A partnership is a common form of business organization that consists of two or more people who join together to operate a business and share in the profits and losses of the business. A partnership is a popular choice for small businesses because its easy to create and operate, it offers a great deal of management flexibility, the laws that govern partnerships are consistent throughout the country, and partnerships are subject to only one level of taxation as opposed to corporations.
How partners structure partnership equity in their small business will affect each partner's ownership interest in the business and may affect who controls the partnership.
Partnership Equity Definition
Partnership equity is the percentage interest that a partner has in partnership assets. In other words, partnership equity represents the partner's ownership interest in the business. The total contributions of all partners plus retained earnings are reflected on a partnership's balance sheet as equity.
Each partner has a separate capital account that represents that partner's equity in the partnership, according to AccountingTools. A partner's ownership interest is set through agreement by the partners and need not be equal among the partners.
Equity Contributions & Withdrawals
A partner may contribute money, other assets or services to the partnership. This figure represents the value of the partner's capital account. A partner's future contributions to the partnership will increase the partner's capital account balance while any withdrawals will decrease it.
The relative equity positions of each partner can change if there are varying contributions or withdrawals by each partner through the life of the partnership. If the control or share of profits and losses is tied to each partner's percentage of equity, unequal contributions and withdrawals can have a significant impact on the partnership.
Unequal Equity
It is not uncommon for an equity partner to have unequal equity in the partnership. For example, Tim, a general contractor, wants to flip houses, but he doesn't have the money to do it and cannot obtain bank financing. Tim's friend, Tessa, is a successful real estate broker who is looking for a good investment. Tim and Tessa agree to form an equity partnership.
Tessa will fund Tim's construction projects but will not be engaged in the actual operation of the business. Tim will operate the business and serve as the general contractor but will not contribute any money. The two agree that the fair market value of services that Tim brings to the partnership is $75,000 ("sweat equity"). Tessa funds the partnership with $100,000. Tim will have about a 42 percent equity stake in the partnership and Tessa will have about a 58 percent stake.
Profit and Losses
Profits and losses are distributed between the partners according to the partnership agreement. While allocation of profits and losses do not have to be equal to the percentage of the equity each partner has in the partnership, it is a common method of allocation.
For example, Michael and Janice open a coffee shop. Michael has a 75 percent equity interest in the partnership, and Janice has a 25 percent interest. Michael and Janice agree to distribute profits and losses in accordance with their respective partnership interest. In the first year of operations, the coffee shop realizes a $100,000 net profit. Michael's share of the profits is $75,000, and Janice's share is $25,000. Any losses borne by the partnership are calculated in the same manner.
Division of profits and losses can be treated differently, according to Startup Nation. For example, one partner may be allocated 50 percent of the profits and 40 percent of the losses while the other partner is allocated 50 percent of the profits and 60 percent of the losses, so long as the allocation complies with tax law. This can be a very complicated tax issue and consultation with an attorney or accountant may be necessary.
