So you have a great idea, and you talk it over with a friend or two, and you decide to go into business together. And everyone wants to feel like they are equals in your new business, so almost inevitably, someone in the business says, "Let's form a partnership!" If you are not a specialist in business structures and their tax, filing, and liability consequences, you're likely to agree, because it just makes sense, right? But you may be making a huge mistake that could not only cost you thousands of dollars in unnecessary taxes, but may also have disastrous financial and legal consequences for your company.
What's the Difference?
In the eyes of the Internal Revenue Service (IRS), just about everything! What you call your business, and how you present yourself to people, could mean a difference of literally thousands of dollars. The reason is that a partnership is a legal business structure. Without further clarification, most of the time a partnership will be interpreted as a general partnership. This can put you into financial liability, and even legal liability. For example, if one of your partners goes and finances a car for the company, and then she or he goes bankrupt, the car dealer will send you the bill. Worse, if your partner has an accident in the car and injures someone, again, you are legally liable for their medical bills and property damage.
In addition, calling your business a partnership may mean that your tax bills are higher, even if you never do anything about the partnership and you and your partner never do any work, and neither of you ever make any money. If your partner reports a side business income she or he has as partnership income (even if by mistake), that may trigger an IRS audit and additional taxes and penalties for you personally.
Other Types of Company Structures
- Sole Proprietorship: Only one person owns the business. This does not mean it's a one-person business! The owner can hire either regular employees or contract employees, and can do almost anything that any other kind of business can do except sell stock.
- Limited Liability Corporation: Like a sole proprietorship, but protects the owner from legal liability. (However, this does not grant you as much financial protection as you might think, and you might be better off in some instances remaining a sole proprietorship and putting your possessions in a trust, or obtaining sufficient business liability insurance. In addition, you may have to file extra tax forms and pay extra taxes. Often, business owners are not informed of this by the so-called business "experts" who routinely suggest an LLC formation without bothering to find out if it is the right choice for the owner.)
- Corporation: There are two basic types of corporations: Subchapter S and Subchapter C. Subchapter S corporations have significant limitations, but good tax advantages. Subchapter C corporations have fewer limitations but the tax advantages are not as good.
Before deciding on a business structure, always consult both a qualified tax professional and a qualified business attorney. The wrong decision could be expensive!
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A Partnership Without a Partnership
If you decide a business structure other than a partnership is right for your startup, talk it over carefully with the people with whom you plan to work. Explain the legal and tax consequences of partnerships to them (remember to explain to them that if they are equal partners, they share equal liability for losses and liabilities), and instead, address everyone's concerns over getting equal shares of the profits by hiring an attorney who specializes in startups to write up a contract for you. That way, everyone feels that they are part of the business, without demanding to be a "partner."
If you decide against a partnership, you must be diligent about how you and the other people in your business refer to each other. You must all very carefully avoid the word "partner" (banish it from your vocabulary, if possible) and refer to the actual business structure accurately at all times. In some states, even a casual use of the word "partner" in a conversation can turn your business into a partnership; make sure that everyone in your business understands this and the consequences!
I am not a lawyer. This article is intended as general advice only, from a person who has started several businesses. Your mileage may vary. Please consult an attorney licensed in business law in your state, as state laws vary wildly.
The Bottom Line
If you're planning to go into business (especially with other people), talk with an attorney, or at the very least a business expert. Do not rely on information you find in books or websites, as the laws concerning business structures are constantly changing, and overnight their information could be out of date. In the United States, you can get free advice by making an appointment with your local office of the Service Corps of Retired Executives, known familiarly as SCORE. The services of SCORE are free, and they are funded by the United States Small Business Association, so their advice will be current and correct. Take your proposed colleagues with you, so that they can understand why a partnership may not be the right business structure, and that it doesn't mean that you value them less if you decide on some other structure for your new company. You'll have the satisfaction of knowing that you won't be saddling your company with unnecessary handicaps, and your new associates will know that you're not making the decision because you want to shut them out.