Partnership Agreements Explained: Definition, Types & How To Create

If you are a business owner, you should have a formal agreement with your partners. Partnership agreements lay out the terms and conditions of your relationship with your business partners and help to protect all parties’ interests. If there is no written agreement, your partnership is governed by default state laws that may not be favorable to you. According to the U.S. Small Business Administration (SBA), partnerships are one of the most popular types of business for entrepreneurs and small business owners.

What Is a Partnership Agreement?

A partnership agreement is the official contract that outlines the terms of your business relationship. There are default rules for partnerships laid out in the Uniform Partnership Act (UPA), but only 44 states have adopted this act. A written partnership agreement will allow you to outline and customize the terms that are best for your business and will help you protect everyone involved legally.

One of the most crucial benefits of a written partnership agreement is legal protection and conflict prevention. According to Nolo, partnerships that don’t have written agreements see significantly higher rates of disputes and misunderstandings.

Types of Partnership Structures

Before drafting your agreement, it is important to understand the different types of partnerships and their liability protection levels. The partnership structure you choose will depend on your business goals, industry, and the level of personal liability protection you seek.

General Partnership (GP)

All partners are liable for all of the debts and obligations of the partnership. Each partner is personally liable for the losses and lawsuits incurred by the partnership:

• Any partner may enter into contracts that bind the whole partnership, without the consent of the other partners
• The personal assets of the partners are at stake for the debts of the business and for the claims of any lawsuits.
• Profits are subject to self-employment taxes.
• Difficulty of Dissolution: Dissolution of the general partnership is hard. All of the partners have to agree to dissolve the business, unless the partnership agreement provides for other options.

Limited Partnership

LP partners are not equal. General partners run the business and have unlimited personal liability for business losses and debts. Limited partners are passive investors in the business and have liability protection. In return for their liability protection, limited partners have no say in the day-to-day running of the business:

• General partners are on the hook for all losses, even if caused by a limited partner.
• Limited partners receive distributions from the business before any distributions to general partners, but they cannot direct how the business is run.
• Limited Partnerships require additional state filings and continuing compliance.
• LPs are a frequently used tool for estate planning. Limited partner interests can be gifted to family members.
• Capital contributions by limited partners must be clearly documented as this is their “equity” in the business.

Limited Liability Partnership (LLP)

All partners have limited personal liability for business debts and obligations.  This is the typical business structure for professional services:

• Partners are protected from liability for malpractice committed by other partners
• All partners have equal management authority unless the agreement specifies otherwise
• Requires formal state registration and annual compliance filings
• Each partner pays self-employment taxes on their share of profits
• Commonly used by law firms, accounting firms, consulting practices, and medical practices
• Provides stronger liability protection than a General Partnership with greater flexibility than a Limited Partnership

How to Create Your Partnership Agreement

Writing a partnership agreement should be a transparent process that includes clear communication and appropriate guidance. Follow these steps to create your own partnership agreement to protect all your business partners:

Step 1: Choose the correct partnership structure for your liability and tax objectives:

• Evaluate the risk of liability in your industry—LLP may be required for professional service firms
• Ask a CPA about self-employment taxes and the financial implications of each type of entity
• Weigh the expense and work of ongoing compliance with annual reports, administrative tasks, etc.
• Determine whether the business will have passive investors (LP) or all-active partners (GP or LLP)
• Review default state partnership law to know which terms you will want to override in the agreement

Step 2: Talk openly about goals, expectations, and concerns with all potential partners:

• Discuss each person’s financial situation and anticipated timeline for availability
• Discuss the role you want the other to have (full-time active, part-time or advisor)
• Talk about exit strategies and long- or short-term objectives for each partner
• Talk about any discomfort sharing profits, management control and voting power
• Understand how disputes will be handled and what decisions must be unanimous
• Discuss passing the business to children if that is a concern for your partnership

Step 3: Clearly define and document each partner’s contributions, roles and ownership percentages:

• Include the amount of capital, or percentage of capital, that each partner is contributing
• Include non-cash contributions such as patents, equipment or technical expertise
• Ownership interests can differ than the sharing of profits
• Title, role and responsibilities of each partner
• Include a clear statement of time commitment and payment expectations
• Include a provision for capital calls in the future if the business needs additional money

Step 4: Set financial and operating terms, including distribution of profits and losses:

• Profit and Loss distribution percentages may not equal ownership percentages
• Distribution of profits can be salaries, draws or both, in addition to profit participation
• Define how profits will be reinvested in the business and when distributions are paid to the partners
• Define how important decisions are made (unanimous, majority or delegated)
• Banking authority (signing of checks and authorizations)
• Accounting procedures, financial reporting and audits

Step 5: Consult with legal and tax advisors to make sure the agreement is legally enforceable and tax-efficient

• Have an attorney review the agreement before signing to ensure state law compliance and other enforceability issues
• Consult a CPA to fully understand the tax consequences of profit distributions and expense deductions
• Confirm that the agreement meets the professional licensing requirements for your industry
• Consult a CPA regarding S-corporation election if applicable to reduce self-employment taxes
• Discuss any relevant retirement plans (Solo 401k, SEP-IRA, Simple IRA) in the agreement
• Ensure insurance requirements and liability coverage are clearly defined in the agreement

Step 6: Draft the partnership agreement and have all partners review and sign the final document:

• Use a template for your state and type of partnership or hire an attorney to draft your partnership agreement
• Allow each partner the opportunity to review the agreement on their own
• Make sure each partner signs the agreement and keep a signed copy for each partner’s records
• Notarize the agreement for more legal strength and authenticity
• Meet with your partners each year to review that the agreement still reflects how your business is operating
• Record any changes or amendments made with the written and signed approval of all partners

Essential Elements to Include

If you want to have an all-inclusive partnership agreement, be sure to cover all of the following aspects. Each element works together to create a comprehensive roadmap that guides decision-making, prevents conflicts, and protects all partners’ interests. Omitting any of these critical components leaves your partnership vulnerable to misunderstandings, disputes, and financial loss:

• Percentage of ownership/capital contributions of each partner. Note the percentage of ownership or capital contributions of each partner for transparency purposes.
• Contributions/financial terms. Include the valuation method, capital contributions, financial responsibilities and authority, and financial decision-making authority.
• Profit and loss distribution. Provide for distribution of profits and losses based on agreed percentages instead of defaulting to an equal split.
• Roles/responsibilities/authority. Note the roles, responsibilities and authority of each partner, including management and day-to-day operations decision-making authority.
• Dispute resolution. Include how conflicts in the partnership will be handled if any should arise (mediation, arbitration).
• Exit strategies for partners. Note buy-out terms and dissolution procedures in case of a partners exit.