advisable to have a partnership agreement. One important provision of the agreement is the right of dissolution and the continuity of the venture. As with every business entity, it is important to have a buy-sell agreement in place.
Personal Liability of Partners in the Partnership
A general partnership is similar to a sole proprietorship in that it does not offer the business owners any form of personal liability protection. Each partner is personally liable for any debts, obligations, or tortious conduct of the business. This means that, if the business stops operating or goes bankrupt, the owners are liable for the debts and obligations of the business. In fact, each partner can be held totally liable for the entire debt of the business. This is known as “joint and several liability”. Per the law of agency, the partnership is liable for the obligations established by its agents or their tortious conduct committed within the scope of employment. As such, each partner is potentially personally liable for the actions of partners and employees of the partnership. This may be true even if a partner or employee exceeds her authority under a partnership agreement or employment agreement. These facts alone make a general partnership a potentially risky entity form under which to carry on business.
- Example: Eric and I from a partnership. We hire an employee, Jane. Jane is careless and injures a third party when driving the company truck. The injured party sues Jane and the business. If Jan receives a judgment against the business, Eric and I will be personally liable for the business debt. If the business does not have funds or assets to satisfy the debt, our personal assets will be at risk.
Compensation of Partners
General partners are compensated by receiving a draw of partnership funds (generally profits). This is known as the partner’s distributive share. By default, this draw is often representative of the percentage of ownership of each partner. The partners may, however, enter into an agreement allocating the distribution of profits or losses differently from the ownership structure. That is, a partner may receive a percentage of partnership profits or losses that is greater than or less than her ownership percentage. This must be justified based upon an economic reality of the partnership, such as one partner spending more time working for the partnership.
- Note: Partners are not entitled to receive a salary based upon their ownership percentage or for services rendered to the general partnership. Only employees of the partnership who are not also partners may receive a salary as compensation. GP arrangements are a favorable tax entity for some relationships as profits and losses can usually be allocated in any manner desired. A partner’s entitlement to profits or losses does not have to match or be related to the partner’s ownership interest in the GP. This is known as a “special allocation” of profits or losses.
- Example: Tanya and I form a partnership with equal ownership. We have one employee, Josh. At the end of the year, the partnership has $10,000 in earnings. The only expense is Josh’s salary of $2,000. Tanya and I will receive a distribution of $4,000 each. Josh, who is not an owner, received a salary. It does not matter whether Tanya and I work in the partnership. As owners we do not receive a salary.
- Example: In the scenario above, Mike and Mike work equally in the business. As partners they are not entitled to a salary for their work in the GP. Rather, they receive a portion of the profits at the end of the year based upon either their percentage of ownership or some special allocation of profits to either partner. If the GP hires employees who are not owners of the business, these employees will receive a salary from the business. The GP will withhold estimated income taxes as well as payroll taxes from the employees’ wages.
What is a special allocation and how does it work?
General partners are not entitled to a salary for services performed for the GP; rather, they receive a distribution or draw of GP proceeds. The default rule is that each partner has equal ownership in the GP and, therefore, shares equally in profits and losses. The parties may, however, allocate the distribution of profits or losses differently from the ownership structure. This must be done through specific provisions in the partnership agreement.
- Example: Tom and Erin made equal contributions to the business and share equally in the ownership interest. The business earns money by providing services to clients. While Tom and Erin both provide services to clients, Tom provides additional services to the business that exceed those provided by Erin. As such, Tom and Erin may wish to allocate an additional percentage of the GP profits to Tom to compensate him for the extra effort. In this case, the special allocation of profits to Tom may be justified.
- Note: Special allocations are subject to review for validity by the IRS. The business must have a valid justification for a special allocation, other than simply lowering the tax liability of a single party. The IRS employs a “substantial economic effect” test to determine if there is a valid economic reason for the business or the individuals to make special profit or loss allocation.
