A partnership agreement is a written document detailing the terms of a business partnership between two or more parties. A business partnership is a business arrangement where two or more individuals share ownership of a business organization. The partners also agree to share in the company’s profits and losses.
The purpose of a partnership agreement is to detail the basics of a partnership for all parties involved to agree upon. The partnership agreement is legally binding and recognized by the law. The partnership agreement sets out the terms and conditions between partners such as:
- A description of management powers and duties of each party.
- The length of the partnership.
- Terms for the termination of the partnership.
- How a party can purchase another party’s share of the partnership.
- Using the percentage of ownership to distribute profits and losses.
- Partnership contract
- Business partnership Agreement
- Articles of partnership
- General partnership agreement
Partnership Agreement- an Overview
If there is no written partnership agreement in the partnership, the partnership becomes subject to state default laws regarding partnerships. State default laws may not be favorable to all business models and the partners would have to act according to the default state laws regarding the partnership.
Partners may be subjected to an unexpected tax liability if a partnership agreement is not in place. The law does not recognize a partnership as a taxable entity, and as such, taxes “pass through” the partnership business to the individual partners since the profits and losses of the business “pass through” the partnership company to the individual partners. As a result, the partners pay their taxes individually from their share of the profits and deduct their taxes from their share of the losses.
Without a written agreement that clearly states each partner’s ownership interest and capital contributions, each partner will be assumed to have a default equal interest. This may lead to an uneven split in the interests of the partnership. Without a valid partnership agreement, partners may also be at risk of additional tax liability. The law recognizes a partnership as a “pass-through” entity for the purposes of taxation, which means that the profits gotten from the partnership are regarded as an individual taxable income for all partners. Without a predetermined ownership share in the partnership, state laws exert equal taxes on all partners involved regardless of their contributed percentage in the partnership.
A partnership agreement is basically set in place in order to deal with every possible situation where there might be disagreement, change, or confusion. When there is more than one owner, a partnership agreement is vital for good business operation. Without a good partnership agreement, both parties may end up in court waiting for a judge to decide what happens to the business which may be a lengthy, and expensive process as opposed to simply following what was written in the initial partnership agreement.
Benefits of a Partnership Agreement
When a partnership has an agreement from the very beginning, they can enjoy the following:
Set up the roles and responsibilities
Each partner involved has predetermined roles and responsibilities that have been described in detail. They are also predetermined processes for decision-making as well. The role of the managing partner is assigned to one of the partners and each individually named partner has their specific responsibilities. In the events that roles and responsibilities change, there is a predetermined process to handle such situations.
Avoid tax issues
The tax status of the partnership is spelled out showing that the partnership is distributing profits based on an acceptable tax and accounting practice hence there are no tax issues.
Avoid legal and liability issues
The partnership agreement spells out the liability of individual partners, as well as the liability of other partners in the partnership should a partner have a liability issue.
Set pre-determined actions
If one of the existing partners has a significant life challenge such as illness, divorce, death, or incompetence, they are usually buyout agreements with each partner to deal with such a situation.
Deal with partner issues
The partnership agreement contains predetermined procedures for issues such as non-compete agreements and conflict of interest.
The partnership agreement has predetermined procedures and conditions for admitting new partners into the partnership.
Override state laws
The laws in some States have required language in their partnership agreements. This choice of words may not be ideal for some specific partnerships. Without the formal written agreement, partners may find themselves having to abide by the default state laws.
Make disputes easier
The inclusion of language in the partnership agreement describing how disputes should be handled is a vital decision. This language will decide if arbitration will be a possibility, who pays for what, and what the responsibility of the parties in the dispute is.
Types of Partnerships
Based on the nature of a partnership, it can be classified into the following types. These types of partnerships have their merits and demerits.
Also known as joint and several liabilities, the general partnership involves each partner having equal rights and responsibility with one partner being able to act on behalf of the partnership as a whole. Each individual partner shares in the profits and losses of the partnership. However, individual partners are personally liable for the actions of the partnership.
- Lower cost of starting up.
- Simple taxes.
- Less paperwork.
- Not appealing to investors.
- Shared management.
