You and your friends or colleagues have a great business idea and are ready to launch a startup. Great. But where do you begin? While having multiple people start a business together can be an exciting venture, before getting too ahead of yourselves it’s important to start your partnership with a written agreement to lay out duties and allocations of tax and economic items.
Partnership agreements usually include some confusing language sprinkled with the occasional “whereof” or “heretofore” just to let the reader know, “This is a legal document.” After cutting through the legal jargon, most partnership agreements are laid out similarly and aren’t as hard to understand as it might seem.
Understanding the partnership economics of transactions and how this relates to partnership agreements, allocating income and deductions and capital accounts will help translate some of the legalese that is hard to follow. For startups, it’s important to understand the details in the partnership agreement since this will govern how the partnership operates. We will cover these items and more to give a peek behind the scenes of transactions in a partnership.
What is a partnership agreement?
In its most simple form, a partnership agreement is a legal document that dictates how a business formed as a partnership will operate. Generally, the partnership will include the basic items related to the partnership such as: name, purpose, formation, management duties and decision-making, and withdrawal or addition of new partners.
We’ll dig into the more complicated issues like tax matters, capital accounts, profits and losses allocations and partner interest.
When reading a partnership agreement, there are two sections that will help navigate and better understand the document: the table of contents and the definitions section. The table of contents will allow you to find the specific item you are looking for to cut through some of the common boilerplate language. The definitions section will give you better familiarity with the terms inside the document.
These two sections are important tools when moving through the partnership agreement. After familiarizing yourself with the definitions, it’s important to have a general idea of what you want to accomplish while reading the document.
With that said, we would advise against reading through the entire document in one sitting. Take your time and use research tools for terms that aren’t defined.
Understanding capital accounts
The capital accounts section, sometimes called capital contributions, distributions, and allocations of income and losses, will give information on making capital contributions, what happens when the partners’ capital account is in a deficit position, information regarding the distributions of capital, and partners’ interest, etc.
Clearly, partners will have an incentive to understand this section since this is where they determine how much money to put into the partnership as well as how much money they can take out of the partnership. In general, the capital accounts section may designate a capital commitment from each partner, which will most likely reflect how much interest and the type of interest (capital vs. profits interest), they receive in the partnership. Once a partner has an idea of how much they will need to contribute, the next question is, “when can I take money out of the partnership?”
The agreement normally specifies whether the partnership distributes on a regular basis or when certain targets are met, but there are unlimited options that can be included within this section, so it is very important to review and understand the options.
Economics of partnership transactions
Usually, under the economics of transactions section, a partner is allocated items of income and deduction based on their interest in the partnership. The partnership agreement can specially allocate items like income, deductions, gain, credits and other tax items. However, if the allocations do not follow normal ownership interest allocations and instead are specially allocated, the allocations must have substantial economic effect.
If the partnership agreement attempts to make allocations without substantial economic effect, the allocation must be in accordance with the partners’ interests in the partnership rules in Section 704(b). In other words, the allocations must make logical sense to someone looking in from the outside.
At a high-level view of the economics of partnership transactions, when a partnership is making money, the allocation of income is typically straightforward. A partner will receive a schedule K-1 with their share of the income based on their interest in the partnership as reported in the partnership agreement. Similarly, losses will be allocated based on partners’ interest; however, when a partner runs out of capital, the losses are then allocated to the partners who funded the rest of the capital.
It sounds confusing, but it makes sense when you think about it. The partner who is funding the losses is the one who receives the benefit of showing a loss on their schedule K-1. This means that a loss may need to be specially allocated to the partners showing a positive capital account. Keep in mind that other items such as credits and gains may be allocated differently based on the partnership agreement as briefly discussed above.
Also note the above example strictly shows the economics of the transactions in a partnership. That being said, there is a chance that the partnership agreement could overrule the economics and allocate losses based on ownership percentage even if the capital account is negative. That is why it is so important to understand the effect of both the economics of transactions as well as the partnership agreement when forming a new partnership. It is also a good idea to review the agreement occasionally to make sure the terms in the agreement continue to make sense as the business grows.
Anders CPAs + Advisors works with startups and entrepreneurs on their financial needs so they can focus on what they do best. Contact an Anders advisor for assistance in reviewing your partnership agreement.
Every day at Anders, we serve as a catalyst for those striving to achieve their highest potential, and carry this mentality on to our clients and community. Through a collaborative approach and a combination of tax, audit and advisory services, we help our clients achieve their goals.
As a tax supervisor at Anders, Max Goewert works with startups, individuals and privately-held businesses on tax and financial planning opportunities. He started as a tax intern at Anders and worked his way up to supervisor. Goewert enjoys helping clients, including startup companies, minimize their tax and compliance burdens.
