Helen Keller once said, “Alone we can do so little; together we can do so much.”
That’s essentially the idea behind companies that decide to form as a partnership. Earlier in this series on the different types of businesses, we talked about “Sole Proprietor Pros and Cons (6 Important Things to Know).” In this post, we’ll take a look at the pros and cons of partnership.
How Do Partnerships Work
As CPAs who have been in the business of helping small businesses for over 40 years, we have seen many times where contractors have decided to get together with family or friends to form a business. Often, it is because the different members of the group complement each other’s skills or licensing needs. By working together, they are able to create a company that can do more than any one of them can do alone.
When this happens, a decision has to be made: Do they form a partnership or a corporation?
(At this point in our series, we will treat LLCs as partnerships for the sake of simplicity in our discussion. Later on, we’ll dive deeper into the differences between an LLC and a General Partnership.)
Investopedia defines partnerships as: “a formal arrangement by two or more parties to manage and operate a business and share its profits.”
Partnerships can be created by any type of group (governments, private sector companies, non-profits, or individuals), and they come in many forms:
- General Partnerships
- Limited Partnership
- Limited Liability Partnerships
General Partnerships are the most common type of partnership. This is usually created when two or more individuals join together to form a single company in which they share ownership and profits.
Limited Partnerships occur when one of the members is an active partner and one (or more) is a silent partner, simply providing funding and accountability without actually being involved in the day-to-day operations of the business.
Limited Liability Partnerships are usually formed by professionals (doctors, lawyers, accountants, etc.) who want to create a larger practice together without being liable for things the other members may do.
For our clients, choosing how to set up their business can have significant ramifications down the road. Failing to get started well can lead to a rocky ride and a disastrous end if they aren’t careful. So let’s take a look at the things to consider when starting a partnership business as well as the pros and cons of partnerships.
Advantages of Forming a Partnership
There are 4 main advantages to forming a partnership with other professionals in your industry:
When there is more than one general partner, it suddenly becomes possible for your business to benefit from multiple people with diverse skill sets running the business. Having more expertise within the business generally leads to an enhancement in the company’s overall performance.
For example, we often see home builders partner with real estate agents in order to gain access to exclusive marketing. Or the family of developers that runs XYZ Homebuilders may partner with their son who does XYZ Landscaping to take care of the HOA needs of the communities they build.
By partnering with someone who is strong where you are weak, or who has a unique ability that you don’t, you can have access to a wider range of expertise for the different parts of your business. A good partner will bring knowledge and experience that you may be lacking, and they’ll have complementary skills which can help grow the business.
It has often been said of relationships that if two people are exactly the same, one of them is unnecessary. So having a variety of experts within one company who each bring something different to the table makes everyone valuable and can help everyone be better!
As we mentioned earlier in defining Limited Partnerships, the right partner can infuse significant cash into your contracting business. It’s no secret that if you’re developing real estate, building homes (or doing anything related to things like that), there are a lot of up-front costs associated with every project. You must be able to absorb those before you get paid. Having a partner with access to money can make all the difference in your company’s success or failure!
3. Minimal Tax Filings
Partnerships file their taxes using IRS Form 1065. It’s not a complicated process at all, and you are not double taxed the way you could be if your business is set up as a corporation. With a partnership, the profits flow directly to the owners instead of having to be routed through the corporation.
4. Family Balance
Many times, we see a parent hire a child to be a part of their contracting business. This is often because the child is “learning the ropes” in order to one day take ownership, or they may already be significantly skilled in a trade that is beneficial to the family company.
Forming a partnership with the child makes it easier to pass the business from one generation to the next when the time comes. Sadly, we’ve seen too many instances where the child worked as an employee of the parents for many years only to have to fight the courts and other potential heirs over the right to access the assets of the construction business…simply because they were an employee and not a partner.
Disadvantages of Forming a Partnership
Two disadvantages associated with partnerships are identical to what you find with sole proprietorships, and there is a third that happens when any kind of partnership is formed:
1. Unlimited Liability
In a General Partnership, the partners have unlimited personal liability for the obligations of the partnership. This liability is considered “joint and several”, meaning that creditors can pursue a single general partner for the obligations of the entire business.
2. Self-employment Taxes
Each partner’s share of the ordinary income (which is reported on a Schedule K-1) is subject to self-employment tax. This tax is 15.3% (covering social security and Medicare) of all profits generated by the business that are not exempt.
3. Loss of Autonomy
When you form a partnership and begin working alongside other owners, it is important to remember that you will be giving up some autonomy. This can often be hard for contractors who are used to working alone and being in complete control of every aspect of their business. Some of that independence gets sacrificed in order to create a bigger and better company with someone else.
Partner With a Good CPA to Keep Your Partnership from Sinking!
With the right partnership agreement in place, you can successfully navigate working in tandem with other owners to grow a great business that benefits everyone involved.
CRS CPA understands the tensions and complexities involved with forming partnerships. We’ve been guiding contractors and other small business owners through the process for 40+ years now!
When you’re ready to explore the pros and cons of setting your business up as a partnership, schedule a call with one of our experts! We’ll be the partner you’ll definitely be glad to have on your side.