- Joint and several liability.
In a limited partnership, there are two types of partners, the general partners, and the limited partners. The general partners are tasked with the responsibility of managing the business. The general partners have the same responsibilities and rights as partners in a general partnership. Limited partners on the other hand are also known as silent partners. They only contribute money to the organization. The day-to-day management of the partnership does not concern the limited partners.
- It is more attractive to investors.
- Tax benefits.
- Limited liability for limited partners.
- Joint and several liability is attached to the general partners.
- Divided authority.
- Additional paperwork.
Limited Liability Partnership
A limited liability partnership gives none of the partners personal responsibility for actions of the partnership. A limited liability partnership is a more formal business structure that requires a written agreement and registration with the state. In some states, there are limits to a limited liability partnership offering this partnership only to professional organizations such as attorneys and accountants.
- No double taxation.
- Limited liability for all partners.
- Limited use in some states.
- Tax limits in some states.
- The partnership must comply with state filing requirements.
Partnership at Will
Partnership at will describes a partnership intended to continue for an undefined period of time at the will of the partners. If a partner decides to dissolve the partnership, the partner can do so with or without notice as expressly stated in the partnership agreement.
- Partners can walk away from the partnership at will.
- The partnership can last for a long time as long as all partners are in agreement.
- Dissolution the partnership without proper warning may cripple the business.
Contents of a Partnership Agreement
These are the important components to include in a legal partnership agreement;
The partnership name is the registered legal name of the partnership. The partnership name can be anything the partners choose as long as it has not been used by another organization.
Partners- The names of all partners who have ownership in the partnership business must be included in the agreement for clarity.
Dissolution- Information on the agreed-upon dissolution procedure and conditions must be included in the agreement so that the partnership business can have a stable system that ensures its survival.
Withdrawal- The conditions by which a partner can leave the partnership must be defined for partners to have a way out should the partnership business fail to yield profit.
Retirement- Instructions are agreed upon for partners to follow if a partner retires, the other partner(s) would follow the agreed upon procedure for allocating the responsibilities of the retired partner.
Removal- Requirements, conditions, and procedures for removing a partner should be agreed upon and specified to ensure that a partner that no longer carries out their responsibility can be ejected from the partnership.
Death– Instructions for the events of the death of a partner should also be specified to appropriate benefits and responsibilities to an agreed-upon party.
Buyout– The right or absence thereof for partners to buy out other partners’ interests if a partner leaves the partnership should be made clear in the partnership agreement.
A detailed description of each partner’s contribution in terms of property cash and other intangible assets. All partners have to agree on how the ownership of the partnership will be split by laying out clear details to avoid confusion and disputes.
- Bank accounts: All partners will keep a separate bank account for the partnership business’ funds.
- Salary and drawing: The partners will decide if they would receive a salary, or they reserve the right t withdraw from their income account at will.
- Capital accounts: each member off the partnership will keep a separate account for their capital contributions.
Profit draws and losses made by the partnership are distributed among the partners. The distribution ratio for profits and losses for the partnership should be established.
Authority to act for partnership
By default, any partner should be able to form a binding agreement for the entire partnership. However, if the partnership agrees for this not to be the case, the details concerning the authority to ask for the partnership should be stated explicitly in the partnership agreement.
Each member of the partnership should have voting power according to predetermined provisions in the partnership agreement. The partners need to agree on how the voting power will be split among the partners using factors such as investment percentage.
The partners should determine which partner will be involved in the following management duties in the partnership organization:
a. Books and Records
c. New Partners
New and departing partners
In the event that the partnership succeeds, and at a point, the need for expansion arises, there may be an opening for new partners. If on the other hand the business does not succeed, and a partner decides to withdraw from the agreement, either voluntarily, or otherwise, there should be a standard procedure for including other partners while ensuring fairness and smooth transition.
The partnership agreement should establish whether or not the decisions would be made by a majority vote, if one partner would be elected to make decisions, if all partners carry equal voting power, and if the level of investment f each partner determines their voting power. While it seems fair to divide the power evenly among the partners, an even number of partners presents a significant risk of attrition.
