Article reference: UK-IA-COM05

Partnership as business structure

This article answers some of the most important questions that come to mind while entering or terminating a business partnership.

 
 

What is partnership?

In law, a business partnership is the situation where two or more people are working together for a common purpose, and with the intention of making money.

That situation might be where two or more people work closely together on a daily basis, like a family plumbing firm, or it might be where individuals work quite separately, but have the benefit of shared support services, in the same way that many firms of solicitors, barristers and other professionals.

In law, a partnership is not a legal "person". Unlike a company or an individual, it doesn't have its own legal identity. Instead, it is just a framework of rules as to how two or more people to work together.

The most significant implication of not being a separate "person" is that contracts with the partnership are in fact contracts with each of the individual partners. In law, responsibility for carrying out the contracts is taken on by all of the partners collectively, regardless of which individual partner signed on behalf of the partnership.

Who is in charge?

Unless the partnership agreement states otherwise, all partners are equal. They have equal rights to take on contracts and equal responsibility to fulfill them. They share profits and losses equally.

Many people work under an informal arrangement of two or three. Without an agreement, the rules of the relationship are governed automatically by the Partnership Act 1890.

This arrangement can work if no great value builds up in the business and none of the partners take any great risks. With little at stake, there is nothing obvious to argue about, and if a disagreement does arise, the partners can go their separate ways without too much loss or stress.

Common problems with informal partnerships

But problems can easily occur if there is no prior written agreement.

By default under the Partnership Act, there is no different entitlement to shares if one partner has a grander title (such as managing partner), or does more work, or contributes more capital into the business.

Without a formal agreement stating otherwise, the assets of the partnership belong equally to all partners.

If one partner works three day weeks and the other six day weeks, the profit from the harder working partner is shared with the other equally.

A common disagreement can be over who contributed most and therefore how assets should be divided: to someone who brings high value skills, to someone who brings cash, to someone who works long hours, or to someone who has contacts that bring sales.

This brings us on to the relative value of intellectual property, and how it is divided. Any trading business soon accumulates IP or intangible assets in the form of work in progress, customer contacts, business reputation and address, domain names, and web sites to name a few. These partnership assets may not be of value to third parties, but they are of considerable value to a partner when a dispute looms. They also have different values to different partners. Deciding who owns what can be very difficult.

Then there is the problem of joint liability. Without an agreement stating otherwise, there is nothing to stop one partner from making a risky contract in the course of business (such as borrowing money from a disreputable source). If that contract goes wrong, he or she, and all the other partners are liable for the debts equally. It is not uncommon for a bad decision by one partner to result in the personal bankruptcy of others who had no idea that the risky contract had been made.

So are all other partners liable for a bankrupt partner?

The short answer is no. If one of the partners becomes bankrupt in his personal affairs, his creditors will be entitled to take his share in the assets of the partnership, but the assets of the remaining partners will be unaffected.

Neither a trustee nor any creditor can automatically become a partner under any circumstances. The options for the trustee or creditor are either:

  • to become a "silent partner", taking a share of profits and losses but not contributing to the partnership work (the arrangement would have to be set out in a new partnership agreement); or, more likely
  • to force a sale of the partnership assets to raise enough cash to pay out the bankrupt partners share.

Since a fire sale is unlikely to obtain the real value of the assets (especially intangible ones that are more valuable to the working partnership than a third party buyer), the trustee or creditor might be persuaded to accept a small guaranteed sum immediately. In some circumstances, this may provide a windfall gain to the remaining partners.

The solution: a written, comprehensive partnership agreement

Every partnership ends some day. Most end sooner than the partners might have hoped when they started to work together. The best way to protect your interest in the business is to have everything agreed at the beginning in a comprehensive agreement. If you don't have one at the start, you can put one in place (or change the existing one) at any time.

Other than through the Act, partnerships are an area of law comparatively unregulated by the state.

There are particular rules as to taxation, but almost all other arrangements can be agreed by the partners.

If the partners do not sign an agreement that effectively covers all the provisions made in the 1890 Act, then the Act applies to those that are missing.

Unfortunately, the Act is rather general so if a provision is missed in the partnership agreement, the Act is unlikely to cover the point in the detail that the partners require.

What should an agreement cover?

The short answer is everything of importance.

Sticking to the principle of keeping it simple by using a short form agreement can be a mistake. It needs to be thorough.

We would advise you to write your agreement in plain English and not over complicate it, but it does need to be comprehensive if it is to do its job.

