When two or more people decide to start a business for a profit, the resulting agreement is called a partnership, governed by state law as well as individual contracts. Following the creation of the business, the execution of a profit-sharing agreement is an important step in properly allocating profits and losses between partners and determining individual tax liabilities. If prepared properly, this written document will represent the true intentions of the partners. It does not necessarily need to be based on ownership percentages.
In the absence of a partnership agreement, the ownership interest in a partnership is split evenly among the partners. When ownership interests are equal, the profits and losses of the business are also shared equally. Unlike in corporations and limited partnerships, ownership interests are not automatically determined by the amount of capital each partner contributed to the business, although the partnership agreement may provide otherwise.
Partnerships are responsible for reporting the income and losses of the business to the IRS. However, partnerships are not responsible for paying corporate income tax. Instead, each partner is allocated a share of the business profits and losses, which he reports on his personal income tax return. Instead of issuing a W-2 to each partner as businesses do for employees, partnerships distribute Schedule K-1, Form 1065, to each partner.
Ownership and Distributions
Unless otherwise specified in a partnership agreement, the ownership, managerial responsibilities and profit distribution will all be equal among the partners. However, the partnership agreement may provide that the ownership percentage does not correlate to profit distribution. Unless otherwise provided by the agreement, the partners will share the losses of the partnership in proportion to the profits. Partnerships have the right to agree to profit/loss allocations that work for the business. For example, a partnership can allocate one partner more of the profits for the first three years of the partnership to compensate him for bringing an important relationship to the table
Read More: How to Take Distributions From an LLP
A profit-sharing agreement is a written contract, signed by all partners, that specifies how profits and losses will be allocated to the partners. Generally, profit-sharing is a part of the partnership agreement, which will also specify the rights and responsibilities of the partners in managing the business. The agreement may also specify how much each partner is expected to contribute to the business, and how the partners may be compensated in their roles as managers. With a partnership agreement, partners may create a profit-sharing arrangement as simple or as complicated as necessary for the business.
- Hemera Technologies/AbleStock.com/Getty Images