Partnership

7

What is a partnership?

Partnerships are a common form of business structure that have existed for hundreds of years, alongside sole proprietorships. However, identifying whether a partnership exists and understanding its terms can sometimes be unclear, both in common law and for tax purposes.

A partnership is when two or more people work together in a business with the aim of making a profit. This common law definition of a partnership is just one aspect of how partnerships are legally recognized and regulated. Additional legal aspects to consider include:

  • In Australia, every state has passed laws that specify how partnerships are recognized, outline the rights and responsibilities of partners, and establish how partnerships are treated in the eyes of the law.
  • Some states in Australia have gone a step further by enacting legislation that allows for the creation of limited partnerships, a specific type of partnership structure with unique characteristics.
  • Australia’s federal tax laws also acknowledge a specific type of partnership for tax purposes. While it resembles a common law partnership in many ways, it doesn’t quite meet all the criteria.

In tax law, a partnership is defined as an association of individuals who either operate a business together as partners or receive income jointly. Notably, this definition excludes companies from being classified as partnerships.

This statutory definition of a partnership is more expansive compared to the typical definitions found in common law or state partnership laws. It includes not only individuals engaged in a joint business venture with the intent to make a profit but also those who share income jointly, even if they aren’t necessarily involved in a common business venture as partners.

Who can be a partner?

In the context of a partnership, a person can refer to a variety of entities, including:

  • Individuals: This includes individual people who enter into a partnership agreement.
  • Companies: Companies, as legal entities, can also be partners in a partnership.
  • Trustees of Trusts: The trustees responsible for managing trusts can participate as partners.
  • Other Partnerships: It’s possible for one partnership to have another partnership as a partner, creating a layered or complex partnership structure.
  • Associations (with exceptions): Certain associations can be partners, though specific exceptions may apply.

Types of partnerships

Partnerships come in different forms, each with its own characteristics:

General Partnership: In a general partnership, every partner assumes unlimited liability for the debts and obligations incurred by the partnership business. This means that personal assets of each partner are potentially at risk to cover the partnership’s obligations.

Limited Partnership: In a limited partnership, partners’ liability is restricted to the amount of capital they have contributed to the partnership. This arrangement provides a level of protection for the personal assets of partners, as their exposure is limited to their investment.

Incorporated Limited Partnership: An incorporated limited partnership allows partners to have limited liability for the partnership’s debts and obligations, but a crucial requirement is that there must be at least one general partner with unlimited liability. This structure provides a balance between limited liability and the need for at least one partner to bear the full responsibility of the partnership’s obligations.

Two woman discussing while looking at a laptop.

Pros and cons of partnership

Advantages

Resource Pooling: Partnerships allow individuals or entities to combine their resources, skills, experiences, and networks, which can enhance the overall strength of the business.

Affordable Setup: Establishing a partnership is cost effective compared to forming corporations. It involves less paperwork and administrative requirements.

Flexibility: Partnerships offer flexibility in how they operate. Partners can define their roles, decision making processes, and profit sharing arrangements as they see fit.

Simplified Taxation: Partners report their share of partnership income on their personal tax returns, simplifying the tax process.

Disadvantages

Unlimited Liability: Partners are personally responsible for the partnership’s debts, potentially putting their personal assets at risk if the business faces financial difficulties.

Conflict Potential: Collaborative decision making can lead to disagreements among partners. A formal partnership agreement is recommended to outline roles, responsibilities, and dispute resolution mechanisms.

Profit Sharing: Partners must share profits, even if one partner has invested more capital in the business.

Partnership Changes: When a partner joins or leaves the partnership, the existing partnership must be dissolved and reestablished, incurring additional costs and complexities.

Asset Vulnerability: There is limited protection for personal assets in case of business debt.

Business Continuity: Changes in partner membership can alter the partnership’s dynamics and impact its continuity.

Transfer Challenges: Transferring partnership interests is more complex than selling company shares.

Partner Limits: Partnerships cannot have more than 20 partners, and certain qualified professionals may face restrictions on entering partnerships with unqualified individuals.

Tax Reporting: Partnerships must file an annual partnership tax return to report income and expenses.

When to use a Partnership Structure

Offsetting Revenue Losses (Subject to Compliance)

Partnerships can be an excellent choice when a business anticipates revenue losses in the near term. Partners in a partnership structure have the benefit of offsetting these losses against income from other sources, but this is contingent on adhering to the rules outlined in the non commercial business activities

Family Businesses

Family owned businesses often find partnerships appealing because they allow for a relatively informal relationship between family members who are involved in the business. This informality aligns well with the dynamics of many family run enterprises.

