Business Formation - Partnerships

by Scott Krokoff

In my introductory blog on business formation issues for independent artists and bands, I discussed the need to choose an appropriate business vehicle for your music business activity, and in particular, summarized the pros and cons of being a sole proprietor (aka, the DBA model).  Obviously, only individual artists may conduct business through a sole proprietorship.  So what can a band do?  A band can form a partnership.

What exactly is a partnership?  A partnership, generally speaking, exists when two or more persons conduct business together.  So all you need is evidence of two or more people operating a business.  You do not need to draft a partnership agreement to have a partnership, although you should have an agreement in place to protect everyone’s interests.  Each person who participates in the business is called a partner, and each partner is considered to own an equal share in the business unless specified to the contrary in the partnership agreement.  Thus, in the case of a band, each band member would be a partner in the partnership.

Generally, there are two kinds of partnerships – general partnerships and limited partnerships.  There are also variations of limited partnerships, such as limited liability partnerships (LLPs) and, believe it or not, limited liability limited partnerships (LLLPs), but I will not be discussing those in this article.  A general partnership is the most basic kind of partnership, and is just like a sole proprietorship except here you have more than one owner.  Unfortunately, the same risk of being of sole proprietor is present in a general partnership – that each partner is fully liable for the debts, obligations and actions of the partnership.  In other words, just like a sole proprietor, a partner in a general partnership has unlimited personal liability.  Moreover, a partner can also be liable for the actions not only taken by the partnership but by the other partners as well, and a party seeking to sue the partnership can go after the partners individually or as a group.  This is called “joint and several” liability and can be a real killer.  By contrast, a limited partnership exists where you have at least one partner serving as the general partner (and thereby bearing the brunt of the risk in the event of liability) and the other partners are “limited partners,” meaning that their risk is limited only to their own investment in the partnership.  While this is more advantageous than the general partnership, bands cannot form limited partnerships because in order to be a limited partner you cannot be active in the business (and have no say in management or control), and bands by definition are active in the business.  So limited partnerships are generally not available to bands, but they can be available to individual artists who need investors who are willing to serve as silent partners (and therefore qualify as limited partners).

Through the partnership, which is treated as a separate entity from the band for non-tax purposes, the band conducts its business (e.g., by entering into agreements with other parties, for example, with respect to booking gigs and licensing songs) and collects any income earned, offset by any losses or deductions.  For tax purposes, however, the partnership is usually treated as a “flow-through” entity and what that basically means is that all tax items earned or incurred by the partnership flow through to the partners to be reported in the partners’ individual tax returns.  In other words, the partnership is not treated as a separate entity for tax purposes (when we discuss corporations, you will see that certain corporations are treated as separate entities and must pay taxes).  The partnership files an informational return with the IRS through Form 1065, but that is for informational purposes only.  The partnership itself does not pay any taxes; only the partners do.

Come tax filing time, each band member receives what is called a Schedule K-1, summarizing his or her ratable share (also referred to as the “distributive share”) of partnership income and losses based on his or her ownership percentage.  For example, assume you have 5 bandmates forming a partnership.  Assuming each band member owns an equal percentage in the partnership, each member would own 20% and therefore be required to report for tax purposes 20% of the partnership’s income and losses in his or her own tax return.  So if a partnership has $10,000 of net income, then each partner would be required to pay taxes on $2,000.  This is a key concept.  What you need to know is that a partner must pay taxes on his or her distributive share even if the partnership does not distribute that partner’s share of the partnership’s net income to the partner.  Put another way, if you are a partner, you must pay taxes on your share even if you decide to leave that money invested in the partnership.  Again, that is because the partners themselves, rather than the partnership, are required to pay taxes.  So you want to make sure the partnership distributes to you sufficient money to cover your tax hit.

You do not need to do much to set up a general partnership.  You may need to file some kind of certificate of formation, depending on where you live, and may need to pay a small filing fee.  You should also draft a partnership agreement addressing such issues as the business purpose of the partnership, the partnership’s term in which it will exist, the terms and conditions of ownership (including what happens if someone dies or if new partners want to buy into the business), how the partnership will conduct business and how profits will be distributed.  If you do not have an agreement, then the partnership will be governed by the law as stated in the Uniform Partnership Act.  To avoid unintended consequences, it is highly recommended that you draft an agreement with the help of an attorney.

Partnerships can be advantageous for a few reasons.  They are usually easier and cheaper to set up than corporations, for example.  They also require less formality (i.e., no need for a board of directors, annual meetings or corporate minutes).  Most importantly, they permit a high degree of flexibility in setting up the economic arrangement between the partners.  Ownership does not have to be equal amongst the partners, and profits (or losses) do not always have to be distributed in accordance with ownership percentages.  The tax rules addressing these issues are very complex and can be very tricky, so please make sure you consult an accountant or tax lawyer when setting up your partnership.

As stated above, the biggest disadvantage in setting up a general partnership is the unlimited personal liability risk (including joint and several liability).  While this risk can be mitigated by purchasing the proper insurance, conducting a general partnership is not recommended.  There are other types of business vehicles available, such as limited liability companies (LLCs), S corporations and C corporations, which will be discussed in subsequent blogs.  In particular, LLCs and S corporations are very popular alternatives, but it was important here to begin the discussion of partnerships since these issues will come up when discussing other business vehicles.  In addition, despite the obvious risks, some bands may still opt for conducting business as a general partnership due to the relative ease and low expense of setting it up.

Next topic:  C Corporations