Entity Selection Series - Part 3, Partnerships

Hello party people! 

I hope that everyone had a restful Thanksgiving and are enjoying the waning months of 2025 as we cruise into the New Year. 

Welcome back to the third installment of my entity selection series, where we will cover the thrilling topic of Partnerships. 

If you recall from the first part of this series, we did a deep dive on Limited Liability Companies, which can be taxed as a partnership. However, did you know there is an entirely seperate category of legal entities that are also subject to the partnership tax rules? 

So let's dig in:

What a Partnership Really Means

When boiled down to it's core, the IRS defines a partnership as:

"... The relationship between two or more people to do trade or business. Each person contributes money, property, labor or skill, and shares in the profits and losses of the business."

This definition by the IRS is incredibly important because it highlights that almost anyone can have a partnership and not even know that they do. All it takes is two people who are looking to go into business together and make money. 

Pros, Cons, and Legal Analysis

Like state corporations and LLCs, partnerships also have their own set of laws that instruct business owners on their rights, remedies, and the taxation of that type of entity. 

With the exception of just a handful of states, almost every state in the nation has adopted some version of the Uniform Partnership Act at this time.

When thinking about partnerships, they generally break down into two key categories:

1. General Partnerships; and
2. Limited Partnerships

General Partnerships

A general partnership occurs either automatically when two or more people agree to operate a business together for profit, even if they never sign formal paperwork or when a partnership is formed under state law. Importantly, however, each partner shares in the management of the business and is personally responsible for its debts and obligations, which means the actions of one partner can legally bind the others. So while simple and flexible, a general partnership does not provide the same type of protection that a Limited Liability Company gives its partners.

So while the entity type is simple and flexible, it relies heavily on trust and clear communication because state default rules fill in the gaps if partners do not create a written agreement. 

Limited Partnerships

The other type of common partnership that we see is a limited partnership, which consists of at least one general partner, who manages the business and bears full personal liability, and one or more limited partners, who contribute capital and share in profits but are shielded from day-to-day liability so long as they do not participate in management.

Now there is some significant case law surrounding Limited Partnerships and ongoing litigation with the US Tax Court, however that is outside the scope of this newsletter.

This structure allows businesses to blend active control with passive investment, making it a popular fit for projects that require outside capital but centralized decision-making. Limited partnerships are also a cornerstone of the private equity industry: funds are typically organized as limited partnerships where the private equity firm serves as the general partner and are responsible for managing investments while institutional investors, pension funds, and high-net-worth individuals participate as limited partners who receive economic returns without direct involvement in operations.

Advantages of Partnerships

So when thinking about whether or not to form a partnership it's important to consider the advantages of this type of model:

• Flexible Ownership. Partnerships give owners a high degree of freedom to design an arrangement that reflects how the business actually operates. Responsibilities can be divided in any manner of ways that fit how business owners work with one another.  There is also flexibility in profit-sharing and decision making. 

• Simple Tax Treatment. Legal partnerships, like LLCs, are pass-thru entities, meaning that all income, losses, deductions, and other tax benefits are passed through to the ultimate owners. The key benefit? A single-layer of tax, unlike C Corporations which have double taxation. For many small and mid-sized businesses, this approach keeps compliance straightforward and often results in more efficient overall tax outcomes.

• Adaptability. Partnerships are built to evolve as the business evolves. Whether you need to bring in a new partner, adjust ownership percentages, or redefine roles, the structure can be updated without the disruption that often accompanies more rigid entity types, such as corporations. This adaptability is especially valuable for growing companies, seasonal businesses, or ventures where contributions shift over time.

Disadvantages of Partnerships

• Shared Unlimited Liability. In many partnership structures, and specifically a General Partnership, each partner can be personally responsible for the debts and obligations of the business. This means the actions or decisions of one partner can create legal or financial exposure for everyone involved. Without the protection of a formal entity like an LLC or limited partnership, owners may find themselves carrying risks they never anticipated.
• Potential for Conflict. Partnerships run into trouble when expectations are unclear or misaligned. Differences in work ethic, financial contributions, or decision-making styles can quickly create tension, especially when the business faces pressure. Most partnership agreements are written in a way where each partner gets 50/50 or their pro-rata share of the profits and losses. So often there are situations where one partner is pulling their weight while the other isn't nearly as involved. 
• Cash Flow and Tax Surprises. Because partnerships use pass-thru taxation, partners may owe taxes on income even if the business didn’t distribute enough cash to cover the liability, which we call “phantom income.” These issues tend to surface when the business hits a rough patch, grows faster than expected, or when partners prioritize cash differently. Clear planning and consistent communication are essential to avoid surprises that strain both the business and the partnership.

Taxation of Partnerships

I'm not going to spend a ton of time on partnership taxation because it was covered in an earlier newsletter:

Entity Selection Series - Part 1, Limited Liability Companies You have seen the hype on social media.... Form an LLC and save thousands in taxes.... One of the very first things that I do when I walk... smb.joshualowenthal.com

But I did want to take a moment to talk about Self-Employment Taxes

Let Me Talk To You About Self-Employment Tax

One conversation that comes up frequently when talking with business owners is the issue of self-employment tax. 

In a partnership or multi-member LLC taxed as a partnership, each partner’s share of business income is typically subject to self-employment tax, which covers Social Security and Medicare contributions. It is an additional tax on-top of ordinary income taxes that covers the half of taxes that are usually paid by an employer when you hold a wage-paying job (read: W-2).

Generally speaking, parnterships owners are subject to self-employment when they play an active role in the partnership. This is a significant consideration, especially when considering giving equity to a key employee to keep them engaged in the business. 

Which leads me to a common oversight that I see: giving equity to an employee without explaining how their situation will be changing. Most W2 employees situations are straight forward. They work, receive a paycheck, and pay taxes on what they earned throughout the year. However, when an employee tranisitons from earning a wage to becoming an owner, their tax situation also changes. First, they will likely have to pay quartely estimated taxes. Second, they may have phantom income, which was touched on above, and Third, they will be subject to self-employment taxes.

There is one exception to the general rule (lawyers, am I right?) and that is with Limited Partners. Under the tax law there is an exception that effectively says that Limited Partners do not need to pay self-employment tax on their income reported from the partnership.

What Should You Do?

Partnerships can be an excellent way to build a business with someone you trust, but they work best when expectations are defined early and clearly. Before moving forward, take time to outline roles, ownership, financial contributions, and how decisions will be made, ideally in a written agreement. 

Pragmatically speaking, if you are considering a partnership, it is important to think through the pros and cons of this legal entity type versus forming an LLC taxed as a partnership. 

Wrapping Up Entity Selection