What you need to know about dividing profits in a small business partnership.
When you go into business with someone, one of the factors you need to consider is how you will share profits. As it will affect the type of company you are and your tax requirements, this should be settled in an official, legal way before you start up.
Deciding how to split profits will affect what kind of company you will create. From there, you need to follow the official steps and make it all legal. Almost everyone needs advice and assistance from a lawyer or accountant, both when considering the options and officially creating the company.
This guide will take you through what you need to know.
What to consider when deciding how to split profits
There are many different ways to split profits. It can be as simple as splitting them evenly down the middle or offering a base salary plus split profits. You can also involve other variables like equity, commissions, bonuses and more.
Before making a decision on what’s right for your company, you should know:
- How many partners will be involved in your business venture. Will there be just two or three people, or more?
- What everyone’s role and responsibilities are. Are some partners contributing more than others? Are all roles equally compensated or are some worth more than others?
- How the company’s shares and ownership will be distributed. If there are two partners, will the company be divided equally 50/50 or will one person have majority ownership and authority? How much equity will everyone own?
- How profits will be shared among partners. Will everyone be identically compensated or will some make more?
To answer these, consider:
- Contributions to the business. Business contributions take many forms: One partner might be offering more of their time, another might have critical experience and another might be putting more of their personal savings into the business. There are no rules for how valuable each is, and it’s entirely up to you and your partners to decide on a profit split that everyone agrees with.
- Who has decision-making authority. You can choose a partnership where everyone must agree before taking action, or you might want one where one person has the last word.
- What the profit is. Capital gains, direct business profits, salaries, commissions and more need to be considered.
- Tax. You will have different tax requirements, both business and personal, depending on how you choose to split the profits. An accountant is the best way to navigate these issues.
- Legal implications. There are different liabilities to consider as well as other legal implications depending on how the company is set up and how profits are divided. A lawyer can help you to consider these.
You have almost complete control over how profits are split, but you should consider it carefully in light of all the factors involved. All partners must agree to a proposed arrangement before it can be set up.
How to set up an official business partnership
Once you know how you plan on splitting profits, you need to make it official. This involves formalising both your business and the profit split agreement in writing.
Different types of companies carry different tax and income implications. Broadly speaking, you will in most circumstances either be registering a partnership or creating a company.
Creating a partnership
Easy and inexpensive to set up and operate, a partnership is an official association of people who do business together, splitting profits and losses among themselves.
- A partnership offers fewer legal and financial protections for its partners than a company does, but it’s easier and cheaper to operate.
- Profits are shared among partners as desired. Losses are also shared.
- The partnership must lodge its own annual tax return showing all income and deductions.
- Partnerships are not taxed. Each partner pays individual tax on their share of the profits.
- Partnerships can have employees who are not partners.
Creating a partnership is a lightweight way of setting up a legal partnership agreement. It can be good for smaller and less organised business arrangements if there is little chance of legal liability issues or business bankruptcy.
Creating a company
A company is its own separate legal entity that pays its own taxes. Profits earned go through the company, as do losses and legal liability.
- A company costs more time and money to run than a partnership does, but it offers many profit-sharing options and gives you a degree of protection from losses, bankruptcy and legal issues.
- A company is formally owned by its shareholders and run by its directors. Directors are usually also shareholders. Profits are allocated through shareholding and salaries, and authority is allocated through directorship.
- Directors personally take on some of the legal and financial risks of the company while shareholders do not.
- Companies pay their own taxes.
Creating a company is essential for many business partnerships. It also lets you split profits and ownership as desired.
How to document your profit split agreement
The partnership agreement that you enter into will formally document the terms of the arrangement. This is used for auditing purposes or if there is ever a dispute between partners. Even if you’re going into business with friends or family you should still keep it professional and set up a formal partnership agreement.
You are not legally required to have a formally documented profit split agreement, as the essential information will be required to register a company or partnership anyway, but it is still strongly recommended for your own convenience and efficiency, particularly if you have any doubts about your partner’s willingness or ability to hold up their end of the bargain.
This should be a written document that details all the relevant information and how certain situations will be addressed:
- How much of the company does each partner own? What is the exact breakdown of authority?
- What are the specific terms of your profit share agreement? The written agreement should detail them exactly.
- How is each partner contributing? If someone is investing their own money, say how much and how often. If one partner gets a bigger share because of their special expertise, detail what the expertise is and how much bigger the share is.
- Which decisions can partners make independently, and what must be referred to the group?
- Who can be a partner or company shareholder? Consider eligibility and the process of adding or removing partners.
- What happens if a partner dies, retires, disappears, becomes disabled or is otherwise absent?
- What happens to a partner’s equity if they leave? Are the other partners required to purchase those shares?
The more detail the better. This partnership agreement will be referred to and held up if difficult situations arise, so it’s a good idea to make sure it has the answers you need.
If you have an idea of how you want to split profits in a business partnership, discuss it with your future business partner and reach an agreement, then discuss it with a professional who can advise you on legally creating a partnership or company and putting the profit split into action.