How to Split Profits in a Small Business Partnership
Starting a business is hard work and sometimes having a helping hand can make all the difference. If you’re considering going into business as a partnership, then you’ll need to be prepared to split the profits. But what’s the best basis for doing so—especially if one partner contributes more work hours, invests more money into the business, or even sets up your business line of credit?
Here’s what you need to know to plan your profit-sharing strategy in a small business partnership, plus some other steps you can take to make that partnership airtight.
Formally structure your small business
Before you make any decisions about splitting profits with your business partners and create a partnership contract for your small business, talk to a lawyer about the best way to legally structure your business.
If you want to go from a sole proprietorship model to a partnership model, here are a few business structure options for you to consider. Two of these are general partnerships and limited liability partnerships. Let’s look at both.
The simplest route is to form a “general partnership”, simply register your “doing business as (DBA)” name and open a bank account in the business’ name. This structure assumes that all profits, liability, and management duties are equally divided among the partners. If the partnership is unequal, such as a 30-70 ratio, then you’d need to document the percentages assigned to each partner in the partnership agreement (more on that later).
Limited Liability Partnerships:
Another option is a “limited liability partnership” also known as an LLP. Professional partners, such as lawyers or accountants, are often advised to go this route since it protects the business owners from personal liability for the debts or liabilities incurred by the partnership. For example, if you run into a cash flow issue and your business fails, neither partner will be personally liable for any debts owed to creditors. Another option is a “limited partnership (LP)” in which one partner invests in the business but doesn’t manage it, leaving that task to one or more of the other partners.
Research these options to understand which makes more sense for you. You may want to ask your financial advisor or lawyer for advice about this, especially when it comes time to register your business as a chosen entity, such as an s-corp.
Decide how you’ll split profits
In a business partnership, you can split the profits any way you want, under one condition—all business partners must be in agreement about profit-sharing. You can choose to split the profits equally, or each partner can receive a different base salary and then the partners will split any remaining profits. How you choose to structure your profit-sharing agreement will be up to the business partners to decide.
Remember, in an equal partnership (50-50) neither partner can make a decision without the other’s approval, whereas in a 51-49 ratio, for example, one partner has final authority. (Read more about setting your salary as a business owner.)
If you know ahead of time that one or more partners will only play a minor role in income generating activities, you might agree to pay the more active partner a higher salary. Another option you have is to pay partners only for work performed based on predetermined rates for certain projects.
Whatever you decide, it’s a good idea to create a profit-sharing agreement and make it part of your larger partnership agreement. All partners should agree and sign, to prevent problems later.
Put everything in writing with a partnership agreement
A partnership agreement is the business version of a prenuptial agreement and should be completed before you start operations and any profits are made (the division of profits is a critical part of this process). Although an agreement is not legally required, it can protect your interests as one half of the partnership for the duration of your partnership and through its dissolution.
Things to include in the agreement include the following:
- Division of profits. This includes both the division of profits and losses and how and when each partner will get paid.
- Contributions to the partnership. If either partner contributes any assets to the business, whether it’s cash, property, or equipment, you’ll need to ensure these are documented.
- Business decision-making. What authority does each partner have to make business decisions? How will you handle disputes? How will you handle the dissolution of the partnership when that time comes?
- Who does what. Divide up your management duties and document them in the agreement. For example, who handles media relations, payroll, etc.
Work with a lawyer and your accountant to develop and formalize the agreement, there are many factors that require consideration when forming any kind of partnership and getting legal and financial advice now will save you a lot of hassle in the long run. If you don’t have an accountant yet, check out our guide: How to Find the Right Accountant for Your Business.
Revisit the Agreement Annually
Let’s face it: business dynamics and personal relationships change. If your partnership has evolved over the past year or is likely to change in the coming year, it’s important that you revisit your partnership or profit-sharing agreement to reflect these subtleties. If you need to change your agreement drastically, consider bringing in the services of your lawyer or accountant to make sure everything is correctly documented.
