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 all make money.
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
A partnership agreement lays the foundation for success in a business. Without it, you could find yourself having to make difficult decisions at some point in your business, which could lead to disagreements and even legal battles with your partners.
The document avoids that by requiring you all to be on the same page from the outset and by clearly communicating and defining details around responsibilities and money in the business.
If you’re going to go into business with at least one other person, you should create a partnership agreement to avoid messy or costly legal disagreements in the future.
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.
A partnership is the default classification for a business with multiple owners. Whether you’ve written up a partnership agreement or not, your business is a partnership if it has multiple owners.
For tax and debt liability purposes, a partnership is considered a pass-through entity, meaning the business doesn’t hold any liability separate from the owners. As an owner, you pay income taxes on your share of business income, and you’re responsible for your share of the debt—all of which should be outlined in the partnership agreement.
A corporation, in contrast, is a separate entity that distinguishes the owners from the business. You and fellow business owners own shares in the corporation and receive a salary, and you’re not personally liable for business debts or taxes.
To create a corporation, instead of a partnership agreement, you’d write up articles of incorporation—a more complicated and likely more costly process necessary for more complex businesses.
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 (and its profits) does each partner own? This is usually noted as a percentage of the business or as a number of shares.
- 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 money will each partner put in to start the business? 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? Are you open to outside investors as needed? How, if at all, does a partner’s financial contribution affect their responsibilities in the day-to-day operations of the business (i.e. will some partners do the work while others supply the funds)?
- Salaries and/or distributions
How will you allocate money among the partners? Detail when and how partners should be repaid for their contributions, when they’ll receive a salary or distributions from profits (and losses), and how those will be distributed.
- Tax responsibility
How will you allocate tax liabilities among the partners?
- 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? 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 dissolution
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 its operational and fiscal responsibilities? It’s vital to define these terms now, while the partners are in good standing, in case you’re on bad terms when this scenario comes up.
Frequently Asked Questions (FAQs)
Partnerships are classified according to where 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.
Limited partnership (LP): One partner (the “general partner”) has total liability, while one or more (usually investors) have limited liability.
Limited liability partnership (LLP): Each partner has total liability but is protected from liabilities due to other partners’ errors or omissions. Typically reserved for doctors, lawyers and accountants, and only available in some states.
Limited liability limited partnership (LLLP): Operates like an LP, but the general partner also has limited liability. Not available in all states, and not thoroughly tested in court.
To legally be considered a partnership, a business relationship must:
– Include two or more people
– Be contractual (oral or written)
– Involve a business
– Be for-profit
– Extend liability to partners
– Not create a separate entity
You can write your own partnership agreement without working with a lawyer, but you’ll likely want a personal lawyer to review it and make sure you understand and are on board with all of your responsibilities and benefits.
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.
