What Happens to the Profits of a Partnership?
Starting a new business is just as demanding as exciting for the partners, and perhaps more. From coming up with a new name that no other company is using to writing a partnership agreement, the partners must complete many tasks, and multiple aspects must fall into place.
Many new small business owners overlook some of the details regarding their new company, no matter how vital the details are. New business owners are constantly pulled in different directions, but they also want to be able to pay their bills, take care of their families, and ensure that their business fulfills their potential.
Entrepreneurs need to have a clear sense of their income. All of us want to be able to estimate our earnings so that we can save money for ourselves and our loved ones. This leads many of us to seek details about how we are paid.
When entrepreneurs decide to form partnerships, they do so to form a capable, responsible team. First, however, the partners must determine how each member will be paid.
Small business owners wonder how profits are split in company partnerships and the most advantageous basis for doing so. For example, what if one partner works more hours than another or feels they are putting more effort into the business?
Starting a business can be complex, but so can figuring out how to split profits in a partnership.
This article will outline how to plan the correct strategy for sharing the profits of a small business partnership. We will also go over a few more steps that will make sharing profits now and in the future safer and easier.
How Are Company Partners Paid, and What Makes Partnerships Unique?
Adding multiple partners to the business equation changes how payments are structured. Therefore, small business partnerships structure their profits much differently than sole proprietorships. A simple comparison helps show what makes small business partnerships unique.
Entrepreneurs declare themselves the only business owner when they start a sole proprietorship. Partnerships, on the other hand, include two or more owners. However, sole proprietorships are similar to partnerships in that the partners’ pay rates reflect the company’s overall profits.
Unlike limited liability corporations, partnerships are not structured as separate legal entities. Therefore, the general partners are responsible for the company’s debts and liabilities.
Typically, the company’s partnership agreement stipulates how each partner is paid.
The key to understanding how much money partners collect is to examine the partners who signed a partnership agreement. All partnership agreements spell out that the business pays the partners and tells each partner what to expect.
How much each partner invests in the business also usually influences their pay rate. When partners help to fund the business and help with labor and other costs, their payments reflect these contributions.
However, the best way to establish how much partners collect in a small business partnership is by examining the partnership agreement. Most partnership agreements are written, signed documents, but in some cases, they exist verbally. Therefore, for individuals in the midst of forming a small business partnership, we recommend a signed, written document that is easy to review later.
Partnership agreements are relatively easy to create, and since they are so vital to the payment process, they are one of the most fundamental documents of all small businesses. Company partners should agree on the document’s terms, and the agreement should be backed up and filed away for future reference. Some partnership agreements rely on a business plan, too, but if individuals start a small business together, they should already have a comprehensive business plan.
For example, Jill, Joseph, and Tina are entrepreneurs and passionate gardeners who have all gone in on a new business in Ventura Beach, California. Herbs and More is a plant store that sells herbs to chefs, restaurants, and gardeners.
Jill is responsible for the business plan, though the group collaborates on the document. Finally, Tina drafts a partnership agreement for the new small business, and all three entrepreneurs approve the document.
After Herbs and More has been in business for a few months, Joseph has many questions about the amount he makes. However, Joseph feels he puts in more time and effort than the other partners, and he is pretty sure that sales have grown stronger and stronger. So why, then, is his paycheck smaller than he expected?
Joseph doesn’t let his emotions fly off the handle and instead schedules a meeting with the other partners. Tina, Jill, and Joseph compare paychecks, and Joseph realizes each partner’s paycheck is more or less the same. Tina reminds Joseph that they decided on an equal partnership, and each partner pledged to work the same amount of hours, 45 per week, with the same amount of dedication and due diligence.
Jill chimes in to remind Joseph that the cost of starting a new small business is reflected in every member’s paychecks, not just Joseph’s. The startup costs for Herbs and More were expensive, from rent payments and equipment bills to setting up the internet and bringing in hundreds of plants.
Joseph is happy to be reminded that all three partners have the same stock options, buyout terms, compensation rates, and more, even though they have different duties for the business. Joseph leaves the meeting confident that Herbs and More will continue to evolve and is happy that his partners support him, even when he has important questions.