General partnerships are not taxable entities; rather, they are pass-through tax entities. The partnership will subtract expenses and other deductions from revenue to determine the annual profits or losses. Like a sole proprietorship, partners report their share of general partnership profits or losses on their personal income tax returns. The general partnership does, however, have to prepare a tax return. This return is known as an “informational return” and is filed on IRS Form 1065. The return outlines the revenues and expenses attributable to operations. It will also outline the percentage or amount of the profit or losses to which each party is entitled. The partnership is obligated to provide individual partners with a Form K-1 outlining that partner’s share of profits or losses. These amounts are then recorded on the owner’s individual tax return.
- Note: A partner is required to pay taxes on her allocated percentage of partnership profits, whether she withdraws the profits from the partnership or leaves those profits in the business entity.
- Example: Barry and I form a partnership. At the end of the year, the partnership has profits of $10,000. Barry and I are equal partners, so we are each entitled to 50% of the profits. The partnership will prepare and information return and provide K-1s to Barry and me. The K-1 will indicate that we received $5,000 in profits, which we must report when filing our individual income tax returns.
- Example: Mike and Mike own a candy store as partners. They share equal control and ownership of the store and there is no special allocation of business profits to either partner. The store brings in $100,000 in revenue with just $80,000 in expenses, producing a $20,000 profit for the year. The GP will have to file an informational return reporting all revenue and expenses. It will also indicate the total profits derived from the business activity. The GP will then produce a Form K-1 that it sends to the IRS, state Department of Revenue, and to the partners. Mike and Mike will each receive a Form K-1 indicating that they received $10,000 in income from the GP. Mike and Mike will then report $10,000 of income on their personal income tax returns. Because it is a pass-through tax entity under Subsection K of the IRC, the GP does not withhold estimated income tax or self-employment taxes from the partners’ interests. As such, Mike and Mike will have to pay both income taxes and self-employment taxes on their respective share of the $10,000.
Discussion: Is there ever a situation when carrying on business as a general partnership is a good idea? Hint: Think about situations where other business entities are the general partners.
Practice Question: In a short paragraph, can you describe the primary attributes of a general partnership?
What is each partner’s tax basis?
This is a complicated subject. Entities taxed as GPs have unique basis rules that differ from other entities. Individual partners must track their basis in individual assets within the business. If the assets are later sold by the GP for a gain or loss, then the partner contributing the assets to the business may be attributed income based upon his or her basis in the assets.
In general, tax basis is the value of assets that a partner contributes to the GP; however, this too is an oversimplification. A partner’s basis also includes other factors, such as any relief of liability on debt that is assumed by the GP or the amount of business debt for which the partner is personally liable. Remember, it is not necessary that the partner personally guarantee GP debt, as partners are personally liable for any debts of the business. Each partner’s basis increases by the product of her percentage ownership in the business multiplied by the amount of debt assumed by the GP. A full discussion of basis calculation for partners is beyond the scope of this text. We strongly advise that you consult a tax professional when making basis calculations for property contributed to a GP.
- Example: Tonya invests $1,000 in the GP, so $1,000 is her GP basis. The calculation becomes more complicated if Tonya contributes property to the GP. Suppose instead of cash, Tonya contributes property worth $1,000 to the GP. In that case, she would have the same basis in the stock as she had in the property transferred (adjusted for any debt relief and/or boot). This is known as a “substitute basis”. If, however, her basis in the property at the time of contribution was $800, then the property has a built-in gain of $200. IRC Section 721 of the IRC allows for the deferral of any recognition of gain on the property. If, however, the property is later sold by the business for $1,000. The built-in gain will be first taxed to Tonya. If the equipment is later sold for $1,200, the $200 gain is taxed to Tonya and the additional $200 of gain is split between all partners. This simple example is not meant to explain all of the basis rules involved in a GP; rather, it is made to demonstrate the complexity of the topic.