Of particular importance is to make sure that it covers the eventualities that if left out would otherwise be covered by the Act. These include:

  • how new partners are taken in
  • how assets and capital brought into the partnership (particularly premises and cash) are owned
  • how partners are to be paid and how profits are divided
  • expenses
  • day to day management of the business
  • the process around retirement
  • the circumstances in which a partner may be removed from the partnership and the process for doing so

As previously noted, the one thing that the Act does cover that can't be changed are the rules relating to taxation.

Other important things to make sure your agreement covers

Decision making

A partnership requires no formal decision making structure. You can set out whatever arrangements you like, so that different partners, or groups, are given power and responsibility for different sections of the business.

Perhaps more importantly, other partners, particularly newer ones, or ones with a lesser share, may be excluded from those business decisions.

Dissolution

Unless the agreement states otherwise, a partnership is dissolved simply by one partner giving notice to the others of his intention to leave, or automatically, by the death or bankruptcy of one partner. An agreement can specify other reasons for automatic dissolution (such as one of the partners committing a criminal act).

If not included in the agreement, a partner who decides to break free could insist on all the assets of the business going under the hammer. This would be disastrous for most businesses. A process that establishes the fair value for the partner's share should be agreed beforehand. Asking an accountant to draw up the accounts as at the date of exit may be a good idea.

In the case of an unexpected death (or a partner hiding likely bankruptcy from his fellow partners) an agreement can set out a process that protects the interests of the remaining partners.

How do I terminate a partnership?

The first thing to remember is to keep the relationship as amicable as possible. The business is likely to continue while you are ending the relationship, and you will have to negotiate the best deal for you.

You shouldn't walk away because you feel it is easier for you not to be involved. You may be in breach of the partnership agreement or of the duty of care imposed by the Act. The courts will not look favourably on you if you leave your partner with contracts that he cannot meet, even if you think it makes the situation easier for both of you. Nor will the courts approve of strong arm tactics to try to end the relationship faster or in your favour.

The process for termination of a partnership should be covered in the agreement itself. If it is not, then a partner simply needs to write to all others giving notice of his intention to terminate it. The process should then be agreed. Net Lawman provides a dissolution agreement that records the final settlement and sets out the procedures.

It would be wise to establish the value of the business at the date of dissolution under normal accounting rules. However, bear in mind that these rules might not value assets (particularly intangible assets and future income) in the same way that other partners value them. A website valued at cost in the accounts may be worth much more, either to one partner or all. Accounting rules value the partnership as a continuing enterprise, not at break up value.

Remember as well that you are liable to the bank and other creditors, as a partner, until the partnership is dissolved. You will still be liable for old debts after it is dissolved. Make sure you continue to receive notifications from banks about old debts so that you are aware of your obligations.

Limited partnerships and limited liability partnerships

Finally, a word about limited and limited liability partnerships.

A limited partnership is set up under the light hand of the Limited Partnerships Act 1907. It is formed between two or more people or companies where one party (called the limited partner) is not liable for partnership debts beyond the capital he puts into the business. This is the opposite of the usual full liability arrangement.

This is a simple and little used device. For example, a limited partnership could be set up between Susan Jones and the company she controls, SJ Ltd. Susan could be the limited partner, leaving the company as a general partner with the unlimited liability. Provided the company had no assets of real value, Susan and her assets would be safe in the event of failure of the business conducted by the partnership.

Limited liability partnerships were created by the Limited Liability Partnerships Act 2000. The Act has enabled partners in many large traditional professional businesses such as accountancy firms to avoid full personal liability for the debts of the partnership.

Although this is a form of partnership, it achieves little that cannot be achieved more simply through a limited company for most businesses. The formation of a limited liability partnership requires both an agreement and the completion of statutory forms supplied by Companies House.

Documents to help you manage your partnership

Net Lawman sells documents that will help you to set up and terminate your partnership.

All partnership agreement documents can be found here. Of note:

Our standard agreement is a comprehensive document suitable for businesses in any industry and with any number of partners. Written as a long form document it allows you to amend the default provisions of the Partnership Act 1890 and also provides additional terms covering how a modern day business operates.

Our agreement for family businesses is slightly less formal.

Lastly, our dissolution agreement is a document that will help you if you wish to wind up your partnership affairs.

Please note that the information provided on this page:

  • Does not provide a complete or authoritative statement of the law;
  • Does not constitute legal advice by Net Lawman;
  • Does not create a contractual relationship;
  • Does not form part of any other advice, whether paid or free.
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