Professional Practices and Contractual Requirements

In certain professional fields, such as law or medicine, partnerships are commonly chosen because professional associations may necessitate that participants contract in their own names rather than through alternative legal structures.

Holding Appreciating Assets

Partnerships can be strategically advantageous when they hold assets expected to appreciate in value over time. Individual partners can benefit from the 50% Capital Gains Tax (CGT) discount, offering a significant tax advantage in such scenarios.

Multiple Equal Participants and CGT Concessions

Partnerships become a suitable choice when a business involves more than two equal participants. In these cases, partners may be eligible for various CGT small business concessions, which can result in substantial tax savings.

Partnership for investing

Passive Investment in Partnerships

  • When a partnership focuses on passive investments, it resembles a collective investment or joint venture more than a traditional partnership because partners are not actively running a common business.
  • Despite the absence of active business activities, such partnerships are still classified as tax law partnerships for taxation purposes, subject to relevant tax provisions.

Key Aspects of Using Partnerships for Investments

  • Each partner is taxed individually on their share of net partnership income or loss from the investments, which can be offset against income and losses from other sources.
  • Partners, for Capital Gains Tax (CGT) purposes, hold a direct interest in underlying partnership assets and a partnership interest represented by the chose in action among partners.
  • Joint ownership of partnership assets does not disqualify individual partners from claiming the general 50% CGT discount on capital gains arising from these assets. However, the entitlement to this discount must be assessed at the individual partner level.
  • Partners are unlikely to qualify for CGT small business concessions since partnership assets are generally passive and not considered active assets for these purposes.

Suitability of Partnership as an Investment Structure

Partnerships are well suited for negatively geared property acquisitions, allowing partners to claim deductions related to partnership property at their individual level and offset them against other income.

If significant capital gains are expected, partners may benefit from the 50% CGT discount.

When there is no need for post formation capital raising and the partnership’s property has already substantially increased in value, a partnership can be a suitable investment structure.

Thus, partnerships are a versatile choice for investment structures, offering tax benefits and flexibility, especially for passive investments and capital gains scenarios.

Two woman talking while sitting on a coffee table.

Setting up a Partnership

Beginning a partnership involves a series of essential steps to ensure a smooth and legally sound start to your business venture. Here are the key steps:

  • Determine the partnership structure, whether it involves individuals or entities like companies or trusts.
  • Draft a comprehensive partnership agreement outlining roles, responsibilities, profit sharing, and dispute resolution.
  • Register the partnership with necessary registrations

Determine the Partnership Structure

In the context of forming a partnership, it is essential to take into account the scope and structure of the partnership. A partnership can involve two or more parties, including:

  • Individuals
  • Entities such as companies or trusts

Seeking professional tax advice is advisable to determine the most advantageous structure based on the specific circumstances, particularly with regard to minimising tax obligations.

Furthermore, it is worth noting that when operating under a corporate structure, such as a company or a corporate trustee of a trust, certain considerations apply:

  • Higher Initial Setup Costs: Establishing a corporate structure typically incurs higher initial expenses due to legal and administrative requirements.
  • Ongoing Regulatory Requirements: Corporate structures generally entail continuous compliance and reporting obligations to regulatory authorities. This differs from operating as an individual, which generally involves fewer regulatory requirements.

Create a Partnership Agreement

A partnership agreement is a formal document that confirms the intention of the partners to engage in business as a partnership, operating according to the terms specified within the agreement. This agreement must be in written form and plays a critical role in outlining how the partners collectively intend to manage and operate the business.

Within the partnership agreement, it is imperative to clearly delineate the rights and responsibilities of each partner. This includes details regarding how they will conduct business, distribute profits, and allocate losses. Specifically, the partnership agreement should:

  • Identify the names and addresses of all partners involved.
  • Document the capital contributions made by each partner to establish the business.

The agreement should also address various operational aspects, including:

  • The method by which profits generated by the business will be shared among the partners.
  • The designation of individuals authorized to make decisions on behalf of the business.
  • The procedures for executing formal documents on behalf of the partnership.

Additionally, it is essential to include provisions for resolving disputes and establishing procedures to be followed in significant events, such as:

  • The death or retirement of a partner.
  • The admission of a new partner into the partnership.

Furthermore, the partnership agreement should detail the processes to be followed in the event of bankruptcy and provide a clear framework for dissolving the partnership if such action becomes necessary.

Thus, a comprehensive partnership agreement serves as a vital instrument in minimizing the potential for disputes among partners. It serves as a documented record of the agreements made during the establishment of the partnership, promoting clarity and reducing the risk of future disagreements and complications.

