When starting a business, roughing it alone can sound overwhelming. That’s why many choose to go into business with a partner 🧑💼+🧑💼. Having a partner means you’re able to share responsibilities, unloading the weight of running an entire business yourself. But with partnerships comes their own challenges. The number one? Deciding how to share profits.
Deciding how to split profits can be an uncomfortable task. But with the right plan in place, you can be sure your profit-sharing agreement is both fair and simple.
We’re sharing tips on how to split profits in a small business partnership so you can better take control of your money. After all, we’re in the sharing mood! So whether you’re a new business or a sole proprietorship thinking about switching to a business partnership, let’s dig in.
What is partnership profit sharing? 🤝
Partnership profit sharing is the method of deciding how to split your business profits between partners. In a business partnership, you get to decide how you split the profits but all partners must agree on a profit-sharing ratio. You can choose to split the profits equally, or each partner can receive a different base salary and the remaining profits will be distributed evenly.
If you form an equal partnership (50/50) between two people, both co-owners must approve the final profit-sharing agreement. But if you have an uneven partnership ratio, the partner with the majority share in the business will make the final decision regarding profit-sharing ratios.
Whatever ratio you decide on, you’ll need to create a formal partnership agreement to document everything in writing. But first, let’s look at some aspects to consider when deciding on the right profit-sharing ratio.
What to consider when deciding on profit sharing
Before making a partnership profit-sharing decision, there are a few components that you should consider in order to ensure the profit split is fair:
Consider how many partners are involved in your business. Are there two, three, or more people?
What are everyone's roles and responsibilities? Do some partners contribute more than others? Are all roles equally compensated?
How are the company's shares and ownership distributed? If there are two partners, the profit share is likely to be divided equally. Or, does one person have majority ownership and authority?
Asking yourself these questions will help you understand how each partner contributes to the business which will inform splitting profit fairly. But how exactly can you do that?
How to split profits fairly
The number one thing to consider when splitting profits is how to do so fairly so all parties involved feel accurately compensated. Each partner must agree on a ratio before documenting it in writing. Follow these four steps to ensure you split profits in a business partnership fairly.
1. 📂 Determine the type of partnership
Before making any business decisions about splitting profits with your partners, you’ll need to create a business partnership agreement. This includes deciding on the type of business you want to create.
Your business structure affects how you pay taxes, your ability to raise money, the paperwork you file, and, most importantly, your personal liability. The two most likely business structures you’ll decide between are a limited partnership or a limited liability partnership.
Limited partnership (LP): Limited partnerships, also known as general partnerships, have only one general partner with unlimited liability, and all other partners have limited liability. The partners with limited liability also tend to have limited control over the company, which is documented in a partnership agreement. Profits are passed through to personal tax returns, and the general partner — the partner without limited liability — must also pay self-employment taxes.
Limited liability partnership (LLP): Limited liability partnerships are similar to limited partnerships, but give limited liability to every owner. An LLP protects each limited partner from debts against the partnership, they won't be responsible for the actions of other partners.
2. 💸 Agree on a profit-sharing ratio
The trickiest part of splitting profits is deciding on a fair ratio for all parties involved. There is no one-size-fits-all answer for what a good profit-sharing ratio is for all businesses. As a general rule, if there are two people in the partnership, it’s 50/50, and if there are three people, it’s a ⅓ split. The biggest thing to remember is that no matter how you split your profits, the percentage must equal 100.
For example, imagine you have three business partners. Two partners contribute to the day-to-day business, and the third only contributes part of the time. In this case, the partners agreed to split the profits 40/40/20.
How many partners you have, what each partner does, and how much money each partner has invested will all play a factor in how you split up profits. While an equal (50/50) partnership may work for a business with two partners, other partnerships may be slightly more complicated and require that one or two partners receive more profit.
3. ✍ Document your profit-sharing agreement
Next, you’ll want to document your profit-sharing agreement in writing. This may require professional help from a lawyer, although it’s not legally required. The written agreement should be finished before any profits are split.
Things to include in the operating agreement include:
Profit sharing ratio: Include how the profits and losses will be split and how and when each partner will get paid.
Contributions: The assets, whether cash, property, or equipment, each partner is contributing to the business.
Decision-making ratio: The percent of authority each partner has when making decisions. This will likely be the same as your profit-sharing ratio.
Duties: Outline each partner’s duties and document them in the agreement.
4. ⏰ Revisit the partnership agreement annually
Once the agreement is in place, it’s a good idea to revisit the stipulations, at minimum, annually. After all, business dynamics and goals change rapidly. Revisiting it often will ensure that all partners remain on the same page, preventing problems and discrepancies down the road.
Partnership profit sharing example
To give you a better understanding, let’s look at an example of how to split profits in a business partnership.
For example, let’s say you started your business yourself as a sole proprietorship. Now, you’re in a position to expand and need two partners, one to run the finances of the business and one to manage the employees. That leaves you to continue managing the daily duties of the business.
Since you started the business yourself and manage the daily duties, you decide to start a limited partnership. This means you have unlimited liability and majority control over the company, while the other two partners have limited liability. Therefore, the profit sharing ratio is 50, 25, 25.
Owner | Partner 1 | Partner 2 | |
|---|---|---|---|
Profit Ratio | 50% | 25% | 25% |
Liability | Unlimited | Limited | Limited |
Contributions | All startup expenses | Finance expertise | Employee expertise |
Duties | Oversees all day-to-day operations | Manages financial operations | Manages employee operations |
Total Business Revenue | $300,000 | $300,000 | $300,000 |
Profit Share | $150,000 | $75,000 | $75,000 |
Profit sharing advantages and disadvantages
When considering if splitting profits and forming a business partnership is right for you, weighing the pros and cons can help you make the right decision. While the obvious downside is making less money, a partnership offers many great benefits like shared responsibility and labor.
Pros of splitting profits: 👍
Having a business partner allows you to share the financial burden for expenses and capital contribution.
A business partner can bring both cash and connections to your company.
By sharing the labor, a partner lightens your workload and helps relieve some stress.
With a partnership, you get tax benefits. This is because each partner only pays taxes on their individual share.
Cons of splitting profits: 👎
Of course, the number one con is that you have to split your business profits, potentially cutting your salary significantly.
A partnership means you also share any business losses and debts.
Conflict can occur in a business partnership due to profit sharing and decision-making.
If you or your partner wish to sell the business or their share down the road, it could be difficult to agree on a decision or buy-out plan.
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