Division of interests
Interests are often divided equally among owners; however, it may not necessarily have to be. Factors such as the level of investment by each partner, how much responsibility each partner handles and how much risk each partner bears may influence how much interest each partner gets.
The agreement should specify if there are any conditions under which a partner can be forced into an involuntary withdrawal. In the other event that a partner opts to withdraw from the partnership, there should be predetermined guidelines and procedures to ensure a smooth transition without affecting the operation of the business Furthermore, it should state how the shares of a withdrawing partner would be figured as well as a payment plan for a withdrawing partner’s share.
Disputes are quite normal in a partnership and dispute resolution must be planned while crafting the partnership agreement. All partners should set up a system where a mediator or other outside party may be invited to help settle disagreements between partners without having to go to court.
Here are some general terms that may also be included in a partnership agreement:
Restrictions on transfer
If there are any restrictions on the partner’s ability to transfer their interest in the partnership, the partnership agreement should specify the restrictions.
The amount of time allowed for disputes about the agreements to be resolved should be specified. Arbitration is different from mediation in that mediation is a method of dispute resolution that involves the parties resolving their disputes with the help of a neutral third party, referred to as the mediator. Conversely, arbitration is a means of dispute resolution whereby the parties abide by the rulings and decisions of the third neutral party according to a prior agreement. The neutral third party is referred to as the arbitrator. The major difference between a mediation and an arbitration is the fact that the mediator has no power to make decisions or enforce any decisions against the parties while the arbitrator has the power vested in them by the parties to make and enforce decisions against the parties.
The law of the state that applies to the partnership in the event of a program with the partnership agreement should be cited.
Federal law allows the Internal Revenue Service (IRS) to treat partnerships as taxable entities, and as such, the IRS audits partnership businesses at the partnership level. Hence, the IRS may choose to audit the partnership as a single entity. It is therefore important that the agreement specifies which partner will represent a partnership for tax purposes.
Dissolving a Partnership Agreement
Partnerships are usually set up to achieve certain goals with all partners involved having predetermined roles, responsibilities, and expectations. However, a partnership is not a permanent thing, and may be dissolved for any of the reasons stated below;
Specified end date
The initial partnership agreement may contain a specific end date by which the partnership agreement is no longer valid. If this is the case, the partnership may be dissolved on such a date. If, however, the partners involved intend to continue the partnership beyond that date, both partners would have to agree and amend the partnership agreement to that effect.
Purpose has been completed
A partnership is usually set up in the pursuit of certain goals. Once these goals have been achieved, the purpose of the partnership is completed, and there may not be in need for the partnership anymore. At this time the partnership may be dissolved.
Death of a partner
The demise of one of the partners ends the partnership. However, if there is a pre-existing agreement with the provision to pass on the role of the partner to another individual or entity as stipulated in the initial partnership agreement, then the surviving partner may act according to the initial partnership agreement otherwise the partnership may be dissolved.
Partners go bankrupt
In the event that either partner or the partnership becomes bankrupt, and unable to fund operations, the partnership may be dissolved.
Partner chooses to withdraw
If one of the partners decides to withdraw from the partnership, the partnership may be dissolved following the predetermined procedure for such an event.
Before entering into a partnership with another individual, partners must first consider other factors, such as trustworthiness which is the most important factor to consider. Also, partners must consider the future growth of the company. Lifestyle companies and slow progressively growing companies can benefit immensely from partnerships.
If the idea or goal of the company is a high-risk one, the partnership will offer the advantage of limiting the risk.
Duties of a Partner in the Agreement
With the establishment of a partnership partners involved are expected to serve specific roles and subsequently, there are certain duties and obligations expected of each partner. These are:
Joint liability for all debts
Each partner is jointly liable for all debts incurred by the partnership. Neither partner is expected to be solely liable for any debt. However, since the partnership incurred the debt, the partnership which includes all partners is expected to be liable for the debt.
Agents of the partnership
The partnership agreement recognizes all partners as agents of the partnership and will be regarded as such. As agents of the partnership, all partners are expected to act on behalf of the partnership according to their set roles in the partnership agreement.
