One of the most dangerous possible pitfalls that can be made in business is to blindly sign a partnership agreement with no real understanding of how it might impact the company and each of its partners down the line.
Prior to entering into a partnership agreement often under an LLC, it is imperative to familiarize yourself with the non-modifiable rules involved with such an agreement, such as registration requirements, a partner’s access to books and records, a partner’s duty of loyalty and care, a court’s standard for expelling a partner, and winding up the business.
Key aspects of a partnership agreement generally include the following:
- Management The partnership can be managed by designated managers or by the partners. The partnership agreement should spell out precisely what types of decisions are day-to-day decisions to be handled by management and what types of decisions must be submitted to a vote by non-managerial partners.
- Control The partnership agreement should clarify what percentage of ownership interest or number of partners constitutes a quorum for purposes of voting and what percentage of those voting is required for an item or resolution to pass. A simple majority might be agreeable for certain issues whereas a defined “supermajority” might be appropriate in other instances.
- Liability to Third Parties A partner in an LLC is generally only liable to third parties for official business of the company to the extent of the partner’s capital contribution except when the partner is responsible for committing a tort (like negligence or fraud) in which case the partner may be liable beyond his or her contribution. Other types of partnerships have liability largely defined by statute. In many cases, the partners can shift liability if set forth in the partnership agreement. For instance, as a partner, it is important to know whether you are jointly and severally liable which means you are liable for the acts of your partners beyond your capital contribution even if you had no involvement in the act that gave rise to liability.
- Partners’ Duties/Ousting a Partner While partners owe each other duties of care and loyalty (among others) that cannot be waived through the agreement, the agreement can define the standards that apply. The partnership agreement should also set forth a process to expel a partner who is not meeting his or her obligations.
- Contributions to Capital Accounts and Allocations of Profits and Losses Typically, a partnership maintains a capital account for each partner. A partner’s capital contributions can be in the form of cash or other assets. Profits and losses are shared equally unless otherwise agreed. The IRS code and Treasury regulations contain detailed requirements regarding maintenance of capital accounts and can operate to invalidate allocation agreements in certain situations. Care must also be taken to ensure the allocations do not violate state law. For tax purposes, a partnership is generally considered a “pass through” entity, meaning the partnership must file a partnership return, but each partner will be responsible for his or her own percentage of tax liability, highlighting the need to address the contribution and allocation provisions in any agreement.
- Restrictions on Transferability Small businesses frequently prefer to keep the business within a close group of individuals, family being an example. If a disgruntled family member finds a lucrative opportunity to transfer his or her interest to a third-party, a partnership agreement should address this scenario. Restrictions are commonly placed on these interests such as a right of first refusal given to the partnership or the other partners (or family members). This may include an agreed upon appraisal process. If this is not addressed in the partnership agreement, it can become a major risk to a family-owned business. If a partner does sell to a third party, another restriction might compel that partner’s resignation with respect to all other titles held in the company, which might include employee, manager, director, or officer.
- Dissolution While there are statutory safeguards with respect to events causing dissolution or winding up, the partners should consider whether it must be expanded to address unique circumstances of the business or the partners.
Without a sound partnership agreement, partnerships and their partners are simply more prone to various types of lawsuits. For example, a minority partner may pursue a minority oppression claim, alleging improper squeeze out from the company. Partners can be confronted with the reality that their investment and planned profits are lost. A well-designed partnership agreement can be an effective risk management tool.
Richard B. Maltby is an Attorney at Frost Van den Boom, P.A., Gainesville, Florida.
NOTICE: This article is for the purpose of providing general information about the law. It is not intended to be legal advice. Anyone with a legal problem should consult his or her attorney, as every matter is different.
By Richard B. Maltby