Register the Partnership

The last step in establishing a small business partnership involves the formal registration process.

Initially, the partners are required to secure an Australian Business Number (ABN) through the Australian Business Register. Additionally, they must proceed to register a business name with the Australian Securities and Investment Commission (ASIC).

However, if the partnership intends to operate using the names of the partners, for instance, D Scott & J Scott, a separate business name registration is not obligatory.

In situations involving silent partners, it is imperative to complete a limited partnership formation registration.

Tax related registrations are also necessary, including:

  • Tax file number (TFN).
  • Goods and Services Tax (GST) if the partnership’s annual turnover surpasses the GST registration threshold.
  • Pay As You Go withholding (PAYGW) registration if the intention is to employ people.

Partnership Tax

There are two common categories of partnerships from a tax perspective. Firstly, a general law partnership which is a partnership through which a business is conducted. Secondly, a tax law partnership which does not involve carrying on a business but generally describes persons in receipt of income jointly from jointly owned assets.

For example, a rental property owned jointly by spouses is a form of tax law partnership. A partnership also encompasses a limited partnership but specifically does not include a joint venture arrangement. Limited partnerships and joint ventures are taxed differently to general law and tax law partnerships. These are not addressed in this article.

The partners of a partnership are the persons taxed on taxable income or ‘net income’ which is produced within the partnership. The partnership itself is not taxed. However, it is necessary that the net income of the partnership is calculated and an annual partnership tax return is lodged (as if the partnership were a stand-alone entity).

The net income of the partnership is calculated according to Division 5 of the Income Tax Assessment Act 1936 as follows:

assessable income less allowable deduction as if the partnership were an Australian taxation resident (with exceptions). Once the net income (or loss) of the partnership is calculated, an allocation of the net income to partners occurs. Essentially, each partner will include in their assessable income, ‘…so much of the individual interest of the partner in the net income of the partnership of the year of income…’. (Section 92 of the Income Tax Assessment Act 1936).

Note that accounting profit and the partnership agreement considered together determine each partner’s percentage ‘interest’ the partnership profits. The partnership net income or loss is then, on a proportionate basis (similar to trusts) allocated to partners according to each percentage interest.

Therefore, the steps below should be followed each year to determine the tax position of each partner in the partnership:

Step 1. Calculate partnership accounting profit or loss for the income year

In some instances, there will be no difference between accounting profit / loss and net income / loss. However, there are technical differences between the two concepts and you should understand when variances can arise. Generally, a qualified accountant would assist to prepare the partnership financial statements and determine the accounting profit or loss.

Step 2: Calculate partnership net income or loss for the income year

Assessable income less allowable deduction as if the partnership were an Australian taxation resident (with exceptions).

Note that partnership assessable income does not include capital gains. These are taxed exclusively in the hands of each partner based on fractional ownership interest in the underlying CGT asset. Also note the following items which are not deductible against partnership net income:

  • personal superannuation contributions (may be deductible to partner in their own tax return)
  • drawings
  • interest paid on capital
  • salaries to partners
  • prior year losses (may be utilised by the partner in their own tax return).

Salaries to partners

A partner salary is treated as a profit allocation prior to the general division among the partners – hence it is not deductible.

Derivation of income

Income is assessable income when it is ‘derived’. In respect of partnerships, this occurs at the point in time when the partnership itself derives the income, not when partners themselves receive the income.

Prior year losses

Any tax loss allocated to partners may be deductible for the partner personally. For example, assume there is a married couple which jointly owns an investment property 50/50. The property is negatively geared and produces an annual tax loss of $10,000. Each partner may include their proportion of the loss, being $5,000 (50% of $10,000) as a deduction against their other assessable income e.g. their salary.

Step 3: Calculate each partner’s percentage entitlement to accounting profit or loss

The partners of the partnership are generally entitled to share profits (or required to bear losses) in accordance with the terms of the relevant partnership agreement. Therefore, refer to the partnership agreement in the first instance to determine each partner’s percentage entitlement to profits or losses.

Note that joint owners under a tax law partnership are not permitted to determine a partner’s entitlement to accounting profit by agreement. Each partner’s percentage entitlement is determined by percentage ownership interest in the underlying assets.

For example, a rental property owned by a married couple 50/50 with an accounting profit and net income of $10,000 for financial year 2023 must be split such that each spouse is assessed on half of the net income, being $5,000 each.

Note that where the property investment activity by the spouses / partners was sufficiently ‘business-like’, the activity may in fact constitute a ‘business’ of investment. In this instance, a general law partnership would exist and the entitlement of each partner could be manipulated by terms of a partnership agreement.

