Key aspects of partnerships

Everyone knows what a partnership is, right? Perhaps in a colloquial sense. However, when  it comes to the formalities of a partnership, I find that people are regularly surprised by some of the key aspects of what a partnership entails.

The Basics

A partnership is simply two or more people carrying on business in common with the aim of making a profit. A partnership does not need to be registered, documented or formally created (although it will need its own ABN). Rather, a partnership may be found to exist by considering the relationship between parties in the conduct of a business (i.e. it can be inferred to exist).

A simple partnership (e.g. between two individuals) is no more complicated as a business structure than a business run by a sole trader – other than the fact that there are two (or more) people involved. Therefore, partnerships between individuals share many of the same characteristics that I mentioned in my post on sole traders. This means that a simple partnership is relatively easy and cost effective to establish, but also has the effect of exposing the individual partners to personal risks associated with the business. Importantly, a business run by a partnership is not a separate legal entity (in the way that a company is). This means that the income derived from the business is split between the partners, and each partner pays tax on that income at their ordinary marginal tax rate.

Key points

Drawbacks of Partnerships

Liability

There are a number of additional factors to be aware of when considering establishing a partnership. These relate to the way the law treats dealings between partnerships and third parties, for example:

  1. every partner is an agent of the partnership and can take actions which are binding on all the other partners;
  2. every partner is jointly bound for all debts and obligations incurred by another partner in respect of the business;
  3. every partner is jointly liable for a wrong committed by a partner in the ordinary course of the partnership’s business (i.e. each partner is jointly liable in the event that a claim is made against one of the partners); and
  4. every partner is bound by the representations or admissions of another partner.

You can see from the above that going into business with a partner can expose you to substantial risks. This makes partnerships between individuals wholly unsuitable to certain professions that involve a high risk of being sued (e.g. doctors have a high rate of negligence claims made against them), because of the need to protect each partner from the risk of claims made against other partners.

Documents

Believe it or not, a partnership does not need a “founding document” to be established. This can be compared to companies (which have constitutions) and trusts (which have trust deeds). However, given the inherent risks involved in being in a partnership it is imperative that partners enter into a partnership agreement to govern their relationship. A well drafted partnership agreement will establish parameters around the conduct of the partners so as to limit these risks. I’ll be posting an article shortly outlining key terms that need to be a partnership agreement.

Limitations

Under a partnership, each partner owns the business and all of the business assets. This makes the process of documenting and admitting a new business partner somewhat complicated, as you cannot ordinarily sell ‘shares’ in the partnership – rather, when admitting a new partner, you sell part of the business to that partner. Likewise, strictly speaking each time that a partner leaves a partnership, the partnership is dissolved and a new partnership is formed by the remaining partners. Thankfully however, there are laws in place that allow this to be treated as a continuation of the existing partnership for the purposes of administering various taxes.

Positives of Partnerships

Flexibility

Whilst basic partnerships (between two individuals) will rarely be recommend as a business structure, keep in mind that companies and trusts can be partners in a partnership (because they are their own legal entities). One of the most flexible and widely used business structures is therefore a partnership of discretionary trusts, which I will discuss when writing about more complex business structures. For now, it suffices to say that such a partnership minimises many of the risks discussed above, because the partners are not personally entering into the partnership and exposes their personal assets to the business risks. Similarly, limited partnerships can be implemented to reduce the liability of silent partners in a venture.

Cost effective

As mentioned above, partnerships between individuals share many of the same characteristics as businesses run by sole traders. This means that a simple partnership is relatively easy and cost effective to establish. However, more complex partnerships will necessarily require more time, cost and effort to establish.

Tax planning

Without getting too caught up in the details, it is worth mentioning that partnerships can allow a business qualify for certain capital gains tax concessions in circumstances where a company or a trust would not. This is because certain small business concessions only apply where turnover does not exceed $2 million or the value of your assets is less than $6 million. In a partnership, these thresholds apply per partner, significantly increasing your likelihood of qualifying for the concession (e.g. a partnership with 2 partners can still qualify as a small business provided that business turnover does not exceed $4 million).