Why Is It Important to Have a Partnership Agreement?
If an individual plans to begin a business with one or more partners, then it is important he or she makes it clear from the start how the company is going to operate. This includes how the partners will share the money the business makes. The best way to make these decisions is through a legal form known as a partnership agreement.
A partnership agreement is a legal document that details how a small business will function under two or more individuals acting as partners. The agreement illustrates the responsibilities and roles of each partner involved in the business, how much of the company each partner owns, and how much profit and loss each partner will take on. The agreement also dictates how each partner will manage the business and addresses various scenarios that might affect the business. These situations include the death of a partner or the departure of a partner.
A partnership agreement is meant to put in writing the answers to common questions that arise in business settings. This way, there is less likely to be a disagreement between partners down the road.
Is It Necessary to Have a Partnership Agreement?
If a company does not have a partnership agreement, then by default its operation will be governed by the relevant state’s partnership laws. These laws provide a regularized approach to managing a partnership, as well as solving common problems. However, they are not specific to an entrepreneur’s business and can cause results that he or she did not anticipate. For instance, perhaps a partnership will have to be dissolved and re-formed if a partner chooses to leave.
A partnership agreement provides the foundation that a business needs to succeed. To make an agreement, partners will need to make clear decisions about who plays what role in the company, how the business will be funded, how profits and losses will be divided, and how the partnership will handle outgoing and incoming partners. Without going through this exercise, it is hard for partners to be on the same page about the company’s operations and future. This makes conflict inevitable, which can jeopardize the future of the business.
Naturally, there will always be disagreements when it comes to running a business. However, a partnership agreement can help resolve disputes when they arise.
How Is a Partnership Different from a Corporation?
Selecting whether to classify a business as a partnership or a corporation affects how a business owner will be taxed as well as how much liability he or she will have in the company.
General partnership is the automatic assignment for any unincorporated business that has multiple owners. This is the case whether or not there is a partnership agreement.
The partners involved in a general partnership are both completely liable for the company’s obligations. A partnership is considered a pass-through business for tax purposes. The partners report their share of the company profits and losses on their personal tax returns, paying personal income tax on them. If they also work in the business, then they will also pay self-employment taxes.
By contrast, a corporation is a business entity that is formed by filing paperwork with the state. Business owners have shares in the corporation, which also has its own legal identity. This means owners are not liable for a corporation’s business obligations, and they might receive a salary as an employee of the company. Corporations may be taxed as C corporations that pay corporate income taxes. But certain small corporations may be taxed as pass-through entities by choosing S corp. taxation.
What Information Should a Partnership Agreement Have In It?
As with any contract, a partnership agreement should include some basic information, such as:
- The business name
- Description of the company
- Contact information of the business and its owners
Also, the partners should include details related to important decisions and situations that may come up in the lifetime of the business. A partnership agreement should therefore address the following subjects:
- Ownership. How much of the business does each partner own, expressed as a percentage.
- Decision-making. Do decisions need to be unanimous, or is it majority rule? How much weight does each partner’s vote have? The decision-making process should be provided in detail so that every voice is heard and no one can question the legitimacy of decisions.
- Capital Contribution. How much will each partner contribute to starting and running the business? Are these contributions cash, services, or property? If the business needs capital down the road, what are the responsibilities of the partners?
- Profits and Distributions. How will profits and losses be divided between partners? This clause should include when and how partners are to be paid back for their contributions, as well as how they will receive distributions from profits.
- Death and Disability. What is the procedure when a partner dies or is otherwise incapable of running the business? Who will inherit their share, and does the new partner take on the same role and rights? Do the other partners have the ability to buy out the exiting partner’s interest?
- Exiting or New Partner. How can a partner leave the partnership? What happens to their share and rights? How will the business continue without their contributions? What is the process for bringing on new partners and giving them profits, losses, and duties?
Let us now go over some other important facts about business partnerships so that an entrepreneur can evaluate if this type of entity is the right choice for their company.
What Is a Business Partnership?
A business partnership is a union of two or more individuals who are working together to pursue a business goal. There is a good reason that business partnerships are compared to marriages. When two or more parties enter into a partnership, they are combining their finances. This means that if the business is sued because of something one partner does, the other partner must answer to the charges as well. If the partners are not careful, the courts and creditors can take from both individuals’ personal assets to make even.
There are four different kinds of partnerships, some of which combat the above risks. Some types of partnerships are only available in certain states, and others are only available to certain kinds of businesses.
Before leaping into a business partnership, one would be wise to review his or her options, as well as the proper way of forming a successful partnership.
A partnership may be described as a business shared by multiple owners. It is not a legal business entity, and it is not required to be registered with the state in which it conducts business. Essentially, if an individual chooses to go into business with another person, and he or she does not file paperwork with the state, they are still officially a partnership.
Some kinds of partnerships are legal entities that are indeed registered with the state. These entities can offer limited liability protection to protect personal assets.
How Are Business Partnerships Different from Other Entity Types?
Similar to a sole proprietorship, a partnership is financially and legally bound to its owners. This means that profits and losses are passed through to the owners’ personal income when tax season comes around. Also, liabilities and debts pass through to the partners as well.
In general, partnerships are easier and cheaper to create than corporations.
Every kind of partnership offers the benefit of pass-through taxation, which means that there are lower taxes than other business entities such as corporations.
What Are the Different Types of Partnerships?