There are a number of factors to be considered in determining whether a business is carried on in a partnership. These factors are set out and considered in Taxation Ruling 94/8. Generally, the higher the degree of active involvement and business-like behaviour, the more likely there will be a business.

In this instance, to carry on with the example above, the married couple could agree by partnership agreement that the first spouse should receive all profits. The first spouse would therefore be assessed on 100% of accounting profit i.e. $10,000. There are obvious tax planning opportunities related to general law partnerships which are not available to partners in a tax law partnership.

Step 4: Calculate each partner’s assessable income / tax deduction

For each partner, multiply the percentage entitlement of each partner calculated at step 3 by the net income of the partnership calculated at step 2.

Worked example incorporating steps 1–4:

Partner A and Partner B run a business through a partnership. At the end of the financial year, the accountant determines the partnership accounting profit is $100,000 and determines partnership net income is $60,000.

In this instance, the reason there is a difference between accounting profit and net income is because the partnership was permitted under tax law to write-off certain assets in the year of purchase.

For accounting purposes, the asset could only be ‘expensed’ or ‘depreciated’ over a period of 10-years, being its useful life. This created a mismatch between accounting profit and taxable income (a common occurrence in practice). The partnership agreement provides that Partner A is entitled to the first $70,000 of partnership profits and the remainder is allocated to Partner B.

Step 1: Calculate partnership accounting profit or loss for the income year
$100,000.

Step 2: Calculate partnership net income or loss for the income year
$60,000.

Step 3: Calculate each partner’s percentage entitlement to accounting profit or loss
Based on the terms of the partnership agreement, Partner A is entitled to the first $70,000 of partnership profits. Here, partnership profit is $100,000. Therefore, Partner A has a percentage entitlement to profits of 70% ($70,000 / $100,000). Partner B is entitled to the remaining profit of $30,000 and therefore has a percentage entitlement of 30% ($30,000 / $100,000).

Step 4: Calculate each partner’s assessable income / tax deduction
The percentage entitlement of each partner calculated at step 3 is used to calculate their share of net income of the partnership. Here, Partner A will include in their personal tax return as assessable income $42,000 (70% share of partnership profit x $60,000 net income). Partner B will include in their personal tax return as assessable income $18,000 (30% share of partnership profit x $60,000 net income).

Partnership salary for tax purposes

As mentioned, a partner salary is considered to be a profit allocation and is not deductible. The payment of the salary to a partner will vary the recipient partner’s interest in the partnership profit (and therefore the partner’s interest in the net income of the partnership).

An example of the implications of a partner salary is shown below.

Example
There is a business run through a two-person general law partnership involving partner A and partner B. The accounting profit for the financial year is calculated as $100,000. The partnership net income is calculated as $150,000. Pursuant to terms of the partnership agreement, partner A is paid a salary of $50,000 and the remaining profit is split 50/50 between the two partners.

Step 1: Calculate partnership accounting profit or loss for the income year
As above, $100,000.

Step 2: Calculate partnership net income or loss for the income year
As above, $150,000.

Step 3: Calculate each partner’s percentage entitlement to accounting profit or loss
For Partner A, interest in partnership accounting profit = 75%.

That is, $50,000 salary + (50% equal share to residual post-salary profits x ($100,000 partnership accounting profit – $50,000 salary)) = $75,000. Percentage entitlement: $75,000 share of partnership profit / $100,000 partnership accounting profit = 75%.

For Partner B, interest in partnership accounting profit = 25%.

That is, 50% equal share to residual post-salary profits x ($100,000 partnership accounting profit – $50,000 Partner A salary) = $25,000. Percentage entitlement: $25,000 share of partnership profit / $100,000 partnership accounting profit = 25%.Step 4:

Calculate each partner’s assessable income / tax deduction
For Partner A, assessable income: $112,500.

That is, 75% partnership interest percentage x ($150,000 net income of partnership / $100,000 accounting profit).

For Partner B, assessable income: $37,500.

That is, 25% partnership interest percentage x ($150,000 net income of partnership / $100,000 accounting profit).

Note that where the partner salary exceeds the partnership accounting profits, the surplus will apply against accounting profits in future income years and in so doing will vary the partnership interests (in the same manner as above) in those future income years.

Variation of partnership interests

A variation of interests in a partnership can occur where a partner retires or becomes deceased or where a new partner joins the partnership. The variation will generally have the technical impact of causing the partnership to cease and a new partnership to commence.

