How to Split Profit in a Partnership: A Guide for Small Businesses

When you’re forming a business partnership to start your business, having a partner can help share the responsibilities and capital needs (startup costs). But that also means you’ll need to share the profits with your new business partner.

Here are some of the basic essentials you’ll need to understand, from partnership profit calculation and equitable partner splits to how you’ll develop and record your profit-sharing strategy.

What is profit?

To start, let’s review exactly what profit is. The simplest explanation is that it’s sales minus expenses.

The explanation gets 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, such as 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.

ZenBusiness’s Money Pro app can keep track of all your expenses. It’s super easy to use. With a few simple clicks, you can track, categorize, and manage all your expenses and small business tax deductions.

Types of Partnerships

First, to determine your split, you need to settle on the type of small business partnership for your firm. It’s not recommended to 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 partnership up with a business name, most states require you to get a DBA (doing business as) name. A DBA is basically just an alias for your business, but you’re usually required to have one if you intend to do business and open a bank account under a company name instead of the legal names of the partners. If you don’t have a legal partnership agreement (which you should), your profits will be assumed to be split equally amongst the partners. (See our DBA definition page for more info.)
• 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.
• Limited liability partnerships (LLPs) are common for professionals such as lawyers and accountants because they offer partners personal protection against business debts and liabilities.
• Equity partners have a share of ownership in the overall partnership and its business assets.
• Salaried partners are partners that are also employees and may or may not have ownership shares.
• Junior and senior partners are different levels of partnership roles. Each has different duties, levels of management input, responsibilities, and financial investment commitments.

Strategies to Split Profits in a Small Business Partnership

There are actually several different ways you can split your profits in business partnerships; you and your partner(s) will need to settle on the strategy that works best for you and your unique business. What’s most important is that you set a strategy from the outset so you don’t encounter tension later on.

Percentage Ownership

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.

Responsibility Division

Partnership profit splits can be decided based on each partner’s work, time, and talent invested in the firm. An example is when Individual #1 and Individual #2 form a partnership company. Individual #1 runs the 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. With this approach, the partner who contributes more cash is often entitled to a greater portion of the profits, but not always. As with everything else about your partnership, it’s 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.

Creating a Partnership Agreement

A partnership agreement is a crucial document that outlines the terms and conditions of a business partnership. It serves as the foundation for the partnership, helping ensure that all business partners are on the same page and that the business operates smoothly. This agreement helps prevent misunderstandings and conflicts by clearly defining each partner’s roles, responsibilities, and expectations.

A partnership agreement is a bit like the operating agreement of an LLC or the bylaws of a corporation; it helps govern your new business. Your profit distribution policy will be a significant component of this agreement.

Key Elements of a Partnership Agreement

A well-drafted partnership agreement should include the following key elements:

1. Partnership structure: Define the type of partnership, such as a general partnership, limited partnership, or limited liability partnership. This sets the legal framework for your business partnership and determines each partner’s level of liability and involvement.
2. Partner roles and responsibilities: Outline each partner’s roles and responsibilities, including duties, obligations, and expectations. This helps ensure that each partner knows what is expected of them and helps ensure the smooth functioning of the business.
3. Profit sharing ratio: Establish a fair and transparent profit sharing ratio that reflects the partners’ contributions, roles, and responsibilities. To avoid future disputes, all partners should agree upon this ratio.
4. Decision-making process: Define the decision-making process, including how decisions will be made, who will make them, and how disputes will be resolved. This helps in efficient management and quick resolution of conflicts.
5. Capital contributions: Specify the capital contributions of each partner, including the amount, timing, and expectations. This helps ensure that all partners are clear about their financial commitments to the business.
6. Dispute resolution: Establish a process for resolving disputes, including mediation, arbitration, or litigation. This provides a clear path for resolving conflicts without disrupting the business.
7. Termination: Outline the circumstances under which the partnership can be terminated, including the process for dissolution and the distribution of assets. This helps ensure that all partners are aware of the exit strategy and their rights upon termination.

Setting the Profit Sharing Ratio

Setting the profit sharing ratio is a critical aspect of a partnership agreement. The ratio should reflect the partners’ contributions, roles, and responsibilities, as well as their expectations and goals. A fair and transparent profit sharing ratio can help prevent conflicts and ensure that the partnership operates smoothly. For example, if one partner contributes more capital or takes on more responsibilities, they might receive a larger share of the profits. This ratio should be clearly documented in the partnership profit sharing agreement to avoid any misunderstandings.

Documenting the Agreement

The partnership agreement should be documented in writing and signed by all partners. It’s essential to have a lawyer review the agreement to ensure that it’s legally binding and meets the partners’ needs. The agreement should be reviewed and updated regularly to reflect changes in the partnership or the business. This helps ensure that the partnership agreement remains relevant and continues to protect the interests of all partners.

Business Partnership Taxes

When you draft your partnership profit sharing agreement, you’ll need 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 their share of the company’s revenue or losses to their taxable income.

In addition, your partnership needs to file an annual tax return, called an information return (Form 1065), reporting sales, expenses, deductions, and losses to the IRS.

How to Calculate Net Profits

1. Add up total revenues for the year.
2. Calculate your cost of goods sold, operating overhead, and expenses, including supplies, administrative fees, and employee salaries.
3. Subtract your costs in Step #2 from the total revenue in Step #1 to determine net profit.
4. Deduct salaries paid to partners, which are considered distributions from profit. Usually, profit is calculated before partner salaries are deducted. Note: Some LLC-structured companies count owner salaries as expenses and thus calculate profit margins after these salaries have been paid.
5. The remaining balance will be paid to individual partners.

It’s highly recommended that you work with a licensed accountant or local tax attorney to get help with your taxes so you can be confident that your tax returns are filed correctly.

When Not to Split Profits

Many fast-growing startups decide not to payout split profits amongst partners for these valid reasons:

1. Reinvest for Growth – The partners agree to reinvest the profit to fund working capital, finance expansion, and grow the business.
2. Outstanding Partner Loans – Some partnerships have granted loans to partners that 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. While there are plenty of other decisions you’ll make together, how to split the money is arguably one of the most important; after all, making money is probably one of the main reasons you went into business together. So, setting a strategy and documenting it in a partnership agreement is essential.

Once you and your partners are in agreement, then you’re ready to start your business and generate profits to split with your partner as agreed.

Additional Partnership Resources

• Profit Distribution Guide
• Business Partnerships 101
• How to Form a General Partnership

Disclaimer: The content on this page is for information purposes only and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.