What is the Best Way to Formally Structure a Small Business?
When business owners focus on structure, they often consider how the partners will split up profits and who will take on the most liability. Entrepreneurs’ company structure lays the foundation for the business and dictates the small business partners’ duties, roles, and responsibilities.
Some individuals who have run sole proprietorships wrongly assume that small business partners will not be much different. However, there are many options to consider when creating a new partnership, and each option has different advantages and disadvantages. We suggest speaking with an experienced business attorney before committing to a company structure. Here are a few options to consider as individuals begin the selection process and figure out exactly how they would like their profits to be structured.
General partnerships offer entrepreneurs a simple, popular structural choice. They can begin by registering their business as a “doing business” (DBA) and start a bank account under the company’s name.
In general partnerships, the partners agree to share management responsibilities, tasks, profits, and debts equally.
Sometimes, partners seek to make the partnerships deliberately disproportionate; to do so, they must note the discrepancies in the partnership agreement. All partners would have to agree on these differences and accept them.
For example, if Mark, Mindy, and Kenneth start a general partnership, they agree to split the new business’s profits and the debts the entity might incur as it gets its footing. However, if Mark was nervous about the company’s liabilities because of weak personal finances, it might make sense for the group to consider a different structure. If Kenneth, on the other hand, didn’t want to take on as much responsibility as the other partners and would rather invest in the business and then step back, perhaps the group should explore a limited partnership or something in that vein.
- Limited Liability Partnerships:
Limited Liability Partnerships (LLPs) are also popular for new small business partners. Many attorneys encourage entrepreneurs to pursue this route. Why?
LLPs are structured to protect business owners from personal liability risks. Whereas in a general partnership, the company’s debts can impact personal finances and assets, this is not the case in a limited liability partnership.
For example, Nick and Dan are partners in a general partnership. Unfortunately, they spend too much credit building their used car business and then do not record nearly enough sales to pay the bills. As a result, Nick and Dan’s finances and assets are vulnerable if their business cannot pay off its debts.
However, if Nick and Dan had structured their business as a limited partnership, neither partner could have been liable for the business’s debts.
Limited Liability Partnerships are popular for “professional” partners, including attorneys and accountants. However, one does not have to be a lawyer or an accountant to take advantage of the ease of the limited liability structure.
How Are Limited Partnerships Different?
Limited Partnerships, known as LPs, feature a slightly different format. In an LP, one partner helps fund the company but does not seek to run the business.
For example, Wayne and Garth are excited to start their new bar called Seabreeze in Solana Beach, California. The two entrepreneurs are passionate about food service and making retro cocktails for the post-beach crowd. However, they are worried about paying all of the bar’s startup costs.
Luckily, Wayne and Garth’s fellow entrepreneur, Jimmy, think Seabreeze will be a hit. Jimmy offers to invest in Seabreeze as a limited partner, meaning he does not want anything to do with day-to-day operations. The three entrepreneurs agree on the additional terms of the partnership agreement, and soon Seabreeze is a hit, known for its delicious mojitos, tacos, and nacho plates.
Business structure is an important concern for new small business owners, so individuals should take their time and conduct proper research. What works for one company structurally will not work for the next, so consider business goals, personnel, and costs as you choose the right structure. Also, do not be afraid to ask a licensed attorney or financial advisor for outside help.
How Are Profits Split Up in a Partnership?
Todd, Erin, and Yosef are in the middle of the startup process for their new Del Mar, California coffee shop, Express Espresso. As the three partners work on their partnership agreement, they debate how to divide profits.
After a brief discussion, the new partners form a plan. Todd and Erin will be entitled to more profits in their limited partnership than Yosef. However, Yosef endorses this idea because he does not want to share in any management decisions. Therefore, Todd, who plans to work the most hours, will take 45% of the coffee shop’s profits, reflecting his annual salary. Erin will take 35% of the business’s profits, and Yosef, as a limited partner and investor, will take 20%.
It is important to note that in this example, both Todd and Erin have unlimited liability for any debts Express espressos takes on. At the same time, Yosef’s role as a limited partner provides him with limited liability for the company’s debts.
