Partnerships: when they work and when they don't

Two people start a business together and, often without realising it, they are in a partnership. A partnership can be a simple and fair way to share a business, but it carries a level of personal exposure that many partners do not appreciate until something goes wrong. Knowing how it works helps you decide whether it suits you, and what to put in writing if it does.

What a partnership is

A partnership is a relationship between two or more people or entities carrying on a business together with a view to profit. It is governed by each state and territory's partnership legislation and by any agreement between the partners. It can exist without anything being signed. If you share profits and run a business together, the law may treat you as partners whether you meant it or not.

A partnership is not a separate legal entity. The partners themselves own the business assets, sign the contracts and owe the debts, even if they trade under a business name with its own ABN.

Partners can be individuals, companies or trustees of trusts. A partnership of family trusts or companies is quite different in risk and tax terms from a partnership of individuals.

How partnerships are taxed

The partnership lodges its own tax return, but it does not pay income tax. Its net income or loss is divided among the partners according to their interests, and each partner includes its share in its own return.

Individual partners pay tax at their own marginal rates.
Losses flow through to partners, who may be able to offset them against other income, subject to the non-commercial loss rules for individuals.
Partner salaries are not wages for tax purposes. A so-called salary paid to a partner is generally an allocation of profit.
CGT applies to each partner's share of each partnership asset, not to the partnership as a whole, which can make changes in ownership complicated.

The profit split must reflect the genuine arrangement between the partners. Arrangements that simply move income to a lower-taxed partner, particularly for personal services income, can be challenged.

When partnerships work well

Professional practices where the partners are actively involved and share risk equally, especially where a professional body or regulator expects personal accountability.
Small family businesses, such as spouses running a business together, where both contribute and losses in early years can be used personally.
Entity partnerships, where each partner is a company or trust, giving the partners some flexibility in how their share is taxed and held.
Short-term joint ventures between businesses, where a properly drafted agreement sets clear limits.

When they do not

Unlimited, joint liability

In a general partnership, each partner is generally liable for all the debts of the partnership, not just their share. If one partner signs a contract or incurs a debt in the course of the business, the other partners can be bound by it. If the business cannot pay, a creditor can pursue any partner for the full amount. Using a company as a partner limits the individual's exposure, but it does not change the partnership's rules.

Growth and retained profits

All partnership profit is taxed in the partners' hands each year, whether it is distributed or not. A growing business that wants to reinvest its profits may find a company more efficient, because retained profit is taxed only at the company rate until it is paid out.

Bringing in or losing a partner

Admitting a new partner, or a partner leaving, can technically end one partnership and start another. That can trigger CGT for each partner, require new registrations and complicate contracts. A company handles changes in ownership far more smoothly, through the transfer or issue of shares.

Selling the business

Buyers of a partnership business usually buy the assets. Each partner's share of the sale is dealt with separately, which is workable but rarely as clean as selling shares in a company; see Structuring your business today for a sale tomorrow.

A partnership is easy to start and hard to change. If you expect the ownership to change, the business to grow, or the risk to increase, think about the exit before you choose it.

The partnership agreement

Without a written agreement, the default rules in the partnership legislation apply, and those rules are often not what the partners would have chosen. For example, the default position is usually that profits are shared equally, regardless of capital or effort. A partnership agreement, prepared by a lawyer, should cover at least:

Each partner's capital contribution and profit share.
Drawings, and how and when profit is paid out.
Decision-making, and what each partner may sign without the others' agreement.
Duties, time commitments and restraints on competing.
Admission of new partners and the retirement or expulsion of a partner.
What happens on death, incapacity or bankruptcy.
How a departing partner's interest is valued and paid.
Dispute resolution and how the partnership is wound up.

Partnership, company or trust?

As a rough guide:

Choose a partnership when the partners want simplicity, are comfortable with shared liability, expect to distribute all profits, and do not expect ownership to change often.
Choose a company when you want limited liability, to retain profits, to bring in investors or employees as owners, or to sell shares one day; see Sole trader or company? How to choose.
Choose a unit trust for co-owned investments or ventures with fixed entitlements; see Unit trusts for co-owners and joint ventures.

Questions to ask before you start

Are we already in a partnership without realising it?
How much personal risk are we each willing to take?
Will we reinvest profits or pay them all out?
What happens if one of us wants to leave in three years?
Do we have a written agreement, and does it say what we actually mean?

How we can help

We help partners decide whether a partnership suits their business, compare it with a company or trust using their own numbers, and work with their lawyer on the agreement. If you are starting a business with someone, or reconsidering an existing partnership, contact us or see our business structuring services.

This article is general information only and does not take into account your circumstances. Speak to a qualified adviser before acting on it.