One of the most fundamental decisions you have to make when forming a business is which structure is right for you. In Australia, you have a number of options, including trust, company, sole trader and partnership. In this blog we'll dive into what a partnership actually is and how they work.
What is a Partnership?
In its simplest form, a partnership is simply an agreement amongst entities that are doing business together. So, if you and a friend decide to open a food truck, you’re now a partnership.
One important thing to realize is that a partnership is not considered a business entity. Rather, a partnership represents a business agreement amongst parties. That means a partnership provides no legal protections from the debts or liabilities your partnership incurs.
As such, some people find it advantageous to form a business entity, such as a proprietary limited company, and then each of you become shareholders in that company, rather than an actual partnership of individuals. However, you’ll want to consult with a professional (like us) to get information on how that may or may not benefit you when doing business.
Who can form a partnership?
A partnership can be formed by two or more individuals, trusts or companies. Most are limited to 20 partners, while some professional partnerships have other restrictions.
Generally, a partnership must be established with a partnership agreement that defines the legal obligations of the partners.
It's important to realize that a partnership does not form a separate legal entity, meaning there is no legal barrier between a partner and the work of their partnership. Rather, all assets are owned directly by the partners either equally and jointly or in the proportions laid out in the partnership agreement.
Typically, partners will share profits and obligations jointly and equally, with each partner being separately liable for the partnership's obligations.
This means that each partner is liable for the actions of the other partners. This, along with no asset protection for your personal assets (e.g your house) makes partnerships a risky endeavor for a business.
What is a general partnership?
By definition, a partnership is a business structure where 2 or more people distribute their income or losses amongst themselves. A general partnership, or GP, is among the most common. In Australia, a GP makes all partners equally responsible for managing the business and places unlimited liability on each of them for the debts and obligations the business incurs.
What is a tax law partnership?
The Australian Tax Office defines a tax law partnership as an association of persons that receive income jointly. Limited partnerships and companies are excluded from this ruling, but other parties may unknowingly fall into the classification of a tax law partnership.
Tax law partnerships differ from general partnerships because, in a general partnership, income is received from the partners' regular business activity. On the other hand, situations where tax law partnerships arise often have to deal with spouses and other joint asset ownership situations.
For example, if two spouses own a rental property together, they're recognized as a partnership by the ATO. In one case of FCT v McDonald, Mr McDonald and his spouse owned two rental properties.
They agreed that the net profit would be distributed like this: 75% of the profit would go to Mrs McDonald and 25% would go to Mr McDonald with Mr McDonald bearing all net losses.
The court determined that they had no general partnership and were simply joint-owners, ruling them a tax law partnership. Thus, they were required to share losses equally. Their private income splitting agreement also had no impact on their respective income taxes in the eyes of the ATO.
So although a tax law partnership should have it’s own tax file number and lodge it’s own tax return, the ATO recognises that this doesn’t achieve much in a practical sense other than more compliance work. So if you own a rental property with your spouse you can just enter 50% in each of your personal tax returns. Win!
Why would you use a Partnership?
There are many benefits associated with a partnership structure, the first being the relative ease with which you can form a partnership. They're also inexpensive to get going and Australia has minimal reporting requirements for partnerships. Partnerships do require a separate tax file number (TFN) and must apply for an Australian business number (ABN) to handle all of its dealings.
The partners will share the business' control and management. The business itself won't pay income tax for any income it earns, although a partnership tax return must be filed with the ATO annually. Each partner will pay taxes based on their net partnership income each year. One of the big benefits of a partnership is that it losses can be used by the partners. They don’t get quarantined or carried forward. This is quite different to the way trusts and companies operate.
Frequently Asked Questions
Wondering who can and can’t form a partnership? Interested in learning more about a partner’s liabilities? Here are answers to some frequently asked questions.
Can Two companies form a partnership?
Two companies can come together and form a partnership in Australia. In fact, a partnership can consist of up to 20 partners, which means multiple companies can come together to create a partnership.
It is also possible to have a partnership consisting of both companies and individuals, which carries with it its own advantages. You’ll want to speak to a tax professional to fully understand them and how acting as either an individual or company could impact your tax liability and other obligations.
Can two trusts form a partnership?
In Australia, a partnership of trusts is not uncommon. The important thing to realize is that a partnership is not a business entity, but rather a form of shared ownership for a property. The partnership is simply an agreement amongst parties (i.e., trusts) to share benefits and obligations between the entities involved in the partnership.
So, in a partnership of discretionary trusts, the partnership simply represents an agreement where each partner is a trustee of a discretionary trust. This does differ from a partnership of individuals, as each individual would be a direct partner in the partnership where as, in a partnership of discretionary trusts, each individual's discretionary trust acts as a partner.
On paper, the differences may sound subtle, but there's a lot of complexity surrounding a partnership of trusts, which means a detailed partnership agreement is important.
Do I need to register my partnership?
Generally, a formal partnership agreement is a good idea, but it’s not essential to operating as a partnership. Proper registration of a tax file number, ABN and GST where applicable), on the other hand, is important to ensuring you meet all of your tax obligations. A separate partnership bank account is a must for a general law partnership.
What taxes will my partnership have to pay?
As stated previously, a partnership is only a business structure, not a standalone legal entity, which means each individual partner is responsible for taxes based on the amount of income they receive through the partnership. This means each partner is responsible for their own taxes. This can mean tax of up to 47% on partnership profits.
However, your partnership will still be required to have its own Australian business number (ABN) and you will need to lodge a partnership tax return each year. Still, the partnership itself will not be taxed.
The amount of taxes you’ll need to pay while operating under a partnership are dependent on whether you’re directly in the partnership as an individual (in which case your income through the partnership will be subject to your usual income taxes) or if you’re acting in the partnership as a company or other entity.
Can a partnership retain profits?
No, a partnership can not decide to retain profits. The partners will get taxed on their share of the partnership profit regardless of what cash they have received from the partnership. This can make partnerships a terribly inefficient structure for a growing business, as the partners are left with tax bills and need cash from the partnership to pay them.
If you’re looking for advice on which structure would be best for you, contact us here.