Partnership Agreements: What They Are and Why You Need One

Clear and effective boundaries empower healthier relationships, including business partnerships. Before you start a business with one or more partners, establish clear communication, define roles and responsibilities, and help prevent future conflicts through a partnership agreement.

What is a partnership agreement?

A partnership agreement is a legal document that outlines the terms and conditions between two or more individuals who agree to manage and operate a business together.

A written partnership agreement clarifies three things:

• Who owns how much of the business' profits and losses
• Who’s responsible for what daily operations
• How to proceed in the event of significant changes within the business

By answering these important questions upfront, you can create clear guidelines that help your business continue to run smoothly when faced with common challenges later on.

Types of partnerships

Various types of partnerships exist to accommodate different businesses' needs. There are three major types of business partnerships in the United States. Another type of partnership is LLLP, but this is not permitted in all states and is not common. The major business partnerships in the U.S. are: 

General partnership: the most common type of business partnership. Under a general partnership agreement, all partners share ownership and equal responsibility for managing the business and are personally liable for business debts.

Limited partnership (LP): a type of partnership that includes both general partners (who manage the business and are liable for its debts) and limited partners (who invest but do not manage the business and have limited liability). They make capital contributions but aren't active in the business’s daily operations or decisions.

Limited Liability Partnerships (LLP): A type of partnership structure where every partner has a limited personal liability for the debts or claims of the partnership. Partners are responsible for daily operations and legal liabilities, but they’re not responsible for the actions of other partners.

Other partnerships: Some states also offer limited liability limited partnerships. Limited liability limited partnerships (LLLPs) are somewhere between an LP and an LLP. Partners are fully responsible for daily business operations but aren't fully liable for business debts.

Key elements of a business partnership agreement

An effective partnership agreement should include at least the following topics:

• The business name and purpose of the partnership
• Each partner's ownership interest
• Profit and loss distribution
• Management and voting practices
• A partner addition and withdrawal process
• Dissolution of partnership: conditions and process
• Dispute resolution tactics
• Adherence or deviations from state partnership law

Other important elements will depend on your partnership business' industry, the rules and regulations of your state, and your partnership's personal needs and expectations. An attorney can help you clarify a more refined agreement.

Why you need a partnership agreement

A partnership agreement is not a legal requirement. However, it's highly recommended if you want to ensure smooth operations and clear expectations among your business partners.

Further, a customized partnership agreement allows you to override state partnership rules and dictate how you want to approach important business issues.

Defines roles and responsibilities

Your partnership agreement should clearly outline each partner's roles, responsibilities, and authority before you start your business. Detail the specific tasks each partner will take on with defined obligations and expectations for each position.

These boundaries prevent conflicts by setting clear expectations on who handles various aspects of the business. Allocate responsibilities in a way that ensures every aspect of the business is equally covered.

Distribute profits and losses

The agreement should specify the percentage of ownership stake. Define how profits and losses will be shared among each partner to ensure that every member is treated fairly and knows what to expect in terms of financial returns or obligations. Determine whether you'll distribute profits and losses equally, by fixed percentages, or based on capital contributions.

Legal protection

Defining the terms of a business relationship provides a legal framework that protects the interests of all partners. In the absence of a partnership agreement, default state laws will apply, which might not be in the best interest of all partners or the specific business needs.

Certain partnership agreements—such as an LLP agreement—can establish rules that legally protect other partners from one partner's bad business decisions. For example, doctors or lawyers in an LLP can determine that not all members are responsible for malpractice committed by one member.

Dispute resolution

The agreement can include mechanisms for resolving disputes among partners, thus avoiding costly and time-consuming legal disputes. It can specify mediation, arbitration, or other methods to address disagreements.

For example, establish the weight of each partner's vote and whether you'll make major decisions based on majority rules or unanimous consent. Detail how you’ll make business decisions that ensure every partner is heard and no partner can question the validity of a decision once it's made.

Regulates entry and exit of partners

It outlines the process for adding new partners and the conditions under which partners can exit the partnership. This includes the steps necessary for a partner's withdrawal, retirement, or expulsion, and details on handling the partner’s stake in the business.

Succession planning

In the event of a partner's death or incapacity, the partnership agreement can specify how the partner's interest in the business is to be handled, ensuring the business continues smoothly without legal complications.

Additionally, you can include a clause to ensure that one partner leaving the company doesn't dissolve the entire partnership and that the remaining partners have the option to buy out the interest of the withdrawing partner.

Prevents misunderstandings

A partnership agreement helps prevent misunderstandings that can arise from verbal agreements by having everything in writing, ensuring all partners are on the same page.

Customizes to specific needs

Several U.S. states currently observe the Revised Uniform Partnership Act that dictates general rules regarding general partnerships and limited liability partnerships. A partnership agreement allows partners to structure their relationship to suit their specific needs and the needs of the business, offering flexibility that laws cannot provide.

