There is a tremendous amount of information to convey to fully understand partnership agreements. This is the first in a series of articles related to partnership agreements. Throughout this series I will explain the various sections and issues a small business owner faces in creating a sound and fair agreement with a single or multiple partners.
In this article I will introduce the reader to what a partnership agreement is and where to find the basic information related to a partnership agreement. In another article I will discuss the terminology used throughout partnership agreements. Other articles will cover partnership interests and the respective capital accounts. The series will continue with related issues addressing income, deductions, credits, and liabilities associated with the partnership. In the future I will write about the management of the partnership, yes somebody has to be the boss. From there I go into some legal issues that may come up from time to time and how the books of record are kept. The series will finish with articles related to tax matters and dissolution issues.
Before reading this article, please make sure you understand why you would want to be in a partnership and the associated advantages. I have written an article that introduces partnerships: please read The Basic Principles of a Partnership .
There are four principles of a partnership that you must understand:
- Mutual Reliance – dependency on each other for financial success
- Low Documentation & Fees – in general partnerships are the least expensive to maintain of any recognized legal entity. In addition, partnerships offer a low paperwork value on an annual basis.
- Pass-Through Taxation – the income, deductions and credits are passed straight through to the partners meaning the entity is tax free.
- Special Allocation – this in income distribution clause or understanding between partners allowing more income to one or more particular partners due to some positive attribute they bring to the partnership.
The partnership agreement is a document that outlines the ‘who’, ‘what’, ‘where’, ‘when’ and ‘how’. So to introduce the partnership agreement, you need to understand the various types of partnerships that exist.
This is the most common form of a partnership. Historically these have been father and son relationships or a sibling form of an arrangement. As commerce increased in the U.S., others found it beneficial to create relationships that are mutually beneficial. For the common person this is the more traditional business relationship.
When you think of a medical practice or law firms, this is where you will find a professional partnership in effect. Unlike a traditional partnership, professional partnerships are designed to expand some of the legal issues associated with a professional license. Often, there are legal issues due to professional conduct or errors and omissions. In addition, professional partnerships are structured to allow for expansion of new partners and address the retirement of a partner.
In professional partnerships, the agreement has more emphasis on these legal issues and the associated licensing, insurance and termination issues.
Unlike the traditional or professional partnerships whereby all the members are general partners, i.e. actively involved and generating revenue; limited partnerships have a different type of an arrangement. In these forms of partnerships, some of the partners may be general partners, others may be considered limited in nature. Limited means that their respective obligation is financial in nature and they have little to no say in the day to day operations. Here, the limited partner is only in it for a return on his investment. The general partners are liable for all other aspects of the business. If there is a lawsuit, the limited partners are only obligated up to their financial investment.
The most common investment made by limited partnerships is in real estate.
Joint venture is a rarely used term, but it is an arrangement whereby two or more parties agree to work together to achieve a specific goal. Most commonly used in construction whereby a project is too intensive or the restrictions for application are elevated that no single small business can meet the requirements. Therefore, two or more similar businesses agree to cooperate and combine resources to comply with the restrictions. Most often it is a capital intensive operation and therefore a larger operation is required.
An example may be two electrician installers agree to work a project together in order to meet the minimum number of qualified electrician requirements for a government construction project.
This is a legal term referring to a type of partnership. Often the entity format is that of a limited liability company and therefore the partnership is no longer a general partnership. The legally allowed term is a member. In these types of entity formats, there is rarely a limited partner and most memberships exist to make a financial profit based on services rendered. So in the more modern era, professional partnerships use a membership agreement to document the relationship.
Now that I have introduced the different types of partnerships, I am going to explain the first section of a partnership agreement. This is often referred to as the introductory section or the primary resolution. Most partnership agreements use the term ‘Article’ to separate the agreement into the basic areas of understanding. So this is Article I.
Article I – Introductory Matters
This is the part of the agreement that identifies the parties involved, purpose, place of operations, term or duration of existence, identification of the general partner in charge (the governing partner) and the limited partner if one or more exist, and finally the governmental authorities the partnership will interact with throughout the partnership’s existence.
Section 1.1 – in this section we identify the formation i.e. where the partnership is being formed and that the partnership is governed by the Uniform Partnership Act of that respective state. It should also state where the initial filing of information is recorded (in most states this is in the local circuit court).
Section 1.2 – identify the purpose to the partnership. Yes, it can be as simple as stating the goal is to create financial success in the business of ‘making and selling widgets’ or any other similar product. Sometimes the goal has some form of a final completion which could be something like a construction project or reaching final adjudication in law. Start out by stating: ‘The purpose of this agreement is to ____’.
Section 1.3 – identify the name of the partnership and the location of the office and principle place of operations (can be the same as the office).
Section 1.4 – Powers of the Partnership – this clause should set the limits of the partnership as a whole. You may want to set the industry of operation or restrict the partnership to operating within a certain territory or state.
Section 1.5 – Term of the Partnership – this is important to understand, the term sets up the dissolution or termination date. It is important to match the term to the goal of the partnership. If the goal is to construct a commercial complex for a developer, than set a reasonable deadline and add six months to that date and there’s your date for termination. Sometimes, the partnership may need to be ongoing as in a professional partnership. In this situation, you may set a 5 or 10 year duration. Prior to this period, the partners can sign an amendment extending the period. But if you set the period too long, then it will next to impossible to shorten the period of the term. So be reasonable in your thinking.
Section 1.6 – set up a fiscal year, in most partnerships this is a calendar year due to tax issues.
Section 1.7 – Organizational Matters – this section is laid out so the governing partner or general partner in charge is responsible to file the documents with the state, circuit court, other tax authorities and receive the proper identification numbers for tax and insurance purposes.
Section 1.8 – Governmental Compliance – the partnership agreement should convey to any reader the respective governmental agencies the partnership will interact with on a regular basis. The following is a short list of the most common:
- Internal Revenue Service – filing of annual tax returns, payroll returns, and any responses to inquiries
- State Revenue Department – filing of annual tax return with the respective state, payroll reporting, unemployment documentation
- Local Commissioner of Revenue – an annual filing may be required for a revenue or property tax reporting
- Regional Governing Boards/State Licensing Board – in the professional environment, this is very common to maintain the licenses of the partners and maintain the firm documentation
- Department of Labor – regular filings based on inquiries and accident reporting
- Regulatory Authority – in some partnerships, the operation may be governed by some regulation at the federal or state level, the partnership agreement needs to recognize this possibility
- License issuing authority may be designated and the frequency of maintenance so that no partner misunderstands the requirement to operate under a license or some certificate of operation
Summary – Partnership Agreements (Introduction)
The partnership agreement identifies the ‘who’, ‘what’, ‘where’, ‘when’ and how of the partnership. It is divided into many different sections and the first section covers basic introductory types of issues. Every partnership agreement is written with the type of partnership being created. Whether a traditional, professional, or limited partnership, understand the agreement in its totality is essential to creating a mutually beneficial relationship.
In our modern era, some entities are formed as corporations or limited liability companies and these organizations use a membership agreement. A membership agreement is nothing more than a partnership agreement shielded by the corporate protection.
This is the first in a series about the partnership agreement. When creating your agreement, seek the advice of legal counsel to ensure a well documented agreement. I am not an attorney and I strongly encourage you to seek advice from a lawyer. However, read this series so that you communicate from a position of knowledge. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.