- Note: Basis matters for calculation of gains upon sale of the business and for purposes of taxing partnership distributions. When choosing a business entity, it is important to understand the concept of basis and the requirement to track one’s basis in assets contributed to a partnership-taxed entity.
What happens if the GP wishes to make a distribution when it is not profitable?
If the GP is not profitable, it may still make a distribution of funds to partners. If the GP distributes an amount of funds to a partner that exceeds the annual profits of the business, then the partner’s basis is lowered by that amount. Remember, profits of a GP are counted as personal income to the partners. If the business does not have profits, the partner’s distribution is treated as a return of invested capital. Any distribution that reduces a partner’s basis below $0, results in taxable income to the partner.
- Example: Alex and Virginia own a shoe store as partners. They each have a basis of $10,000 and have not withdrawn any funds other than profits. At the end of the year, the store breaks even and produces no profits. Alex needs money to renovate his home, so he takes a distribution of $5,000 from the GP. Since the business produced no profits, the $5,000 distribution is treated as a return of his capital invested. As such, the distribution is not taxed, but Alex’s basis is reduced to $5,000 in the business.
- Note: A GP cannot count distributions to partners as business expenses for calculating profits and losses. On the other hand, corporations that pay salaries to shareholder-employees may deduct the salary to these employees as expenses.
What if the partners leave any of the profits in the business, rather than take them out as a distribution?
If the partners decide not to distribute any portion of the GP profits, the percentage of business profits attributable to each partner is still taxable to her. As previously discussed, this is known as “phantom income”. The partners report their share of profits on their personal income tax returns, even if it is not actually distributed. The GP now has additional operating funds and the amount of retained funds allocable to a partner raises that partner’s basis in the GP.
- Example: In the situation above, the following year Alex and Virginia’s shoe store makes a profit of $20,000. Neither of the partners is in need of money, so they decide to leave all of the profits in the business with the intent of growing operations. Even though they leave the money in the business, Alex and Virginia will still have to report taxes on $10,000 of the profits on each of their personal income tax returns. Each partner’s basis in the business will increase by $10,000.
- Note: Phantom income can be a large burden on partners. Because the GP retains the profits, they may not have the personal resources to pay the taxes on their income from the GP activity. For this reason, it is important to address within the partnership agreement the allocation of funds sufficient to cover the partners’ tax liability for phantom income.
What happens if the GP suffers losses?
Just like profits, losses pass through to partners and are reported on their personal income tax returns. Since each partner is considered to be actively involved in the GP, the owners can use the losses to offset “active” income earned from other sources. The losses cannot be used to offset passive income.
- Example: Winston earns a salary from his day job. He also formed a GP to carry on business with Louise. The GP has lots of expenses and suffers a loss for the tax year. Since this is a GP, Winston can offset these losses against his active income from his day job.
- Note: Losses are calculated as income minus expenses. You should familiarize yourself with general accounting principals to determine what is an expense and what is a capital investment.
How is a Partnership Funded?
This is a very complicated topic that draws upon one’s knowledge of tax law. The partners fund the partnership by contributing assets to the partnership. The value of the assets contributed to the partnership is in exchange for an ownership interest in the partnership.
If partners contribute assets of equal value and ownership of the partnership is divided equally, then there is no tax issue. If, however, one partner contributes assets of greater value and the ownership interests are equal, then the partner contributing property of a lower value is treated as having received income from the partnership. The income attributed to this partner equals 1/2 of the difference between the value of the property contributed. This is as a form of “phantom income”.
A partner may have a basis (amount of money invested) in the property that is higher or lower than the actual value of the property contributed to the partnership. The partner does not generally recognize any income or losses when contributing this property to the partnership. The partnership, however, takes a basis in the property equal to that of the contributing partner. The situation gets very tricky when the partner receives some kind of value other than an ownership interest back from the partnership. This other value is known as boot. The situation is further complicated if the partnership later disposes of the property. There is a significant issue as to how the profits or losses are allocated for tax purposes.