How to create a partnership agreement in 5 steps

Every business partnership is unique and requires a customized approach. You may draft several versions of this agreement before all the partners agree. However, we've drafted some best practices for crafting your contract.

Step 1: Get legal advice

Whenever you draft a legal document of this nature, you'll want to consult a legal expert. Your attorney will act as both an advisor and a mediator to ensure both the needs of the business and the needs of each individual partner are adequately addressed. Their knowledge of state and federal laws will also ensure that you've addressed any governing law that can impact your business down the line.

Step 2: Understand the tax implications

Taxes are another area in which you'll greatly benefit from legal counsel, but we'll outline some important points that you should know.

Partnerships must file an annual tax return that reports the income, deductions, gains, and losses of that tax year. However, the partnership itself does not pay income tax. Instead, profits or losses "pass through" to its partners, who report their share of income or loss on their personal tax returns.

However, partnerships with 100 or fewer partners who are part of an eligible partnership can elect to opt out of the centralized partnership audit regime for that year.

These partnerships are eligible:

• Individuals
• S corporations
• C corporations
• Foreign entities that would be treated as a C corporation in the U.S.
• Estates of deceased partners

Partnerships that elect out of the centralized partnership audit regime choose to be treated as taxable entities instead of filing individual audits.

Step 3: Collect all core information

Every partnership agreement should include core partnership details such as the names, addresses, and established roles of all partners, where the business is located. Here are a few of the basic details that your agreement should include:

The partner's names and addresses: Include the full names and addresses of all partners involved in the partnership as well as the address of the business. This information identifies the parties responsible for the partnership’s actions and is essential for legal and practical purposes. Specify if each partner is an individual, partnership, LLC, or corporation, as this will have tax implications.

The business name and purpose: Your business name is also necessary for legal purposes. Search for available names in your state to ensure you choose a name that another business isn’t already using. Define business goals upfront to ensure all partners are aligned on what you aim to achieve.

The industry and partnership roles: Your type of business and the services you provide will impact the type of partnership agreement you want to enter into and how you'll allocate roles and responsibilities. Clearly outline the specific duties of each partner—including management responsibilities—to avoid overlap and ensure the partnership operates efficiently.

Step 4: Draft the agreement

Once you've established the basics, you can start to lay the foundation for your partnership. You'll want to outline all key elements and terms clearly and comprehensively.

Details will vary, but there are some key elements every partnership agreement should include:

Capital contributions: Record the value of each partner's contributions to the business and what those contributions are. This refers to the amount of time, money, or assets each partner will offer the business.

For example, one partner may contribute $100,000 in cash, another might contribute the property from which the business will operate, and a third partner may contribute the industry expertise necessary to ensure successful operations.

Partnership rules: Establish a set of rules to prepare for the most common business occurrences. This should include if and how the partnership will allow new members, rules around how a partner may withdraw, and how to approach a voluntary dissolution of your partnership.

Management responsibilities: Determine which, if not all, partners will manage the business. Consider voting methods, partnership liability, signing authority, and which decisions require unanimous consent.

Accounting principles: Decide upfront how you will make financial decisions. Determine how your partnership will vote on financial decisions, how you'll distribute profits and losses, and whether or not partners will receive additional compensation for services performed for the business.

If you didn't build this agreement with the help of an attorney, review the draft with a legal expert to ensure compliance with state laws and the protection of all partners’ interests.

Step 5: Sign and formalize

Don’t rush the drafting process. Take as much time as you need to ensure every partner's voice is heard and the language is clear and concise. Once you've laid out the terms of your contract and reviewed it with an attorney, all partners will sign the agreement.

Register the partnership

State agencies may require partnerships to register their business with the Secretary of State’s office, a business bureau, or a business agency in the state where they do business. Partnerships often have to work with a registered agent in your state who'll receive official papers and legal documents on behalf of your company. 

Frequently asked questions about partnership agreements

If you have more questions related to partnership agreements, explore these frequently asked questions.

Is a partnership agreement legally required?

No, a partnership agreement isn't a legal requirement. However, having a partnership agreement can protect you from a lot of potential confusion and unwanted outcomes down the line by creating rules around how your business will operate, who will be responsible for what, and how you'll approach changes when they arise.

Can a partnership agreement be changed?

Yes, you can amend a partnership agreement if aspects of the business change and call for a restructuring. However, you must modify the agreement before the end of the tax year.

If you identify the need for an amendment, communicate it to your partners, negotiate new terms, draft an amendment, and hold a vote. This type of vote should likely be unanimous.

What's the difference between a partnership agreement and an operating agreement?

A partnership agreement is used in partnerships, while operating agreements are used specifically for LLCs (limited liability companies). However, both clarify how the business will run, the ownership and investment stakes, and the division of profits and losses.