The following are the four main types of partnerships:
As the most basic kind of partnership, a general partnership does not require the partners to form an official business entity with the state. Most times, the partners form the company by signing a partnership agreement. Ownership and profits are typically divided evenly among the partners, but this division may be decided otherwise in the partnership agreement.
This kind of partnership gives partners a lot of power, but it also means a lot of responsibility. For instance, let’s consider a partnership that has three partners. One of the partners decides to take out a loan that the business cannot repay, meaning that the whole partnership is now liable for that debt.
General partnerships are also easy to create and dissolve. When a partner dies or goes bankrupt, the partnership will usually dissolve automatically.
Limited partnerships, or LPs, are formal business entities that are authorized by the state. They will have one general partner who take full responsibility for the business, in addition to one or more limited partners who make monetary contributions. These limited partners, however, do not manage the business.
Limited partners choose to invest in the business to make money down the road, but they are not responsible for the company’s liabilities and debts. This is known as silent partner limited liability. This means that the limited partners can take a share in the profits of the business, but they cannot lose more than they have invested. Depending on the state, limited partners may not be eligible for pass-through taxation.
If the limited partners begin to play an active role in managing the business, then they may lose their designation as a limited partner, in addition to the protections that come with the status.
Some limited partnerships decide to make a limited liability company the general partner so that no one has to suffer unlimited personal liability. It is important to note that this option is not available in most states, and it can also be much more complex than a typical limited partnership.
- Limited Liability Partnership
A limited liability partnership, or LLP, works similarly to a general partnership in the sense that all partners play a role in managing the business. However, this entity type limits their liability for one another’s actions.
The partners will still be liable for the business’ debts and liabilities, but they are not responsible for the mistakes of the other partners.
LLPs are only available in certain states and are generally limited to specific professions. These professions include doctors, accountants, and lawyers.
- Limited Liability Limited Partnership
As one of the newer forms of partnerships, a limited liability limited partnership is only available in certain states. It works similarly to a limited partnership in the sense that there is one general partner who manages the business. However, this kind of partnership limits the general partner’s liability so that every partner enjoys liability protection.
Currently, limited liability limited partnerships are permitted in the following states: Alabama, Arkansas, Arizona, Delaware, Colorado, Georgia, Florida, Illinois, Hawaii, Idaho, Iowa, Maryland, Kentucky, Minnesota, Montana, Missouri, Nevada, North Dakota, North Carolina, Oklahoma, Pennsylvania, Texas, South Dakota, Virginia, Washington, and Wyoming.
At present, the state of California does not permit LLLPs, but it does recognize LLLPs that have been created in other states. However, because LLLPs are not recognized in every state, they are not a great choice for companies that operate in multiple states. Also, their unique liability protections have not yet been tested in the courts.
How to Form a Legal Partnership
An individual who is interested in forming a partnership should follow these steps:
- Choose a Partnership Structure
The first step in forming a business partnership involves selecting the best structure for one’s situation. An entrepreneur should research the permitted partnership types in their state. They may do so by checking their secretary of state’s website to figure out which kinds of partnerships are available and which are allowed for the specific type of business.
This is also the time to discuss the business vision and goals of the company. The entrepreneur should ask him or herself what they want out of the business: a steady income, a tax shelter, or the opportunity to pursue one’s passion? Are there friends or family members who may want to play a role in the business? How will accounting be handled?
Depending on the answers to the above questions, an entrepreneur should pick the appropriate partnership structure. This would also be the right time to consult with an attorney and tax advisor.
- Draft a Partnership Agreement
Though some partnerships have been founded with a handshake, most are formed using an official partnership agreement. Like a corporation’s articles of incorporation, a partnership agreement determines how the business will be run, how profits and losses will be divided between partners, and how the company will navigate changes, such as the exit or death of a partner.
The partnership agreement should be signed by every involved party. It should also cover the following questions:
– Who are the partners?
– How is ownership divided among partners?
– Who manages the business? Does one partner have more responsibility than the others?
– Are there limited partners? What do they contribute?
– How are disputes resolved? Does one partner have the final say? What happens if there is a conflict that cannot be resolved?
– How are profits and losses shared?
– Will family be involved in the partnership? Will they have any special powers or benefits?
If an entrepreneur is creating a limited partnership, a limited liability partnership, or a limited liability limited partnership, then he or she must register the company with the state. To do so, they must follow these steps:
– Select a Home State: If the business is spread out over many states, then one should choose a state of formation. In general, the best state for this purpose is the one where the majority of business is conducted.
– Review Licensing Requirements: One should figure out what licenses are needed to conduct business in the specific state.
– Apply: One should complete the certificate of partnership for the relevant structure and file it with the secretary of state. This application will usually include the names of the partners, their positions, the purpose of the company, and the expiration date of the partnership.
– Appoint a Registered Agent: One should name an individual who has a physical location during business hours. This way, they can accept notices of lawsuits and other business documents for the partnership. There are also professional services that can act as a registered agent.
– Submit the Application: It is important to submit the requested number of copies of the certificate along with the necessary fee to the secretary of state’s office. Typically, this may be submitted online.
– Preserve Documents: After the company’s application has been approved, it is important to house the documents in a permanent business file.
If the partnership is registered as a limited partnership, a limited liability partnership, or a limited liability limited partnership, it will be necessary to file annual reports to update the secretary of state about basic information regarding the business. Most states ask for these reports either annually or biannually, in addition to a filing fee.