Although a partnership requires no written agreement to exist as a trading entity, it is vital to draw one up and have a solicitor check it for you. Why? Well, circumstances and ambitions change, partners fall out or die. Without a partnership agreement clearly setting out everyone’s position, what the law says is to happen in certain circumstances may not be what the partners would have wanted. Or, in other circumstances, things can become hostile and partners can end up in disputes that could have been avoided. This guide discusses the pros and cons of partnerships and how to protect yourself from the start.
Many businesses begin as partnerships without knowing it. A partnership is a trading status that is created automatically when two or more people start running a business, possibly sharing the workload and expenses and/or investing capital to get things going.
Usually people choose to form a partnership, rather than trading as a limited company, because of its simplicity. However, if you run a business with someone but don’t employ them – often the case with husbands and wives, or friends working together – you may find that you have unintentionally formed a business partnership.
Partnership pros and cons
The pros of a partnership are considerable. It is easy to set up, there are no fees or registration and few ongoing legal chores. Each partner has a stake in making the business succeed. There is scope to discuss things with someone who is an equal in the business. You share responsibilities and the workload to your mutual advantage. You can feed off each other’s ideas and enthusiasm and concentrate on your strengths.
On the other hand, there are downsides. The greatest of these is that each partner is responsible for all the partnership’s liabilities, and there is no limit to this, regardless of how you share the profits. As a result each partner is responsible for business debts incurred by any of the partners – even if these expenses were not agreed. This does not apply to the same extent in the case of a limited partnership or a limited liability partnership where the maximum liability of partners can be limited (as explained later in this guide).
Also, you do not have total control. Your partners might not work as hard as you. They may have different ideas of how to achieve your aims or even develop different long-term goals altogether. After a while, partners can drift apart, and buying them out can prove expensive. For these and many other reasons, it is wise to have a proper partnership agreement that spells out how you will deal with any problems that might arise.
Choosing your partner(s)
It is clearly important to choose your partners carefully – you have to trust them. But how well do you really know them?
Though you may have known them a long time – as a work colleague, a friend, or even a spouse – could you work well together in a business? Do your skills and experience complement each other? Can you all put in the same amount of time and effort, or do you also have other, external, commitments? What are your financial circumstances? Do your temperaments match or complement each other or could clashes emerge? In many ways, a partnership is like a marriage and requires as much thought and commitment.
Buying into a partnership
The same sorts of consideration apply if you are buying into or joining an established partnership. How well do you know the existing partners and how well will you be able to work with them? Will they welcome a new person, with a right to some control, on board? Also, investigate the business as well as the other partners closely. Run a credit check on them. Listen to the grapevine. You want to be sure that the partner(s) have assets to cover their share of the debts should things go wrong – or you could be left paying for everything.
The legal position
There are three main types of partnership:
However an LLP’s accounts will generally have to be audited and filed at Companies House.
The legal position of each of these types of partnership is as follows:
If something is not covered by your partnership agreement, the appropriate provision of the relevant Act takes effect. However, the provisions of the Partnership Act may not always seem fair. For example, unless your partnership agreement states otherwise, a partner can withdraw from the business at any time on giving notice, and insist on the return of their capital contribution. This could cause the business to collapse. The Act also states that partners share the profits and the capital of the business equally. You may not want this if one of you has invested far more time and/or money in the business than the other(s).
The main elements of a partnership agreement
A partnership agreement allows you to override the provisions in the Partnership Act that do not suit you, either now or in the future. It should cover:
1. The fundamentals
State the name of the partnership, its trading address and the nature of its business. Include the date the partnership started and, if applicable, when or how it will end.
2. Financial matters
Provide details on financial matters such as:
3. Profits and pay
How will you allocate profits? How will you handle losses? Will partners receive a salary? How will their equity share be affected if, say, one person invests the capital to get the business going while the other person does all the work and receives a salary? How will equity shares be affected if one partner invests another capital sum in the business?
4. Introducing new partners
How will you handle the introduction of new partners? How will this affect the existing partners’ equity shares in the business?
5. Management
Who will do what? What restrictions will there be on what partners can do without each other’s consent, including what commitments or expenditure can be made? Will voting be unanimous or by majority?