The three new partners finish their partnership agreement and open a shop soon. Express Espresso is a hit, partly because they make a delicious cup of coffee but partly because all partners agree on their profit-sharing structure.
Many wonder how profits are split up in business partnerships, but the answer is relatively simple. Company partners can divide the profits based on their preferences as long as all partners agree on the terms.
Some partners decide to split profits equally when they draw up the partnership or operating agreement. For example, when Jack and Ryan open a fruit stand, they know that they both must work the same hours and labor equally as hard to give the stand a chance. Therefore, it is only natural that both partners, who invested equally in the business, agree to split all profits down the middle.
When business partners form a partnership, the division of profits is one of the major decisions they must make. For example, some partners each receive a unique base salary based on their investments in the business, duties, or responsibilities, and then the partners split the profits the company makes.
Should Partnerships Use Equal Partnerships or Tiered?
In equal partnerships, partners cannot make decisions without consulting. However, if the ratio is set up as 55-45, the partner earning more has final authority. Setting partners’ salaries can be complex, and an experienced business attorney can help figure out how to set up a fair earning system.
Sometimes, deciding whether to pay partners equally depends on each partner’s role in the business or desire for responsibilities.
For example, Jeff and Lee open a bookstore, but right from the start, both entrepreneurs know they want different roles. Lee, who is 25, wants to work 75-80 hours per week in the store and give everything he has for the business’s success. This occasion is Lee’s first shot at opening a business, and he wants to establish his career, develop his talents, and then continue with other companies.
Jeff is 55 and eyeing retirement. He sees the bookstore as his last chance to provide some more college-fund cash for his family.
The partners are open about their goals and expectations, and Lee takes care of day-to-day operations while Jeff works a few shifts per week and is in charge of hiring employees and finances. The profit-sharing agreement works because the partners are open about their goals, and it is easy to come up with the correct ratios. Jeff and Lee agree on a 70-30 salary split, with Lee taking much more based on his role and responsibilities. Since Jeff accepts this and wants to play a limited role, the agreement is easy to make. Plus, the two partners pledge to wait a year and then meet to adjust the numbers as needed.
In other cases, business partners are paid only for their tasks based on agreed-on rates. Sometimes, this is in addition to a base salary or profit-sharing.
For example, Frank is part-owner of a music store and is paid for the instruments he sells. The more valuable the instrument, the more Frank makes. Frank also makes an hourly wage.
Regardless of what the partners decide, two important recommendations regarding the division of profits in a partnership are:
- Establish and agree on a profit-sharing agreement that all partners sign off on
- Add the profit-sharing agreement to the company’s partnership agreement
What Should Partnership Agreements Include?
When companies run into trouble, it is often because:
- Their partnership agreement is unclear or incomplete
- They lack a partnership agreement
Creating a comprehensive partnership agreement is essential to starting any type of business. While business partnerships are often compared to marriages, partnership documents are commonly compared to prenuptial agreements. Why? Because excellent partnership agreements are built on clear expectations and include goals, responsibilities, partners’ duties, profit-sharing provisions, and more.
Before a business begins operating or collecting profits, the partners should create a partnership agreement. First, partners must agree on all the terms, and then the document should be signed and saved for future reference. Sometimes, partners agree to make changes to the agreement as time passes, so it is best to keep the agreement handy.
Partnership agreements are not legally required, and some business owners and partners rush through the process or skip it altogether. However, since a partnership agreement helps partners protect their interests, it is vital to spend time creating one. Partnership agreements differ from business to business, but they regularly include provisions such as buyout clauses and instructions regarding partner disputes and company dissolution. Many business partners find that consulting with a qualified business lawyer helps them figure out what their specific agreement should contain.
Since we are focusing on partnership profits, let’s look at how the partnership agreements relate to partner contributions and payments.
When will the partners be paid, and how much will they receive? Again, remember to include profits and losses, and also be specific about whether payment comes from salaries, percentages of profits, commissions, or some combination of all three.
- How Partnership Contributions Are Structured:
Document partner contributions according to the rates that partners have agreed on. Many partners contribute property, assets, or finances to their companies, especially as they get off the ground. Document all of these arrangements now so that you do not have to figure out allocations later.
