What is a Partnership?
Partnerships are a common form of business structure that has been around for a long time, 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, in essence, is when a group of 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:
- 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.
Partnerships in Tax Legislation
In tax legislation, 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.
The specific exclusion of companies from this definition serves to prevent the argument that a company could be classified as a partnership for tax purposes. Companies have distinct legal characteristics and are treated differently in tax law.
Treatment of Trusts
Unlike companies, trusts are not explicitly excluded from this definition. This is because trusts, specifically their trustees, often do not meet the criteria of the positive aspect of the partnership definition.
Trustees typically receive income on behalf of the trust and may later distribute it among multiple beneficiaries.
While in some cases, a statutory partnership could potentially exist between co trustees, it can be argued that a true partnership doesn’t exist because the co trustees are not in beneficial receipt of the income themselves.
The Partnership Business Structure – When and Why to Use It
Partnerships offer a versatile business structure that is commonly chosen for various reasons due to their flexibility and potential tax benefits.
Below, we explore situations in which partnerships are particularly advantageous:
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 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.
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.
Key Steps To Start 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 six 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 officially to ensure legal recognition and compliance with relevant regulations.
- Register for tax purposes, obtaining necessary tax identification numbers or registrations as required.
- Establish a dedicated business bank account to separate business finances from personal ones.
- Apply for any licenses or permits required for your specific business activities and location.
Now, we will explain all these steps in detail:
Considering the Partnership's Scope
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:
- 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.
Once a decision is made concerning the entities or individuals that will constitute the partnership, the next crucial step involves creating a partnership agreement.
This agreement serves as a comprehensive document that clearly delineates how the partnership will be managed.
It outlines roles, responsibilities, profit sharing arrangements, and procedures for resolving disputes within the partnership.
Creating 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.
Registering the Partnership
The subsequent 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.
Addressing Taxation Registrations
Following the partnership’s registration, it becomes essential to attend to various taxation related registrations, which may include the following:
Establishing a Partnership Bank Account
In the final phase of setting up a partnership, it is essential to create a dedicated bank account for the partnership entity. This serves a crucial purpose in tracking the inflow and outflow of business finances, maintaining accurate financial records, and facilitating the accurate submission of taxation related documents.
It is worth noting that access to this partnership bank account may be governed by the terms and conditions outlined in the partnership agreement.
For instance, the agreement may specify that one partner is entrusted with the authorization to oversee and access the bank account, while other partners may have distinct responsibilities and varying levels of access.
Obtaining the Requisite Licenses
Lastly, to operate the business in compliance with regulatory requirements, obtaining the necessary licenses is imperative. The specific licenses and registrations needed can vary considerably based on the industry in which the business operates.
To assist in identifying and acquiring these essential licenses, regulations, and council approvals, the Australian Business Licence and Information Service offers a helpful questionnaire tailored to the unique requirements of the business activities.
Pros and Cons of Partnership in Australia
Partnerships offer distinct advantages and disadvantages worth considering when choosing a business structure. Let’s explore these one by one:
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.
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.
The Partnership as an Investment Structure
Partnerships are not only used for operating businesses but also serve as investment structures for various purposes.
However, it’s important to distinguish between partnerships primarily engaged in passive investment and those aligned with business activities.
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.
Partnerships vs Joint Ventures
A joint venture differs from a legal partnership (as discussed earlier) primarily in its nature. Unlike a partnership, a joint venture doesn’t involve sharing profits. Instead, it revolves around sharing costs and resources to collectively maximize returns from a specific project, which generates distinct outputs for each party involved.
These outputs can then be managed individually by each party, creating separate and independent sources of income or profits.
Furthermore, a joint venture is distinct from a tax law partnership in the sense that the participants in a joint venture do not receive income jointly.
In a tax law partnership, income is typically received jointly and reported as such for tax purposes. In contrast, a joint venture allows for separate handling of income by each participating entity or individual.
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.
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.
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.
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.