Understand How Business Partnerships are Taxed
As you structure your profit-sharing agreement, you’ll also need to be aware of how the IRS taxes partnerships.
In a partnership, the business “passes through” any profits or losses to its partners. Partners include their respective share of the partnership’s income or loss on their personal tax returns. Partnerships do, however, need to file an annual information return (Form 1065), also known as a “Partnership Tax Return” to report income, deductions, gains, losses, and more with the IRS.
Partners are not employees and should not be issued a Form W-2. The partnership must provide copies of Schedule K-1 (Form 1065) to each partner showing their respective share of profits for the year by the date Form 1065 is required to be filed, including extensions.
Read more about partnerships tax obligations on IRS.gov.
Plan for a Happy and Profitable Partnership
Protecting yourself before you start a business partnership is your best strategy for ensuring the union is a happy one. To make sure you’re both getting the most out of this partnership, you’ll want to come to terms on profit-sharing. Let’s look at a few common profit-sharing questions for more insight into this important aspect of a partnership.
What is profit-sharing in a business?
How you decide to split your profits depends on your small business partnership agreement. When creating your partnership agreement, all the partners in the business need to agree on how to share profits. You may choose to share the profits equally or you may decide to pay each partner a set salary and then divvy up any remaining profits in a certain type of way.
If you form an equal partnership (50-50) between two people, you will both need to make decisions regarding profit-sharing together and will need each partner’s approval to make these decisions. However, if you have an uneven partnership ratio, the partner with the majority share in the business will get to make the final decision regarding profit-sharing and salaries.
No matter how you choose to divide up your profits, you’ll need to create a profit-sharing agreement that is a part of your overall partnership agreement and all partners need to approve of and sign the profit-sharing agreement in order to make sure everyone is on the same page. In this partnership, you’ll also want to put into writing how you will divide any losses.
What is a good profit-sharing percentage?
There is no one clear answer for what a good profit-sharing percentage is for all businesses. How many partners you have, how much work each partner does, the experience they bring to the table, and how much money each partner has invested in the business will likely play a factor in how you split up profits. While an equal 50-50 partnership may work for a business with two partners who are equally involved, other partnerships may not be built on such equal footing and may require that one partner receives more profits.
Who is eligible for profit-sharing?
Who is eligible for profit-sharing will depend on your profit-sharing and partnership agreements. Working with a lawyer and accountant to develop a profit-sharing agreement will help ensure that everyone knows exactly what their role in the business is and how that relates to their profits. You want to have a legal agreement in place to help avoid any confusion and disagreements from popping up in the future.
What are the disadvantages of profit-sharing?
The most obvious disadvantage of profit-sharing is that you have to share your profits. While sharing your profits with business partners may work well for a while, the profit-sharing agreement business partners originally put in place may not feel appropriate over time as the business evolves and changes. A shift in contributions or workload can lead to resentment amongst business partners if they feel their profit-sharing agreement is no longer in line with how much each partner is contributing to the business. In many cases, a profit-sharing agreement can work well and never need to be changed, but it is also a possibility that changes may need to occur over time.
That’s why it’s a good idea to reevaluate your profit-sharing agreement from time to time. You may want to agree upfront to reevaluate your profit-sharing agreement annually in order to reflect on changes that occurred throughout the year. Working with your lawyer or accountant can be helpful if you need to change your agreement substantially, as they can make sure these important changes are documented properly.
If you have any doubts about whether a partnership is right for you, read these 8 Questions to Ask Before Entering into a Business Partnership. Profit sharing is an important consideration but there are many moving parts to a business that you should consider and include in your partnership agreement.
For more tips for running a successful business partnership, check out these articles:
- 10 Ways to Avoid Friction in a Business Partnership
- How to Get Out of a Bad Business Partnership and Go It Alone
- Spring Cleaning for a Business Partnership
This post was originally published on How to Split Profits in a Small Business Partnership on Fundbox.- Fundbox – Fundbox Forward