6. Time off
Set out each partner’s holiday entitlement – the length, the frequency and the timing.
Set out how you will handle sick leave, maternity/paternity leave and pay.
7. Incapacity or death
Consider what would happen if one of the partners develops a long-term illness. Under the Act, they would continue to be entitled to a share of the profits. For this reason, it is wise to stipulate a time limit on this profit-sharing. Consider, too, what would happen if a partner were to become permanently unable to continue through physical or mental ill health or death.
For example, if one partner dies, their share of the business may pass to their spouse. Unless you stipulate otherwise, the spouse may become involved in the business, and inherit the deceased partner’s right to a share of the profits.
Alternatively, consider what happens if the spouse has no interest in the business and needs to realise the deceased partner’s share of the business – they may have no other source of income. If you do not have the cash to buy out the spouse’s share, your options are limited. You can:
A wise precaution therefore, is for partners to provide in the agreement for the taking out of life insurance on each other to provide a fund to buy out their share on their death.
8. Withdrawal
What if a partner no longer wants to work full-time, or fails to pull their weight? How will you share the benefits then?
What if one of you wants to retire or just wants to leave? How much notice must partners give if they want to withdraw? How will the other partner(s) finance buying their share? Can the leaving party sell their share of the business to an outside party? If so, under what circumstances?
9. Dismissal
What if you want to get rid of a partner who has, for instance, lost interest in the business? Can you give them notice to leave? How do you value their share and can you force them to sell?
10. When a partner leaves
Specify what will happen if a partner leaves, or if you dissolve the partnership, so far as assets, goodwill, capital contributions and any undrawn profit share are concerned.
There are other provisions you may like to include in your agreement (some may relate to the specific type of business). For instance, you may wish to take steps to prevent a departing partner from setting up in competition with the partnership. Such steps could include restrictions against taking on clients or staff.
These are complicated areas for which you will need legal advice.
11. Disputes
It is expensive to settle disputes in court. You may be able to avoid this by stating that all disputes will be resolved by arbitration or mediation, which are generally cheaper options. If you belong to a trade or professional body, they can nominate an arbitrator or may help you choose a mediator, or disputes can be referred to the Institute of Arbitrators.
It is wise to build a mechanism for resolving disputes into your partnership agreement, particularly with 50:50 partnerships. This is because the court generally will not be prepared to allow one 50% partner effective dominance over the other.
Typical clauses to resolve disputes include:
Obviously, the issues are slightly more complex when there are several partners.
Money aspects
While your accounts as a partnership must be accurate, and will need to be sufficient to satisfy the tax inspector, you don’t need to get them audited, unless your business is a limited liability partnership.
As a partnership, you have to submit tax returns for the partnership as well as each partner submitting their personal tax return. The profits are shared out and the taxable income is worked out as if you were self-employed – you can deduct allowable business expenses, though the partnership gets tax relief on capital expenses. Fortunately, you are not responsible for paying your partners’ tax bills if they fail to pay.
As a partner, you pay flat rate Class 2 National Insurance contributions (NIC) plus Class 4 NIC, which is a percentage of your profits to an upper limit.
If you sell a partnership asset for a profit, as a partner, you become liable for capital gains tax if your capital gain exceeds your annual exemption.
Never too late
If you’re serious about your business partnership, it’s worth doing things properly. That means getting a proper partnership agreement drawn up by a solicitor.
The chances of a business partnership surviving increase greatly if everyone knows exactly where they stand, both in the good times and in the bad. If you are in a partnership and have no partnership agreement, sort one out, especially if you are married to your business partner.
Remember that no matter how things started – or are now – circumstances can change. It would be a pity for the business to collapse because you hadn’t planned for every eventuality.
Useful contacts
Lawyers for Your Business
Run by the Law Society, this scheme has 1700 participating members in England and Wales who can give a free half-hour consultation on the legal issues and pitfalls to avoid when starting up or developing a business.
113 Chancery Lane, London WC2A 1PL.
T: 020 7242 1222
F: 020 7692 9998
W: www.lfyb.lawsociety.org.uk
