When you are forming a business partnership to start your business be ready to split the profits, responsibilities and capital needs with your partners.
Here’s all the information you will need to understand partnership profit calculation, equitable partner splits and how to develop, and record, your profit-sharing strategy.
Learn more in my guide: How to Start Your Small Business Legally – Important Legal Requirements
What is Profit?
To start let’s review exactly what profit is anyway. The simplest explanation is that it is sales minus expenses.
It becomes more complicated as you further define profit into gross profit (sales revenue minus the cost of goods or services sold) and net profit (all revenues minus expenses; the cost of goods, administrative, and overhead). Most partnerships split profits based on net profit and agree, in advance, specifically which expenses are included in that profit calculation.
Types of Partnerships
First to determine your split you need to settle on the type of small business partnership for your firm. I highly recommend that you do not set up your partnership yourself instead use a competent legal service or your local business attorney.
- General partners will participate in the operations and management of the businesses within the partnership and additionally have personal liability for the debts of the partnership. To set this up you will register your company as a DBA (doing business as). If you do not have a legal partnership agreement, which you should, your profits will be assumed to be split equally amongst the partners.
- Limited partners will invest, often financially only, in the business partnership concerns, but usually, do not participate in the daily management and running of the company. LLP (limited liability partnerships) are common for professionals such as lawyers and accountants because it offers partners personal protection against business debts and liabilities. When you set up your LLC discuss with your legal counsel how to also form your limited partnership LLP.
- Equity partners have a share of ownership in the overall partnership and its business assets.
- Salaried partners are partners that are also as employees and may or may not have ownership shares.
- Junior and senior partners are different levels of partnership roles. Each of these partnership types has different duties, levels of management input, responsibilities and financial investment commitments.
Profit splits can match partners’ ownership shares, or not, as you deem acceptable – as long as all the partners are in agreement. Some companies split their profits equally, while many others pay each partner a salary and then divide up the remaining profits.
Begin by deciding the roles and ownership of each partner and their assigned salary and expense accounts. After that, you can discuss your profit splits. Be sure to include a detailed description of your profit-sharing arrangement in your partnership agreement document.
Partnership profit splits can be decided based upon each partner work, time and talent, invested into the firm. An example is when Individual #1 and Individual #2 form a partnership company, and Individual #1 runs firm and is responsible for its daily operations, thus they receive 70% of the profit while the less active Individual #2 gets 30%.
Capital Investment Contribution
Often partners invest different capital amounts to launch the company. As such the partner who contributes more cash is often entitled to a greater portion of the profits, but not always. As for everything about your partnership, it is up to the people involved and their preferences. Thus if one partner invests 80% of the total launch funds they could receive 80% of the profits or less. Differing profit distributions to capital investment could be due to the other partner’s investment of work, time and talent.
Written Partnership Agreement
The key to a good working partnership is a clearly written, and well-discussed, agreement on these vital points. Not legally required in all states or industries, this document will protect the partners’ interests and assist in daily business operations.
- Profit Division – Profit and loss partition by partner and date of payments
- Capital Contribution – Lists of the assets each partner contributes such as money, property, and equipment.
- Decision-Making – Authority of each partner for business decisions and how to handle disagreements.
- Roles and Tasks – The management duties of each partner detailed by departments such as sales, personnel, legal, accounting, and publicity.
Business Structure Differences – DBA, LLC or INC
Take into consideration what your partnership and company business structure, whether DBA, LLC or INC, dictates about profit splits. Corporations generally issue stock shares and pay dividends as a form of profit splits, while LLC distribute profits, in direct relation to cash investment, in accordance with the operating agreement drafted at inception.
Business Partnership Taxes
When you draft your partnership profit sharing agreement to be cognizant of how your partnership, and each partner, will be taxed on profit payments. Most partnership business profits or losses pass through directly to the individual’s personal tax returns. Thus each partner will add his share of the companies revenue or losses to their taxable income.
In addition, your partnership needs to file an annual tax return, called an information return, reporting sales, expenses, deduction and losses to the IRS.
How to Calculate Net Profits
- Add up total revenues for the year, including rents received and dividends.
- Calculate your cost of goods sold, operating overhead and expenses, including supplies, administrative fees and employee salaries.
- Subtract your costs step #2 from total revenue step #1 to determine net profit
- Deduct salaries paid to partners, which are considered distributions from profit. Usually, profit is calculated before partner salaries are deducted.
Note: Some LLC companies count owner salaries as expenses and thus calculate profit margins after these salaries have been paid.
- Balance to be paid to individual partners
When Not To Split Profits
Many fast-growing startups decide not to payout split profits amongst partners for these valid reasons:
- Reinvest for Growth – The partners agree to reinvest the profit to fund working capital, finance expansion and grow the business.
- Tax Purposes – To avoid paying taxes on profits the partners can elect to defer profits to another year. Ask your accountant about your options.
- Outstanding Partner Loans – Some partnerships have granted loans to partners which remain outstanding at the end of the tax year, so no profits are split and the partner’s share is credited to their loan balance.
Profit splitting is a major concern for business partners but is only one of the many decisions you need to decide with your partners, and document in your partnership agreement, before launching your new firm.
Once you and your partners are in accordance, then you are ready to start your business and generate profits to split with your partner as agreed.
Learn more on my in-depth blog Business Partnerships 101.