How are general partnerships taxed
A general partnership (or simply partnership ) is an association of two or more people carrying on a business with the goal of earning a profit. A partnership is viewed as being one and the same as its owners. There is little formality involved in creating a partnership. In fact, if someone can establish that you are in business with somebody else, then there is a general partnership. The intention or lack thereof of having a formal partnership is not important.
Existence of a Partnership
Rules for determining the existence of a partnership are outlined in Part II of the Uniform Partnership Act (UPA). Some of these rules are summarized as follows:1. Joint tenancy, common property, part ownership, etc. does not by itself establish a partnership, regardless of whether the owners of the property share any profits from it. Three ways to jointly own property are:
Tenants in common - when one dies, one's portion of the partnership is transferred to one's heirs.
Joint tenancy - right of survivorship - when one dies, the entire interest goes to the other person.
Tenancy by entirety - for example, a husband and wife. Each tenant owns by whole and by part. If a third party has a claim against the husband, the claimant cannot go after the property since it belongs wholly to the wife as well. For this reason, banks often require both the husband and the wife to sign a loan.
2. Sharing of gross returns from jointly held property also does not by itself establish a partnership.
3. The receipt of a share of profits from a business is evidence of being a partner of that business, unless the profits were received as payment on a debt, interest, wages, rent, etc.
A person may be considered a partner even if not formally included in the partnership. This is known as partnership by estoppel. "Estoppel" means that one is not permitted to deny. In the context of partnerships, it means that a person cannot deny being a partner if he permits the partnership use his name. Take for example, a situation in which partner A and partner B start a business and offer non-partner C a profit interest in the company if they can use C's name in the business. If a bank lends money to the partnership and the partnership becomes insolvent, C would be considered a partner and could be held liable.
Like a sole proprietorship, a partnership has only one level of taxation. A partnership is a tax-reporting entity, not a tax-paying entity. Profits pass through to the owners and are divided in accordance with what is specified in the partnership agreement. There are no restrictions on how profits are allocated among partners as long as there is economic reason, so there is latitude in allocating income according to which partners have the best tax rates.
While pass-through taxation is an advantage, owners of a partnership have unlimited personal liability. In general, each partner in a partnership is jointly liable for the partnership's obligations. Joint liability means that the partners can be sued as a group. Several liability means that the partners are individually liable. In some states, each partner is both jointly and severally liable for the damages resulting from the wrongdoing of other partners, and for the debts and obligations of the partnership.
Three rules for liability in a partnership are:
- Every partner is liable for his or her own actions.
- Every partner is liable for the actions of the other partners.
- Every partner is liable for the actions of the employees of the business.
As an example to illustrate liability in a partnership, suppose there is a partnership formed by partners A, B, and C. If partner A accidentally runs over somebody while driving on a personal trip to the grocery store one weekend, then A alone has unlimited personal liability. If partner A accidentally runs over somebody while making a delivery for the partnership, then A still has unlimited personal liability, but all three partners would be jointly and severally liable. If the victim wins a judgement of $1 million against the partnership, and only partner B has the money, then B would have to pay the judgement. Partner B could assert a right of contribution against partner A, but if A has no money it would not be worth the effort. If an employee of the partnership, employee E, accidentally runs over somebody during the course of work, then the
partnership is liable since the employer is responsible for the actions of an employee within the scope of business. If the accident happened while the employee stopped for something personal, then the employer would not be responsible (frolic and detour).
Risk and Control
Absent an agreement to the contrary, UPA gives partners equal voting rights, even if they contributed different amounts of capital. Squeeze-outs are a common issue in partnerships.
Expense and formality
As in the case of a sole proprietorship, if the partnership chooses a ficticious name (different from the names of the partners), it is required to file that name with the state.
Fiduciary Duty in a Partnership
Partners owe both a contractual duty and a fiduciary duty to one another. According to Black's Law Dictionary, a fiduciary duty is the duty to act for someone else's benefit while subordinating one's personal interests to those of the other person. These days however, many operating agreements waive the fiduciary duty so that one can pursue other opportunities that may come along.
Case: Meinhard v. Salmon
Salmon wanted to lease some property in New York. The lease was to run from 1902 to 1922. He formed a partnership with Meinhard who put up 50% of the money. Salmon would be the active manager and would pay Meinhard 40% of the profits for the first five years, and 50% thereafter. In 1922 the lease was up for renewal and the owner of the property, speaking only with Salmon, offered to make some adjacent property available. Salmon signed a lease for the property on behalf of his own firm, Midpoint Realty Company, of which Meinhard was not an owner. Salmon had not told Meinhard anything about the new lease or even the possibility of a new project.
Meinhard claimed that Salmon had a fiduciary duty to provide him the opportunity to participate in the deal.
The court ruled in favor of Meinhard.
The new deal was an extension of the old one. While Salmon did not act in bad faith, he had a fiduciary duty to Meinhard.
As one person put it, "a partnership is just like a marriage."
Issues to Address when Forming a Partnership
To reduce the chances of disputes among the partners, a written partnership agreement always should be drawn up before going into business as a partnership.
The Revised Uniform Partnership Act (RUPA) was issued in 1994. It is a revision of the original Uniform Partnership Act that dates back to 1914. UPA is interstitial; it fills in the gaps in the specific partnership agreement.
Issues to address in forming a general partnership:
Amount of capital contributed by each person, and if more is needed at a later date, who contributes it, and any limitations to someone's maximum contribution.
Rights and responsibilities of each partner.
Division of profits among the partners.
Distribution of assets upon dissolution of the company. If one partner wakes up one day and wants out, the partnership dissolves. But liquidation would destroy the value of the business, so the partnership agreement should provide rules for a partner's exit. One partner can transfer a profit interest to an external party, but not control. Some options for distribution of assets include:
Right of first refusal - a provision that requires the departing partner to allow the remaining partners to buy his or her share of the business at the same price of a bona fide external offer.
Right of first offer - since the time delay associated with giving existing partners the right of first refusal may discourage external parties' interest in bidding, the right of first offer may be used instead. The right of first offer is a provision that requires the departing partner to offer to sell his or her share of the business to the other partners before offering it externally.
Dutch auction - a provision in which one partner offers to sell to the other partner at a particular price. If the other partner refuses, the first partner must buy the other partners share at that price. This arrangement provides strong incentive for a fair asking price. Note that the term "Dutch auction" has other meanings as well - it also refers to both a descending price auction and to an auction in which several identical items are auctioned and all successful bidders pay the either the price of the lowest successful bidder or their bid prices, depending on the specific auction rules.
Third party arbitrator - an outside party sets the price.Source: www.quickmba.com