A general partnership consists of two or more people who conduct business together for their mutual benefit, each contributing services, money, or other property, with a community of interest in the profits. Forming a partnership requires no particular formalities. All that is required is an agreement to share the profits and losses produced by a common enterprise and the intent to form a partnership. Each partner is an agent of the others, with the authority to bind the entire partnership. In addition, all the partners are jointly and severally liable for the debts, obligations, and liabilities of the partnership. For that reason, we find it difficult to imagine a situation in which we would advise a client to conduct business as a general partnership rather than forming a corporation or, more frequently, a limited liability company, and most business lawyers would probably agree with us.
Even so, there is one aspect of partnerships that has an extremely important bearing on businesses that are organized as limited liability companies, and that is the aspect of partnership income taxation. As explained elsewhere, LLCs can elect to be taxed in one of three ways: as a corporation under Subchapter C of the Internal Revenue Code, as a corporation under Subchapter S of the Internal Revenue Code, or as a partnership under Subchapter K of the Internal Revenue Code. Of those three, taxation as a partnership under Subchapter K is probably the most common choice of LLC owners. That factor, combined with the tremendous growth of the use of LLCs as the entity-of-choice for so many businesses, means that the number of businesses taxed as partnerships has increased even while the number of true partnerships has probably decreased.
Income Taxation as a Partnership under IRC Subchapter K
The primary reason taxation as a partnership is such a popular choice among owners of LLCs is that, unlike a Subchapter C corporation, a partnership does not pay income tax. Instead, the partnership files an information return that accounts for its income, gain, deductions, losses, and credits, which are then allocated among the members. The same is true of Subchapter S corporations, but there are significant differences, with perhaps the primary one being that the members of a limited liability company taxed as a partnership have the ability to structure the allocations in ways to provide additional tax advantages.
In a limited liability company taxed as under Subchapter S, all income, losses, and other tax items must be allocated among the members in proportion to their ownership; however, under Subchapter K, the members may allocate income, losses, and other tax items other ways. If one member is in a higher tax bracket than another, the members may allocate more of the income to the member in the lower tax bracket and more of the losses to the member in the higher tax bracket. There are, however, limits, but careful drafting of the operating agreement can ensure that those limits are not exceeded.
We can work with your accountants to draft an operating agreement for your LLC to take advantage of the benefits offered by partnership taxation.