The pitfalls of a partnership

 

The present legal structure allows for tremendous flexibility in the organisation of a partnership and the regulation of the rights and obligations of partners. However, the underlying legislation was passed in 1890 and is basic and blunt. It’s a good idea to document what the partners intend should happen if they cannot agree at some future point. This means that partners should always enter into an agreement to regulate their affairs if they wish to avoid unintended consequences.

The attractions of partnership are principally:

  • The lack of formality of creation
  • The tax regime that applies. Income tax and NI are payable on a partner’s share of profits and are not subject to employer’s NI. Partners are treated as self-employed, which brings additional benefits.
  • Examples of partnership businesses.
Unfortunately, the informality of the structure is also the cause of considerable difficulty if partners get into dispute.  A partnership agreement is essential to avoid such costly or intractable disputes.

As a minimum it should address the practical issues of:

  • Admission to and leaving the partnership.
  • Capitalisation: How and when payments in and out of capital will be made.
  • Profit-sharing arrangements: How they are to work and be reassessed over time in order to motivate both junior and senior partners.
  • Management. It’s important to agree who is to manage the firm. Partnerships can suffer from everyone wanting to have their say and to do their own thing. Establishing a system whereby the partners have the opportunity to air their views and to come to a consensus is essential. Management must then have the power to manage and implement an agreed business plan. Having a mechanism to replace the senior management is also essential.
  • Performance: Addressing the difficult issues of bad faith, double-dealing and non-performance in a partnership agreement may seem unnecessarily negative and a waste of time to prospective partners. Like newly-weds, they can have a rose-tinted view of the future. Be assured, at some point in the future such issues will arise and all concerned will regret not having nailed down the “divorce” procedure at the outset .
  • Liability: Partners share equally unlimited liability for all obligations incurred in the course of business. As a partnership is not a legal entity in itself, one partner can bind all of his colleagues personally. A partnership agreement should provide the necessary safeguards to avoid the partnership being drawn into liabilities and to provide indemnities from any erring partner.
  • Retirement and expulsion: It is easier for a partnership agreement to deal with sensitive areas such as compulsory retirement and the expulsion of a partner.
  • Dissolution: Without a partnership agreement providing the contrary, a firm is automatically dissolved whenever there is a change of partner.
Partners must appreciate that disputes between them are inevitable and a well-drafted partnership agreement can set out how they will be resolved. Indeed, the existence of a partnership agreement may keep a partner who intends to play fast and loose in check.

And remember: unlimited liability means just that.

Martin Varley is a partner at Thomson Snell & Passmore.

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