This regularly presents a tax problem for partnerships as the cessation and creation of a partnership is a trigger point for various taxation events. In these instances, assets of the partnership are deemed to have been disposed by the old partnership and acquired by the new partnership.

Specific tax consequences can include

  • capital gains tax (at the partner level).

  • assessable amounts from balancing adjustments in relation to depreciable assets.
  • trading stock notional disposal.
  • the requirement to prepare two (or more) tax returns for the year. This includes a return for
  • the old partnership and a separate return for the new partnership.

There are various concessions which may be available to avoid these often undesirable tax consequences.

For example, the partners could consider:

  • Including a partnership continuity clause in a partnership agreement that provides that continuing partners are permitted to carry on the business with no need to take accounts. If this occurs, the ATO will treat the partnership as a reconstituted partnership. Only one partnership tax return will need to be lodged.
  • Taking steps to best ensure previous partners maintain an ownership interest of at least 25% in trading stock. A trading stock election can be made that prevents the trading stock from otherwise being deemed ‘disposed’ for market value.
  • Taking steps to best ensure that certain partners continue to hold at least a part interest in depreciable assets before and after variation. An election can be made such that disposal proceeds of a depreciating asset are deemed to be current written-down value. The implication being that no assessable balancing adjustment is required.

Dissolving a Partnership

Dissolution of a business partnership

A business partnership can come to an end for various reasons, including:

Expiration of Partnership Agreement: When the partnership agreement outlines a specific term, and that period reaches its conclusion.

Legal Ownership Issues: If a partner becomes legally disqualified from owning or operating a business, the partnership may need to dissolve.

Court Ordered Dissolution: Circumstances that warrant a court ordered dissolution include:

  • A partner being declared permanently mentally unfit.
  • A partner becoming permanently incapable of fulfilling their partnership obligations.
  • A partner engaging in conduct detrimental to the business.
  • Willful or persistent breach of the partnership agreement by a partner, making it impractical for others to continue.
  • The business becoming financially unsustainable.
  • Any other situation where dissolution is deemed just and equitable.

Bankruptcy: If a partner goes bankrupt, it can trigger the dissolution of the partnership.

Death of a Partner: The death of a partner results in the dissolution of the partnership unless the partnership agreement states otherwise.

Business Bankruptcy: If the business itself goes bankrupt, it can lead to the partnership’s dissolution.

Dissolution by Partnership Agreement

Partnerships typically have a partnership agreement that specifies when and how the partnership can be dissolved. This agreement may stipulate dissolution under conditions such as:

  • The partnership having a fixed time frame, which has concluded.
  • The partnership being established for a single project that has been completed.
  • The partnership being open ended, but a partner has given notice of their intent to dissolve it (subject to the requirement of unanimous consent).

Dissolution due to Death, Bankruptcy, or Illegality

According to the law, every partnership dissolves when:

  • A partner passes away or becomes bankrupt.
  • An event occurs that renders the partnership business unlawful or prevents partners from conducting it together.

Ending a Business Partnership

The process of ending a business partnership is typically outlined in the partnership agreement. In cases where no such agreement exists, the process is guided by legal provisions.

Considerations before dissolving a partnership

Before proceeding with the dissolution of a partnership, partners should carefully consider the future of the business and their individual plans post dissolution. Key considerations include:

Closing the Business

  • Filing final tax returns and Business Activity Statements.
  • Closing bank accounts associated with the business.
  • Cancelling relevant insurance policies.
  • Deregistering the business with the Australian Securities and Investments Commission (ASIC).
  • Settling any outstanding debts.
  • Ensuring payment of employee entitlements if applicable.

Continuing the Business

  • Establishing a new business structure if the business is to continue.
  • Obtaining a new ABN and TFN if the business is converted to a company.

Careful planning and documentation are essential to ensure a smooth and legally compliant dissolution process, whether partners choose to close the business or continue it under a new structure.

Documenting a partnership dissolution

When dissolving a partnership, it is advisable to formalize the process through a deed of dissolution. This legal document outlines the terms and conditions of the dissolution, future plans for the business (if it continues to exist), and how partners can engage with each other and the business post dissolution.

Key Components of a Deed of Dissolution

A typical deed of dissolution includes provisions such as:

  • Buyout Terms: Details on how a partner’s exit from the partnership will be financially settled, including the purchase price.
  • Contract and Customer Management: Instructions for managing existing contracts and customer relationships within the business.
  • Intellectual Property: Guidelines for handling the intellectual property assets of the business.
  • Restrictive Clauses: Provisions related to restraints, non compete agreements, and confidentiality clauses.

This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.