The actions of employees
The employees of the partnership are employees of partners. Under the law, partners are regarded as the employer of the partnership organization employees, and as such the partners are held liable for the actions of their employees if the law recognizes the action of the employee as a liability of the employer.
Taxation of a partnership
As a joint owner of a partnership, each partner is responsible for paying the taxes on the partnership. The partners may be required to file their taxes jointly, or in accordance with the state laws for the jurisdiction of the partnership.
The partnership organization is a collaboration of each partner with the other partners and as such, opportunities that arise in the execution of the operations of the organization shall be shared similarly to profits and risks.
As a co-owner of the business organization, each partner is obligated to be responsible for the organization as well as the operation and management of the organization.
The bedrock of every partnership is trust between all partners involved, and as such, every partner is obligated to maintain that trust for the duration of the partnership and beyond.
Download Free Templates
Download our free and customized templates from here:
Before going into a partnership, certain details of the arrangement should be set with consideration to some legal issues. The partners must delegate the responsibility for the day-to-day operations and decision-making of the organization to one or more partners by coming to an agreement . The partnership agreements must also be put in writing to make provisions for eventualities in the future and to protect the interest of the partnership.
In a general partnership, all partners are equal, hence the consequences discussed below only apply to a general partnership. As a direct consequence of being in a general partnership, each partner has joint and several liability for all debts of the partnership. Consequently, the liability of any and all debts of the partnership is an equal responsibility of all partners. If a partner does not have the ability to handle their share of the debt, the other partners are obligated to take up the unresolved debt.
Furthermore, all partners are recognized as agents of the partnership, hence they may be legally bound to outside parties as agents of the partnership. The partners are responsible for the all contracts created by other partners in the name of the partnership.
Importance of an attorney
Having a partnership agreement has only one disadvantage: incomplete or unclear language. By crafting a partnership agreement, partners run the risk of not getting the wording right. A poorly worded agreement is worse than no written agreement at all.
With the presence of an attorney, the process of preparing the partnership agreement may be expensive, however, the attorney will be able to put every possible situation or contingency into the partnership agreement which will prevent expensive and lengthy court proceedings in the future.
Frequently Asked Questions
Is my partnership agreement good enough for my LLC?
In a general partnership, every partner is liable for all debts and obligations of the partnership company. In the event that one partner is unable to If one partner does not have the ability to meet their obligations to the partnership, the burden is split evenly among the other partners. In an LLC, each member has limited liability and enjoys similar protection to shareholders in a corporation. An LLC would not create and distribute misleading or ambiguous documents that allows clients or other business associates to rely on the liability characteristics of a general partnership. If any harm should occur as a result, the reliance may be used to defeat the protection from limited liability of the LLC in court. So, NO!
Where do I file my partnership agreement for a general partnership?
A partnership agreement for a general partnership is simply an agreement between two or more individual partners, and as such is not filed. Companies such as LLC, LLP, and corporations whose owners enjoy limited liability are required to register. Ina general partnership, the partners have unlimited liability for the debts and obligations of the partnership.
How are partnerships taxed?
According to federal law, a partnership will not pay income taxes. The partnership income paid to the partners as profit or losses will be taxed from individual partners.
What factors should I consider before a partnership?
There are several other factors to be considered such as trustworthiness of the partners. With that said, the most important factor to consider before entering into a partnership agreement is the future growth of the company. Slow progressing companies and lifestyle companies thrive with partnerships; however, a high-risk company is better incorporated.
How do I limit my partners’ authority to sign binding contracts on behalf of the partnership?
By giving notice to outside parties that the partner does not have the authority to make contracts or perform any other action that may legally bind the partnership, the partnership can avoid being bound by those actions.
Does an agreement have to be notarized?
Usually, a partnership agreement does not have to be notarized. Unless the state specifically requires by municipal law that a partnership agreement be notarized the partnership agreement does not necessarily need to be notarized.
Is a partner’s interest transferrable in a partnership?
By default, and in accordance with state laws, partnership interests are transferable. However, if the partnership agreement specifies otherwise a partner may find it difficult to transfer their interests.
