A partnership is an arrangement between two or more individuals who have pooled their assets and skills to form a business and who will share profits and losses according to predetermined proportions that are set out in the partnership agreement. A partnership may be either a general partnership or a limited partnership:
- General Partnership — Under a general partnership, each partner has responsibility for running the business, is personally liable for the debts of the entire business, and is responsible for the actions of every other partner (unless otherwise specified in the partnership agreement). A general partnership is dissolved immediately on the death, withdrawal, or insolvency of any of the partners, although the personal liability to partnership creditors exists even after the partnership is dissolved. However, the partnership’s assets will first be applied to the creditors of the business and the partners’ individual assets will be first be applied to their personal creditors, with any surplus in a partner’s personal assets then being applied to the remaining business creditors.
- Limited Partnership — Under a limited partnership, a limited partner has limited liability based on the amount he or she invested in the partnership, does not typically participate in the management and operation of the business, and has limited decision-making ability. A limited partnership will have at least one general partner who manages the business and is personally liable for the debts of the entire business. A limited partner’s death, withdrawal, or insolvency does not dissolve the partnership. Because limited partnerships often are formed as tax shelters, it is more likely that IRS Form 1065, Schedule K-1, will reflect a loss instead of income. In such cases, the borrower’s ability to deduct the loss will be limited by the “at risk” amount of his or her limited partnership interest (and will probably be subject to passive loss limitations).
The partnership must report its profit or loss on IRS Form 1065 and each partner’s share of the profit or loss on IRS Form 1065, Schedule K-1; however, the partnership pays no tax on the partnership income.
Each partner uses the information from IRS Form 1065, Schedule K-1, to report his or her share of the partnership’s net profit or loss (and special deductions and credits) on his or her IRS Form 1040—whether or not the partner receives a cash distribution from the partnership. Individual partners pay taxes on their proportionate share of the net partnership income at their individual tax rates.
To quantify the level of the borrower’s financial risk, the lender must:
- determine whether the borrower has guaranteed any loans obtained by the partnership (other than loans that are considered as nonrecourse debt or qualified nonrecourse debt),
- determine if the borrower received a distribution from the partnership, and
- determine the borrower’s share of non-cash expenses that can be added back to the cash flow of the partnership business.
For additional information, see the following:
- B3-3.3-07, Income or Loss Reported on IRS Form 1065 or IRS Form 1120S, Schedule K-1
- B3-3.4-01, Analyzing Partnership Returns for a Partnership or LLC
- B3-3.2-02, Business Structures