US Partnerships Basics

Understanding US partnership basics can save you a bunch of time, stress, and money in the long run.

Generally, a partnership is a business entered into for profit which is owned by more than one person.

Partnerships are so easy to create that many are formed unwittingly. A hand-shake deal could be enough to form a partnership.

Formal documents like a partnership agreement are not necessary. Partnerships are not separate legal entities.

Types Of Partnerships

There are two types of partnerships – general partnership and limited partnership.

In a general partnership, all partners are considered general partners and may or may not be invested in the partnership. However, general partners participate in running the partnership and are liable for all acts and debts of the partnership and any of the other partners. Each partner shares in the profits, losses, and liabilities of the general partnership.

Because general partnerships are not separate legal entities, we disfavor them because they offer no asset protection.

Limited partnerships have two classes of partners – general and limited partners.

Limited partnerships are controlled by the general partners who run the day-to-day operations and conduct the partnership’s business. Limited partners are simply investors and are not involved in the management.

General partners have unlimited liability while limited partners have limited liability. However, limited partners that begin to control and/or become involved in the management of the limited partnership compromises their limited liability status.

But if limited partners only serve as silent partners, they are afforded some personal protection for the actions of the partnership and general partners.

Advantages

A general partner can control the partnership without being the majority owner – a benefit sought by many investors.
Income can be shifted between the partners through the use of disproportionate contributions, special allocations, and distribution rights.
Property may generally be contributed or distributed without triggering a taxable event. This is especially important when assets have appreciated in value or that were acquired through debt.
Partners may deduct losses in accordance with their respective share of capital and partnership indebtedness – particularly relevant for real estate investments.

Disadvantages

There are highly complex rules for tracking contributions and distributions of property to the partnership. These “basis adjustments” alter the calculations of gains and loses – often to the disadvantage of the taxpayer.
Partnership income is subject to self-employment taxes if the partner materially participates in the operation of the partnership.
Passive activity rules apply for people that do not materially participate in the operations meaning losses may not be deductible in the same year they are incurred.
Partnerships are notoriously difficult to sell or exchange. Partnership agreements must be modified to admit for new partners.

Taxes

Partnerships are not subject to tax as separate entities.

Partners are taxed on their respective share of partnership income or loss.

Partnerships must file a Partnership Tax Return (Form 1065) and must prepare a Form K-1 for each partner showing each partners’ allocation of income and deductions.

Administration

Administering a partnership can be relatively easy or very difficult – everything depends on the nature of the business, the number of partners, their responsibilities, and the complexities of the partnership agreement.

Converting To LLC

For better asset protection, many people involved in partnerships desire to operate the business through an LLC. With an LLC, everyone has limited liability.

Sometimes, converting to an LLC can provide tax benefits.

Converting to an LLC can be done in two ways.

The traditional way to convert a partnership to an LLC requires you:

Step 1: Form a new LLC
Step 2: Dissolve the partnership
Step 3: Transferring assets to the LLC

The second method is known as a “statutory conversion.”

Some states in the US have a specific form that converts a partnership to an LLC. A statutory conversion simultaneously dissolves the partnership while forming an LLC and placing the assets inside it.

Tax Consequences Of Converting To LLC

Generally, converting a general or limited partnership to an LLC is a nontaxable event.

But there are still many complications and considerations that must be made.

In changing to an LLC, debt that shifts from being a personal liability of a partner to that of the LLC can result in a large tax bill as the IRS essentially treats it as a cash payment.

Changing ownership interests in this process can also result in undesirable tax consequences.