Under the “Actions that require Unanimous Consent of the Partners” section, what does “Endangering the ownership or possession of partnership property” mean?
When it comes to partnership property, individual partners have no property rights. Partnership assets may be put at risk either by loaning to a third party or placing he asset in an environment that risks theft or loss, and as such, the partnership may wish to demand the unanimous consent of all the partners before making such decisions.
Under the “Actions that require Unanimous Consent of the Partners” section, what does “Releasing any partnership claim except for full consideration” mean?
If the partnership business has a claim against anther individual or business entity where a debt is owed to the partnership, the partnership’s best interest is to seek full repayment. However, if the partnership is to release the obligation for less than full consideration, the interests of each partner must be represented and each partner may provide or otherwise withhold consent to the transaction.
Under the “Actions that require Unanimous Consent of the Partners” section, what does the “Sale of a partnership asset with fair market value greater than a fixed amount” option mean?
The sale of any significant partnership asset must require the unanimous consent of all partners to protect the interests of all partners. An individual partner may not sell or otherwise dispose of partnership property, neither can an individua partner use partnership property for collateral for a loan without the unanimous consent of the partners. There should be a practical fixed amount selected as requiring unanimous approval for the sale of nominal assets would constitute an unnecessary administrative burden.
Under the “Actions that require Unanimous Consent of the Partners” section, what does the option “incurring single transaction expenditure over a fixed amount” mean?
All general partners have jointed several liability for the debts and obligations of the partnership. As a result, individual partners are exposed to varying degrees of personal risk as the result of the failure of the partnership. While a wealthy partner may be willing and able to withstand substantial risk, a less wealthy partner may be risking all their personal assets. Hence, to protect the interests of all partners, a unanimous consent is required for all substantial purchases.
Under the “Actions that require Unanimous Consent of the Partners” section, what does the option “incurring total partnership liabilities over a fixed dollar amount” mean?
Due to the several joint liability on all partners, any expansion of the partnership requiring a sizeable financial investment that involves a significant debt load must be considered with the interests of all partners in mind. If there is a great risk or an individual partner stands to lose some or all of their personal holdings, the partnership may wish to protect the interests of the individual partners in the partnership agreement. The partner can agree on the dollar amount of liability that is acceptable. Any liability over the set dollar amount would require the unanimous consent of all the partners. For liability under the set dollar amount, the consent of a majority of the partners would suffice.
Under the “Actions that require Unanimous Consent of the Partners” section, what does the option “Assignment of ownership rights of partnership property” mean?
When it comes to partnership property, individual partners do not have property rights. The partners may require unanimous consent for issues involving the use and assignment of property rights in the partnership property to protect the interests of all partners from unauthorized behavior involving partnership property.
Why does the partnership agreement require unanimous consent on some conditions, and not others?
Business decisions are typically resolved by a majority vote of the partners. However, if the impact of such a decision on an individual partner would be significant, the decision is best resolved through a unanimous vote to protect the interests of the individual partners. Areas that are deemed critical to the success of the partnership such as Critical areas on which the success of the partnership depends, such as firing/hiring of employees or other things that will affect the interest of all existing partners should require a unanimous vote to protect the stakes of all existing partners in the enterprise.
Why should a partnership choose to have an initial period of probation on withdrawal?
Functioning in the best interest of the partnership is a core duty of the partners, and as such, if a prohibition is enforced on withdrawal, individual partners will be motivated to take their responsibilities as partners seriously and commit to no less than a minimum period with the partnership. All partners will feel comfortable relying on the commitment of their fellow partners to the goals and purpose of the partnership.
What is a tax matters partner?
The tax matters partner is the partner entrusted with the role of preparing and submitting the tax returns and reports according to the requirements by the taxation legislation.
Who requires a partnership agreement?
A group of people running a business for profit together must have a partnership agreement. A partnership agreement serves as the operating agreement for the company. The agreement establishes set rules and guidelines for all partners to follow to avoid conflict as time goes on.
What are the most common situations that necessitates a partnership?
If a group of individuals come together to form a business, they should have an agreement in lace to establish their conduct and responsibilities. Partnership can be formed by bringing friends, family and acquaintances together to form a business.