The key question here is regarding decision-making. Which partner or partners can make decisions regarding business operations? If a dispute arises between partners, what is the process? If one partner retires or passes away, or the partners must dissolve the business, who handles the details of these complex processes?
The more detail partners provide regarding business decisions and authority early in the process, the less chance there is that partners will disagree. Of course, disputes occur within all businesses, but partnership agreements can lower the chances of the complex, messy disagreements that doom promising companies.
- Partners’ Duties and Responsibilities:
Another important aspect of the partnership agreement is establishing the partners’ responsibilities. Companies require partners to assume different roles depending on the partners’ projected positions in the business. However, if the partners are open about their talents and aware of each other’s experience levels, they can place partners in roles they will excel at.
For example, Tyler and Erik are forming a new company, and first, they need to create a partnership agreement. When they reach the point of designating roles, Tyler admits that he was the head of media at his last company and excelled at promoting the business. Therefore, giving Tyler the main media relations duties makes sense since he has experience in this position.
In addition to media relations, even small businesses come with many responsibilities. From payroll and human resources to dealing with suppliers and hiring, there will be no shortage of duties to divide up at your small business partnership.
What To Do When the Partnership Agreement is Finished
When the partners have gone over all the important provisions and terms, it is time to finalize the agreement so the company can begin doing business. An accountant and an attorney are essential for this process and will provide financial input and legal advice.
Once the partnership agreement is finalized and drafted, ensure all the partners read through it more often. Then, each partner should sign the agreement and take a copy for safekeeping.
Revisiting the Partnership Agreement
One of the essential things partners should know about the partnership agreements they sign is that they are not set in stone. Company dynamics change over time, as do priorities and personal relationships.
When companies evolve, take on new members, or reprioritize, do not be afraid to revisit the partnership agreement as a group and consider updating the document.
Updating the agreement usually requires the presence and input of an attorney, so make sure to contact an experienced business lawyer when doing so.
How Are Business Partnerships Taxed?
When starting a new business, all entrepreneurs should know how the Internal Revenue Service (IRS) will tax the company.
The IRS taxes partnerships as a unique category based on the partnership’s “flow-through” taxation. Flow-through taxation refers to the process through which a business partnership passes profits and losses to the partners.
When business partners do their taxes, they must include their share of the company’s income and/or losses on their returns. All partners must do this, depending on how many make up the company.
Additionally, the partnership itself must file an informational return, or a Partnership Return, to report to the IRS regarding
- Income
- Deductions
- Gains
- Losses
Employees of the business, not partners, must fill out additional forms, such as typical W-2s. All business partnerships must also give copies of form 1065 to each partner.
The IRS website is an excellent resource to find more information about how small business partners can correctly file taxes for themselves and their businesses.
Is Profit-Sharing Important for Partnerships?
Many partners have questions about profit-sharing. They wonder how the process works within a small business partnership and whether it is an effective strategy for dividing payments.
Profit-sharing can help partners protect themselves and their interests before the company begins operating. Then, when partners can successfully agree on how to share profits, they go into the partnership ready to work together and maximize the company’s earnings.
How Are Profits Split Up When Profit Sharing?
It is up to the partners to divide the company profits as they see fit. When writing the partnership agreement, all business partners must collaborate, and part of that collaboration agrees on the profit-sharing numbers.
Some partners decide to split profits equally. In other configurations, the company pays each partner a different salary, and the remaining profits are divided.
For example, Winny and Kevin open a juice stand on the beach and decide to make Juicy Fruits an equal partnership. However, since Juicy Fruits uses a 50-50 split, both partners must discuss how to divvy up the profit shares.
Kevin proposes that the business pay him 65% of the profits based on his initial investment, but Winnie disagrees. So finally, the two entrepreneurs settle on paying Winnie 45% and Kevin 55%, and since both partners approve, they can move forward.
When partners decide on an uneven partnership ratio, the partner with the larger share can decide on the final terms of salaries and profit-sharing.
We’ve noted that a formal profit-sharing agreement is crucial for all small business partnerships. This document should be approved and signed by all partners before the company opens its doors. Do not forget that the profit-sharing agreement should also address the division of losses.
