If you’re starting a business with one or more partners, you want to get on the same page and be clear upfront about how the business is going to operate—and how you’ll share the money you make. The best way to do that is through a legal document called a partnership agreement.
What is a Partnership Agreement?
A partnership agreement is a legal document that dictates how a small for-profit business will operate under two or more people.
The agreement lays out the responsibilities of each partner in the business, how much of the business each partner owns, and how much profit and loss each partner is responsible for. It also includes rules about how you’ll manage the business and addresses potential scenarios that could affect the business, such as death of a partner or how a partner can leave the company.
The purpose of a partnership agreement is to get in writing answers to common questions that could arise in the business, so you and your partner(s) don’t find yourselves at odds down the line.
Why You Need a Partnership Agreement
In the absence of a partnership agreement, your partnership’s operation will be governed by your state’s partnership laws. These laws offer a standardized approach to running a partnership and resolving common issues, but they’re not customized to your business and can lead to results you didn’t intend. For example, your partnership may have to be dissolved and re-formed if one partner decides to leave.
A partnership agreement lays the foundation for success in a business. To create an agreement, you’ll have to sit down with your partners and make clear decisions about who will play what role, how you’ll fund your business, how you’ll allocate profits and losses, and how you’ll handle new partners and departing ones. If you don’t go through this exercise, it’s easy to assume you’re all on the same page when really you have very different visions for how your business will run. The conflict this creates can set your enterprise on a course for failure.
There will always be disagreements and difficult decisions in the life of a business. A partnership helps to minimize disputes with your partners and give you clear guidelines when disagreements do arise.
Partnership Vs. Corporation
Whether you classify your business as a partnership or a corporation determines how you’ll be taxed and how much liability you have in the business.
General partnership is the default classification for any unincorporated business with multiple owners, whether there’s a written partnership agreement or not.
The partners in a general partnership are each fully liable for the company’s debts. For tax purposes, a partnership is considered a pass-through business. The partners’ report their share of company profits and losses on their personal tax returns and pay personal income tax on them. If they work in the business, they’ll also pay self-employment taxes.
A corporation, in contrast, is a business entity that’s created by filing paperwork with the state. You and fellow business owners own shares in the corporation, which has its own legal identity. Owners aren’t personally liable for a corporation’s business debts, and they may receive a salary as an employee of the corporation. Corporations are taxed differently than partnerships. They can be taxed as C corporations that pay corporate income taxes. Some small corporations can be taxed as pass-through entities by electing S corp. taxation.
What Should a Partnership Agreement Include?
Like any typical contract, your partnership agreement should include some basics:
- The business name
- Description of the business
- Contact information for the business and owners
In addition to that, include details to cover important decisions and scenarios you’ll face throughout the life of the business. At a minimum, your partnership agreement should include clauses to address:
- Ownership. How much of the business does each partner own? This is usually expressed as a percentage interest in the business
- Decision-making. Does every decision need to be unanimous? Which decisions will you leave to majority rule? How much weight does each partner’s vote carry (for example, based on their percentage of ownership)? Detail exactly how you’ll make decisions in the business to ensure all voices are heard fairly and that no partner can question the validity of decisions after the fact.
- Capital contribution. How much will each partner put in to start and run the business? Will contributions be cash, property, or services? If the business needs more money down the road to continue operating, what is each partner’s responsibility — or, will you close your doors if you run out of cash?
- Profits and distributions. How will you allocate profits and losses among the partners? Detail when and how partners should be repaid for their contributions, and when and how they’ll receive distributions from profits.
- Death and disability. What happens if a partner dies or becomes unable to continue operating the business? Who inherits their share of the company, and does the new owner(s) also inherit their responsibilities or decision-making rights? Do the other partners have a right to buy out the departing partner’s interest? Include this clause to prepare your business for the unexpected as well as to think long-term about the possibility of your business outliving its founders.
- Withdrawal or addition of a partner. If anyone wants to leave the partnership, how can they do that? What happens to their share and decision-making rights? How will the business absorb their operational and fiscal responsibilities? What’s the procedure for admitting new partners and allocating profits, losses and responsibilities to them? It’s vital to define these terms now, while the partners are in good standing, in case you’re on bad terms when these scenarios come up.
Frequently Asked Questions (FAQs)
What’s the difference between a partnership agreement and an operating agreement?
A partnership agreement and an operating agreement are very similar in what they define: ownership and investment stakes, division of profits and losses, and so on. However, a partnership agreement is used in partnerships, while operating agreements are used in LLCs.
What are the four types of partnership?
Partnerships are classified according to how they distribute liability among partners, as follows:
General partnership (GP): Each partner has total liability for all of the business’s financial and legal obligations, including obligations caused by another partner’s actions.
Limited partnership (LP): At least one partner (the “general partner”) has total liability, while one or more “limited partners” (usually investors) have limited liability.
Limited liability partnership (LLP): Each partner has total liability for business obligations but is protected from liabilities due to other partners’ conduct. LLPs are typically reserved for professionals like doctors, lawyers and accountants, and are only available in some states.
Limited liability limited partnership (LLLP): Operates like an LP, but the general partner also has limited liability. LLLPs are not available in all states, and their liability protection has not been thoroughly tested in court.
Where can I find a partnership agreement template?
You can find partnership agreement samples, templates and guidance through your state’s bar association’s website, through the Small Business Administration resource Score, or from private companies such as Rocket Lawyer and LegalZoom.
Can you write your own partnership agreement or do you need a lawyer?
You can find partnership agreement samples, templates and guidance through your state’s bar association’s website, through the Small Business Administration resource SCORE, or from private companies such as Rocket Lawyer and LegalZoom.