The problem with partnerships

Partnerships are one of the most popular business ventures; they are relatively easy to establish and allow pass-through taxation, which means the partnership itself isn't taxed, but all of the benefits of income, deductions, credits, etc., pass through to the individual partners. In addition, businesses usually benefit from partners with complementary skills.

With all partnerships come potential problems. We all remember when Enron acknowledged that the partnerships they formed were misused, inflating the company's financial reports, which investors and thousands of Enron employees relied on when deciding to buy or sell its stock. These partnerships, coupled with other major accounting errors, destroyed the public's confidence in the company, and Enron sank into bankruptcy.

Although Enron is an extreme case of partnership problems, there are some risks to consider when forming a partnership:

Liability for your partner

General partners are 100% liable for the actions of other partners. If one general partner makes a mistake, all general partners are liable for that mistake and any accompanying debt or other obligations that go along with that mistake.

If liability is an issue, you may want to look into forming a limited partnership (LP), which has one or more general partners and one or more limited partners, allowing the limited partners limited liability.

LPs still have at least one general partner with unlimited liability. This type of partnership is usually best suited for companies investing in real estate.

Another option is a limited liability partnership (LLP), limiting liability for all partners. This partnership is only available for certain occupations, such as attorneys or physicians, and is not available in all states.

Raising capital

It is difficult to raise capital in general partnerships since all general partners have unlimited liability. Choosing an LP or LLP may be more attractive to investors, as it allows a limited partner to invest without taking on any liability. As stated above, however, there are restrictions to LPs and LLPs that must be considered. Additionally, LPs and LLPs are more expensive to form than a general partnership.

Sharing responsibility

Being a partner means sharing profits and sharing decisions with other partners. Disagreements may occur in both cases. Additionally, all partners must devote a significant amount of time to the company, adding more responsibility to each partner.

Minimum tax deductions

Unlike certain types of corporations, which can deduct the full cost of fringe benefits such as health insurance premiums, some employee benefits are not deductible from business income on a partner's tax returns.

Protecting your stake in a partnership

There are many advantages to forming a partnership, but also many things to watch out for when taking on a partner. In all cases, partners should have a legal agreement that places restrictions on each partner's decision-making abilities.

The agreement should state, among other things, how decisions will be made, profits will be shared, and disputes will be resolved. Just in case the partnership does not work out, the legal agreement should also describe how partners can be bought out, how new partners will be admitted to the partnership, or what steps should be taken if the partnership needs to be dissolved.