Which Profit-Sharing Percentages Most Commonly Used?
Since small businesses come in every shape and size and exist across all different industries, there is no specific profit-sharing percentage that works for everyone. However, when working on the profit-sharing agreement, here are a few questions for partners to consider:
- What is the total number of partners?
- How much does each partner work in terms of hours?
- What are each partner’s responsibilities, if they vary?
- How much experience does each partner have?
- How much has each small business partner invested in the business?
While 50-50 partnerships are popular, they only work if the partners are equally involved in the business. Unfortunately, when small business partnerships feature partners with disproportionate roles, an equal partnership can lead to problems.
The key to negotiating and choosing the right profit-sharing percentage for your business is to start the process openly, be honest about responsibilities and experience, and do what works for all partners. A clear and equitable profit-sharing agreement benefits everyone and will help the company start on the right foot.
Can All Partners Participate in Profit-Sharing?
Partners are eligible for profit-sharing based on the company’s established partnership agreement and the profit-sharing agreement within.
While enlisting the help of an accountant and a professional attorney is helpful at this juncture, the key is to hold productive talks among partners. Every partner should be aware of their role in the business and be content with their share of the profits. When partners are unhappy with the profit-sharing agreement, discontent and disputes can quickly build.
Why Do Some Partners Refuse to Share Profits?
Some small business partners did not expect to share their profits and are unhappy with the proposed arrangement. In this case, if the business is still in its infancy, the partners should try to explore further negotiations and new percentage splits.
In other cases, a profit-sharing agreement works for a few months or years, but as the business changes, partners begin to question the terms of the agreement. Sometimes, partners feel their profits do not match the time and work they invest in the business.
For example, Taryn and Samantha started a jewelry business called Sparkles as equal partners and decided to share all profits equally. The two women are promising young entrepreneurs, and they carefully draft their partnership agreement and profit-sharing agreement. During the first year, the company’s stock rises, business is brisk, and Samantha and Taryn work diligently to promote and run the company.
However, during the second year, Taryn starts her small sole proprietorship and begins paying less attention to Sparkles. Taryn is content to let Samantha and their hired employees run day-to-day operations, and she no longer works 45 hours per week as she used to. Taryn, a skilled marketer, also does not help with the jewelry store’s outreach anymore.
Samantha ultimately decides she must speak to Taryn about restructuring their profit-sharing agreement. Unfortunately, Samantha has no other job or project and is all-in on Sparkles. Luckily, the two women can successfully restructure the company’s profit-sharing agreement with the help of an attorney. Although the two women no longer share profits equally, they agree on the division of labor and profits, and business continues to rise.
Often, a profit-sharing agreement pays off and can remain unaltered, but the possibility exists that the partners may need to change the document at some point.
Making a plan to reevaluate the company’s profit-sharing agreement is an excellent strategy for small business partners. For example, the partners can agree to come back to the agreement in six months or a year simply to ensure that all partners are still happy with the division of profits. This strategy of reevaluation will also help partners anticipate problems and keep disputes from harming and disrupting the business.
When is the Right Time to Contact Nakase Wade?
Small business partnerships are an excellent choice for many aspiring entrepreneurs, but these entities also come with their share of questions. For example, many would-be business partners have questions about how payments work in business partnerships, and that makes sense: everyone wants to know when their next paycheck is coming.
If you are debating forming a small business partnership, let us help. Our California business lawyers and corporate attorneys provide varied assistance to business partnerships, from helping with partnership agreements to consulting about profit-sharing plans.
At Nakase Wade, we know that the secret to a successful partnership lies in the ability of the partners to cooperate and work together for a common goal. As a result, we are with our clients every step, from when the company’s doors open to the final fiscal year.
Even the most successful companies require adjustments along the way. Sometimes, partners need to revisit their partnership agreements. Then, as the company evolves, business owners return to their profit-sharing agreements to make salaries and rates more equitable.
When you need a skilled business lawyer you can count on for help with your small business partnership, contact Nakase Wade. We offer free consultations, and if you have a question about business partnerships, chances are we know the answer.
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