Partnership agreements

In short

A friend of mine once split a landscaping business with his brother on a handshake, and it worked fine until the first big check came in. If you are thinking about going into business with someone, put your deal on paper before you earn a dollar together. Write down who puts in what money and what work. Write down how profits and losses get split, and who can sign for the business. Decide now what happens if one of you wants out, gets sick, or dies. Then have a lawyer in your state read it, because a page that feels friendly today can be hard to fix later.

The whole of it

What it is

I once watched two good friends stop speaking over a lawn mower. It was not about the mower. It was about the fact that nobody had ever said out loud who owned it. A partnership agreement is the written answer to questions like that one. It is a contract between the people who own a business together, and it says how the business will be run and how the money will be shared.

You may not know this, but a partnership can exist without any paper at all. If two or more people carry on a business for profit as co owners, most states treat them as partners. That is the general rule under the Uniform Partnership Act, which many states have adopted in some form. So the real choice is not between having a partnership and not having one. The choice is between a deal you wrote yourselves and a deal your state writes for you.

The written agreement can be short or long. It works alongside your state's rules and can change many of them. For the parts it leaves out, the state's default rules fill the gaps. Those defaults can surprise people, and we will look at a few of them below.

How it works

If you are holding a business idea with a partner, picture the agreement as a set of promises about money, work, and control. On money, it names what each partner puts in at the start. That might be cash, a truck, or equipment. It also says whether anyone can be asked to put in more later, and how.

On profits, it says how the business income is divided. Many people assume the split follows the money put in, but it does not have to. You can split it evenly, or by ownership share, or by some other formula you both accept. The partners then report their share on their own tax returns. The partnership itself files an information return with the IRS, but the tax is paid by the partners. The IRS explains this on its Partnerships page at irs.gov.

On control, the agreement says who makes which decisions. Small daily choices can belong to whoever runs that part of the work. Big choices, like taking on a loan or bringing in a new partner, can require both of you to agree. Spelling this out matters because, in a general partnership, each partner can usually bind the whole business to a contract. One partner's signature can put the other partner on the hook.

That leads to the part people like least. In a general partnership, each partner can be personally responsible for the debts of the business. If the business cannot pay, a creditor may come after your own savings. A limited liability company or a limited partnership can change that picture, and your state's business office explains the options.

Finally, the agreement should cover the exit. It can say how the business gets valued if one partner leaves. It can say who has the first right to buy the departing share. It can also say what happens if a partner dies or becomes unable to work. A buy sell clause is the usual name for this, and it is worth an hour of your time.

The numbers, and where to find yours

Nobody likes to hear it, but the numbers here mostly come from your own deal. Your agreement should list each partner's starting contribution and ownership percentage. It should also list any salary or draw, which is money a partner takes out of the business during the year.

A few figures do come from the government. Partnerships file Form 1065 with the IRS, and each partner receives a Schedule K 1 showing their share of income and deductions. The filing deadline and any penalty amount are set by law and change, so check the current the current figure, which the official source publishes each year and the the current figure, which the official source publishes each year on the IRS Partnerships page. If you are a working partner, you may owe self employment tax on your share, and the rate is the current figure, which the official source publishes each year. The IRS page on self employment tax lays it out.

To find your state's rules, look up your Secretary of State's business division. Most states post their partnership statute and filing fees online. Look for the section on general partnerships if you have not registered as an LLC.

A worked example

Let me tell you about Marisol and Dev. They opened a small bakery together. Marisol put in 30,000 dollars for ovens and supplies. Dev put in 10,000 dollars and agreed to work the counter full time. They had no agreement, just a warm feeling.

In the first year the bakery made a profit of 24,000 dollars. Marisol figured she should get most of it, since she put in more cash. Dev figured he should get more, since he worked every day. Both had a fair point. Both were sure they were right.

Here is how it would have gone with the state default. In many states, absent an agreement, partners share profits equally no matter who put in what. Split evenly, that is 24,000 divided by 2, which is 12,000 dollars each. Marisol would have felt shortchanged. She put in three times the money.

Now suppose they had written it down first. They could have agreed to split profit by capital put in. Marisol's share is 30,000 divided by 40,000, which is 75 percent. Dev's is 10,000 divided by 40,000, which is 25 percent. On 24,000 dollars of profit, Marisol gets 24,000 times 0.75, or 18,000 dollars. Dev gets 24,000 times 0.25, or 6,000 dollars. Dev would feel cheated, since he worked all year.

They could also have paid Dev for his work first. Say they had agreed on 12,000 dollars for his labor. That leaves 24,000 minus 12,000, or 12,000 dollars of profit to split. Then they would divide by capital. Marisol gets 12,000 times 0.75, or 9,000 dollars. Dev gets 12,000 times 0.25, or 3,000 dollars, plus his 12,000 salary, for 15,000 dollars in all. Check the sum. 9,000 plus 15,000 is 24,000. Every dollar is placed, and both partners can see why.

Notice what changed. The money did not change. The paper did. Writing it down lets each partner see what the other brought. The right split is theirs to choose.

Where it goes wrong

I have seen more trouble come from silence than from anger. The first common mistake is leaving the agreement unwritten because you trust each other. Trust is fine. It just does not remember details the same way twice.

The second is skipping the exit. Nobody plans to leave when they start. Yet people do leave, and without a plan the fight is over value and timing at the worst possible moment.

Third is forgetting that one partner can bind the other. If your partner signs a lease or takes a loan for the business, you may be responsible. Talk about signing limits early.

Fourth is copying a form off the internet and never reading it. A template written for another state, or another kind of business, can quietly say things you never meant. A short visit with a lawyer licensed in your state is cheap next to a lawsuit.

Fifth is never updating the paper. Businesses grow. A partner takes on more work, or new money comes in. Sit down once a year and ask if the deal still fits.

Questions to answer before you leave this page

Have you and your partner said out loud how much each of you is putting in, and in what form? Do you both agree on how profits and losses will be split, and does that split reward the work as well as the money? Who is allowed to sign contracts or take on debt, and up to what amount before the other must agree? What happens if one of you wants to leave, and how will the business be valued on that day? What happens if one of you dies or cannot work, and who gets the first chance to buy that share? Have you checked what your state's default rules say, and have you asked a lawyer in your state to read your draft? And when will you next sit down together to see if the deal still feels fair?