The minimum you need to know about running a business as a partnership
In our previous post on business structures we discussed the pros and cons of running a business as a sole trader. In this post we offer some basic considerations for doing business in partnership with someone else.
Remember that this article is not legal advice and it's always a good idea to consult a lawyer before making decisions that are this fundamental to your business.
All states and territories have legislation which governs business partnerships. While there are differences in the legislation, the definition of the partnership is generally a relation or an association which exists between persons carrying on a business in common pursuit of profit.
A partnership is not the only business structure used to conduct business for the profit of the participants. There are also syndicates, joint ventures and profit sharing arrangements which overlap with the technical aspects of a partnership. To avoid confusion and keep this article relevant to our readers, we have limited our discussion to partnerships between people who run a small to medium sized business.
Creating a partnership
A partnership can be formed orally or in writing. As with contracts, it is a common and preferred practice to form the partnership by signing a partnership agreement. The partnership agreement is governed by the relevant Partnership Act of your state or territory.
If two persons enter into some other arrangement but it has all the legal characteristics of a partnership, then the law will treat that arrangement as a partnership. That could occur if the parties conduct the business with a mutual interest and share all of the profits from the arrangement or venture.
The Corporations Act (Cth) stipulates that a partnership can comprise a maximum of 20 individuals. Professional partnerships of lawyers, accountants, medical practitioners, actuaries, stockbrokers, vets, architects and chemists are exempt from this limitation.
A partnership can trade under the names of the partners or under a registered business name.
Once the partnership is formed, then by law each partner becomes an agent of the other. This means that each partner can enter into a binding agreement on behalf of other partners and has a duty to act in the interest of other partners. For example, a partner can incur debts or sign a contract on behalf of the other partner(s). This is a very important consequence of being in a partnership so take care who you enter into a partnership with.
When creating a partnership the partners can agree on how much capital and property they contribute and in what proportions they will share profits and losses. However, all partners are jointly liable for losses or damage to persons outside of the partnership. For example, if the partnership delivers a faulty industrial product which causes a client to suffer a financial loss, the client can seek to recover that loss from all partners regardless of how much each partner contributed to the partnership.
A partner directly owns and has rights in the partnership property whereas a shareholder of a company does not own the company property. The shareholder owns a share of the company and his/her interest in the company is distinct from their interest in the property held by the company. In contrast, a partner has a direct claim to the property.
Thus, issues can arise when a partner leaves the partnership or decides to cash in their share of the partnership property. The partnership might have to sell the property to compensate the leaving partner and as a result the business can lose goodwill.
A partnership must file an annual partnership return with the Australian Tax Office (ATO) but it does not pay tax. The ATO uses the return to assess the total income or loss and from the business and how it was allocated between partners. Individual partners file their own tax returns which includes income or loss as allocated in the partnership tax return.
Since partners pay tax as individuals they are able to take advantage of:
a) offset revenue and capital losses from the partnership against the income and losses from other venture or employment,
b) offset the depreciation from the partnership against any income, and
c) the 50% capital gains discount when disposing of assets (see ATO website for more information).
However, when partners sell a share in the partnership to raise capital, every partner can be affected by a punitive CGT tax. Thus, the partnership agreement should stipulate how capital is raised to minimise potential CGT events.
The partnership agreement
The written partnership agreement will generally set out the following:
- the rights and duties of partners
- which provisions of the Partnership Act are excluded or varied (where applicable)
- under which circumstances the partnership can be dissolved (where applicable)
- an agreed partnership restructure mechanism if one of the partners dies or becomes a bankrupt
- an agreed procedure to account for the deceased partner's share of assets and benefits
- a restraint of trade clause which precludes the outgoing partners from competing with the partnership or taking business from the partnership.
- an agreed method of calculating the goodwill component of the partnership business when a new partners buy or sell their share in the business.
Each jurisdiction has specific rules which determine whether the partnership exists. While we are not going to delve into the detailed requirements of each state and territory, below we list the common features of a well-formed partnership:
- a written partnership agreement (of course)
- a registered business name for the partnership
- evidence in any written agreement which shows that partners have the authority to bind the partnership (e.g. enter into a contract)
- registered business name if partners don't trade under their names
- a partnership bank account
- proper financial records (e.g. a book of accounts)
- office stationary in the name of the partnership and contact details
- documents which prove ownership or leasing of assets by the partnership
- proof of partners sharing profits
- evidence of each partner having real and effective control over that partner's share of the profits
- evidence of a partnership by conduct (i.e. partners contributing capital, effort, resources and sharing of the losses and profits).
Pros and cons of operating a business as a partnership
- cheaper compliance cost (vs a company) because a partnership does not submit ASIC returns and is not required to keep a register
- ability to offset losses from the partnership against other income derived by the partner outside of the partnership
- it's easy to dissolve
- partners can vary profits and losses between each other every year
- income can also be split so as to take advantage of lower marginal tax rates.
- difficult to manage as all partners are entitled to enter into contracts and to manage the business
- partners are jointly and severally liable for all claims against the partnership
- capital gains tax event occurs when a new partner contributes capital
- partnership property may be subject to a court order due to personal matters of a partner (e.g. divorce)
- a partnership is dissolved if a partner dies or leaves the partnership. These circumstances need to be addresses in a partnership agreement to ensure business continuity.
Running a partnership is relatively cheap and straightforward from the compliance point of view. Partners can use income or losses to optimise the amount of tax they pay on other income.
However, a key disadvantage of a partnership is that unlike a proprietary company, a partnership does not limit your potential liability to the amount you invest into the partnership. Furthermore, each partner is potentially liable for acts or omissions of every other partner is the partnership.
You should enter into a partnership with people who you can trust, who have good financial standing and who will not mind the obligations which will flow from the partnership.
Seek legal advice
We recommend that you seek legal, tax and accounting advice before creating a partnership.
To ask us about this article or begin to discuss the most suitable business structure for you, simply contact Source Legal Online at email@example.com or 1300 609 450.