A partnership agreement is an agreement between two or more business partners. The partners use the agreement to determine their rights to debt, distribution of profits and losses. The agreement also sets out general partnership rules such as withdrawals, capital contributions and financial reporting.
What is a Partnership Agreement?
A general partnership, often referred to as simply partnership, is a form of professional relationship in which two or more individuals engage in business and other related activities with the goal to yield a profit.
Although not strictly a formal structure—as it’s not a separate tax entity—a partnership remains one of the most popular ways of doing business for many entrepreneurs, especially when it comes to family ventures. As pass-through entities, partnerships are exempt from federal income tax. Instead, all partners report their annual profits and expenses on their personal returns using Form 1065.
Given that all participants invest in the venture by contributing financial assets, labor efforts, professional skills, or property, they also have a respective share in the profits. This extends to all assets and liabilities as well, meaning that every partner has to have a clear sense of their responsibilities.
As it’s not a separate legal structure, a partnership does not grant its participants any liability protection. Because of this, all partners should be aware that they may be held liable for the actions of their colleagues.
This is why it’s become a normal practice for partners to draft a partnership agreement prior to commencing any business operations. This document is designed to clearly outline the contributions and responsibilities of each party, helping prevent internal conflicts. Similar to the way operating agreements function in the context of LLC management, partnership agreements act as a security net that establishes a set of regulations and procedures used to maintain a fair and transparent business enterprise.
Who needs a Partnership Agreement?
Any informal business venture led by several individuals may be viewed as a partnership if it unequivocally pursues profit by providing goods, services, or engages in another form of commerce.
Even if a partnership is operated by spouses, family members (for example, siblings, parents and children, etc), or close friends, a partnership agreement is vital for its effective operation. Disputes, however small, are not uncommon and can be a cause for many grievances especially if they mount over time and hinder the partnership’s efficacy.
Having a document that outlines the internal rules of the business can only help you maintain a stable enterprise and avoid disagreements pertaining to administrative procedures, partner responsibilities, allocation of shares, and more.
Important Aspects of a Partnership Operating Agreement
Given its administrative importance, a partnership agreement typically covers all key aspects of running a business, even if it isn’t done under a formal structure. But that’s why it exists in the first place—to provide clarity to a business relationship that lacks corporate regulatory tools.
Contribution and Interest
Perhaps one of the most essential parts of the document, the section that describes the extent of each partner’s contribution is usually one of the first to be drafted. Its main job is to serve as proof of how much each member initially contributed to the startup capital, their recurring investments (money, property, etc), and their percentage interest, i.e. their stake in the partnership. This percentage of capital contribution plays a major role in the allocation of profits.
Allocation of Profits and Losses
There are a few ways to distribute profits or expenses between participants. Under a fixed interest, each partner will hold a percentage that might not be uniformly distributed among all members, but the total always amounts to 100%. When you choose equal share distribution, all members’ interest rates are identical, leading to an even allocation of profits. And finally, shares can be set based on the capital contribution of each member—the largest investor gets the biggest cut.
Being an active partner rather than an investor who doesn’t get involved in the daily operations means you can be appointed as a manager. Many partnerships elect an acting managing partner early on, while others bring in hired managers who do not hold any shares in the business.
When it comes to voting procedures, they usually go hand in hand with the share distribution system. Voting rights can be granted based on the size of the profit share, capital contribution, or it can be equal, giving all members a vote each.
A typical partnership is classified as a flow-through, allowing each member to report all profits allocated according to their share on their individual returns. In some cases, however, the IRS may survey the partnership in its entirety rather than review members separately. To manage the entity under the new tax regulations and prepare the partnership for any form of audit, all members must elect a tax representative.
Changes in Membership
To avoid state default laws, a partnership agreement should lay out partner withdrawal procedures, as well as an admittance policy for new members. In some cases, a partnership may face automatic dissolution following the departure of a partner. For this reason, each step of the withdrawal process should be carefully outlined, including terms of exit and notice periods.
Even if a partnership was established by a close-knit group, business disputes are unavoidable. The agreement presents a highly efficient way of handling potential internal conflicts by setting up ground rules for dispute resolution like majority voting, inviting a mediator, proposing a vote proportional to contribution or fixed rate, hiring an advisory agency, or giving the ruling power to the chief executive officer.
There are multiple reasons for ending a partnership, and not all of them are a product of a crisis. For instance, the entity may already have a dissolution date from the moment of its inception. Or its main purpose of existence has been adequately realized, so it makes no sense to keep maintaining it. It can also be dissolved when a partner withdraws or passes away. One of the more drastic reasons for dissolution is bankruptcy, either of one member or the entire enterprise. Whatever the cause, the agreement can be utilized to define the process of asset allocation post-dissolution.
Writing a Partnership Operating Agreement
The rules for drafting an agreement tend to alter slightly depending on the structure of a partnership. For instance, an agreement for an equal partnership can only be considered a properly authorized document if all partners took part in the drafting or at least fully consented to the conditions.
But the same can be true for entities with other types of ownership distribution. An agreement can only be truly effective when all parties are allowed to contribute or review the regulations before signing off on them.
Most entrepreneurs that choose the informal business path that a partnership presents also prefer working with professional business consultants and attorneys who can not only mediate the preliminary discussions but also help draft the document.
The agreement itself is not a required document, meaning you don’t have to submit it with any agency. It exists solely for your benefit but is nevertheless a fully legal document, and can be used in court in case of any litigation.
Agreements tend to be rather lengthy as is their purpose—they need to plan for every contingency. Some of the key elements typically found in a document like this include:
- Purpose of the partnership;
- Formation statement and name;
- Duration of the partnership’s existence;
- Addresses of business;
- Initial capital contributions of all members;
- Other information on capital-related operations;
- The relationship of interest and capital;
- Distributions of profit/loss;
- Financial, accounting, and banking procedures;
- Regular reporting with the state;
- Dates for the preferred fiscal year;
- Tax and audit rules;
- Partner withdrawal, admittance, etc;
- Voting rights;
- Dissolution process, allocation of assets, interest valuation;
- GAAP treatment;
- Duty of accountability, loyalty, etc;
- Forbidden acts and liability rules.
The agreement becomes a legally binding document once it is signed by all participating partners.