If you’re considering going into business as a partnership, then you’ll need to be prepared to split the profits. But what’s the best basis for doing so — especially if one partner contributes more work hours, invests more money into the business, or even sets up your business line of credit? Here’s what you need to know to plan your profit-sharing strategy in a small business partnership, plus some other steps you can take to make that partnership airtight.
Formally Structure Your Small Business
Before you make any decisions about splitting profits, talk to a lawyer about the best way to legally structure your business.
There are a few options to consider. Two of these are general partnerships and limited liability partnerships. Let’s look at both.
The simplest route is to form a “general partnership”, simply register your “doing business as (DBA)” name and open a bank account in the business’ name. This structure assumes that all profits, liability, and management duties are equally divided among the partners. If the partnership is unequal, such as a 30-70 ratio, then you’d need to document the percentages assigned to each partner in the partnership agreement (more on that later).
Limited Liability Partnerships:
Another option is a “limited liability partnership” also known as an LLP. Professional partners, such as lawyers or accountants, are often advised to go this route since it protects the business owners from personal liability for the debts or liabilities incurred by the partnership. For example, if you run into a cash flow issue and your business fails, neither partner will be personally liable for any debts owed to creditors. Another option is a “limited partnership (LP)” in which one partner invests in the business but doesn’t manage it, leaving that task to one or more of the other partners.
Research these options to understand which makes more sense for you. You may want to ask your financial advisor or lawyer for advice about this.
Decide How You’ll Split Profits
In a business partnership, you can split the profits any way you want–if everyone is in agreement. You could split the profits equally, or each partner could receive a different base salary and then split any remaining profits. This will be up to you and your partners to decide.
Remember, in an equal partnership (50-50) neither partner can make a decision without the other’s approval, whereas in a 51-49 ratio, for example, one partner has final authority. (Read more about setting your salary as a business owner.)
If you know ahead of time that one or more partner will only play a minor role in income generating activities, you might agree to pay the more active partner a higher salary. Another variation is to pay partners only for work performed based on pre-determined rates for certain projects.
Whatever you decide, it’s a good idea to create a profit-sharing agreement and make it part of your larger partnership agreement. All partners should agree and sign, to prevent problems later.
Put Everything in Writing with a Partnership Agreement
A partnership agreement is the business version of a prenuptial agreement and should be completed before you start operations and any profits are made (the division of profits is a critical part of this process). Although an agreement is not legally required, it can protect your interests as one half of the partnership for the duration of your partnership and through its dissolution.
Things to include in the agreement include the following:
- Division of profits – This includes both the division of profits and losses and how and when each partner will get paid.
- Contributions to the partnership – If either partner contributes any assets to the business, whether it’s cash, property, or equipment, you’ll need to ensure these are documented.
- Business decision-making – What authority does each partner have to make business decisions? How will you handle disputes? How will you handle the dissolution of the partnership when that time comes?
- Who does what – Divide up your management duties and document them in the agreement. For example, who handles media relations, payroll, etc.
Work with a lawyer and your accountant to develop and formalize the agreement, there are many factors that require consideration when forming any kind of partnership and getting legal and financial advice now will save you a lot of hassle in the long run. If you don’t have an accountant yet, check out our guide: How to Find the Right Accountant for Your Business.
Revisit the Agreement Annually
Let’s face it: business dynamics and personal relationships change. If your partnership has evolved over the past year or is likely to change in the coming year, it’s important that you revisit your partnership or profit-sharing agreement to reflect these subtleties. If you need to change your agreement drastically, consider bringing in the services of your lawyer or accountant to make sure everything is correctly documented.
Understand How Business Partnerships are Taxed
As you structure your profit-sharing agreement, you’ll also need to be aware of how the IRS taxes partnerships.
In a partnership, the business “passes through” any profits or losses to its partners. Partners include their respective share of the partnership’s income or loss on their personal tax returns. Partnerships do, however, need to file an annual information return (Form 1065), also known as a “Partnership Tax Return” to report income, deductions, gains, losses, and more with the IRS.
Partners are not employees and should not be issued a Form W-2. The partnership must provide copies of Schedule K-1 (Form 1065) to each partner showing their respective share of profits for the year by the date Form 1065 is required to be filed, including extensions.
Read more about partnerships tax obligations on IRS.gov.
Plan for a Happy and Profitable Partnership
Protecting yourself before you start a business partnership is your best strategy for ensuring the union is a happy one. If you have any doubts about whether a partnership is right for you, read these 8 Questions to Ask Before Entering into a Business Partnership.
Profit sharing is an important consideration but there are many moving parts to a business that you should consider and include in your partnership agreement.
For more complete information on business partnerships check out these guides from the IRS, About.com, and FindLaw.com.