08 April 09

Why Do We Need A Partnership Agreement?

“We’ve been partners for years.  We all get on fine.  If there’s any problem we can sort it out without a formal agreement.”  Right?

At the time this statement was made there were no problems for the four partner business..  However, six months later one of the partners started to spend more and more time on his outside interests and his commitment to the partnership had waned.  A partnership meeting was held to discuss it, but he didn’t turn up.

What options do the partners have now?  With no partnership agreement to refer to they have no guidance on how this issue should be tackled.  The lack of a partnership agreement means that in law they are a “partnership at will.”  This means that no changes can be made to the structure of the partnership and it is automatically dissolved if someone leaves, even if the partners agree that they don’t want this to happen.  So unfortunately our partnership is stuck with the recalcitrant partner unless they want to sell up and start again.

If you have wisely chosen to have a partnership agreement it is essential that it is always kept up to date.  This means having the deed amended each time a partner joins or leaves.  To avoid having to change the agreement every time the profit sharing ratios are amended you can use a catch-all phrase such as “or as the partners agree from time to time” thus enabling you to agree the ratios outside the scope of the deed.

The consequences of allowing your agreement to fall out of date can be dire.  If you have negotiated a contract, for example with a government department, that contract is technically no longer valid if your partnership agreement is not up to date.  This could be used as an excuse for the government department to withdraw from the contract.

Hopefully we have persuaded you of the need for a valid partnership agreement.  You now need to ensure that your deed does exactly what you want it to.  We have seen agreements which state that in the event of the partnership wanting to expel a partner, the vote to expel him must be unanimous.  Would you vote to expel yourself?  Possibly not.

You should also make your agreement tax efficient.  The value of your share of the partnership assets should be protected from inheritance tax if you die while still working as a partner.  This is because “business property relief” covers the amount that might otherwise be taxed at 40%.  However, if your partnership agreement contains a binding contract to buy your share of the assets from your executors, there will be no relief and your family may inherit less than you might have expected.

There is a simple way round this.  Your agreement should contain a “cross option” clause.  This gives your executors the option to sell your share back to the partnership and it gives the partnership the option to buy your share.  Either side can exercise their option, but there is no binding contract because if neither side wants the sale to go ahead then it does not have to.  Full business property relief should be available in that case.

Drawing up a partnership agreement is a tricky task and failing to do it correctly can mean pitfalls that are not spotted until it is too late.  It is essential to have your deed drawn up by a legal adviser who understands the workings and concerns of your business, and will be able to anticipate problems that may not be immediately obvious. 

We would also advise that you have your draft agreement checked by your tax advisers and accountants, in case there are any tax problems or practical accounting issues with the clauses you have included in your agreement.

If you have any queries about your agreement (or lack thereof!) please call us for advice.