The Basics of a Partnership Agreement
When business owners decide to form a partnership in order to manage their company, they often overlook the importance of a partnership agreement. This can sometimes come from sheer haste in forming the business: running a startup is hectic and stressful, so some elements of the process can become almost an afterthought. Sometimes, forming a partnership just becomes a matter of practicality, and as the word "partnership" implies, the two business owners simply become partners with little formality. In any case, the vast majority of partnerships are formed without any kind of written agreement in place.
A partnership agreement lays out all of the rights and responsibilities of each partner, and identifies all of the terms of the partnership. This avoids any ambiguity as to responsibilities and provides a clear process for tackling things like the addition of new partners or the departure of an existing partner, sharing profits and losses, and the dissolution of the partnership . Without these guidelines in place, the partners must rely on the laws of their state to resolve any matters that may arise—and the statutes governing business and commercial entities in most states is generally very rudimentary in its protection of the rights of owners of small businesses.
In cases of larger businesses, partnership agreements are much more common because it is important to have the ability to lay out a clear hierarchy of responsibility. Enterprise-level companies tend to have many thousands of owners and shareholders, so all options must be considered to ensure operations can continue if one business owner decides to leave or need to be removed from the business. The same should be true for smaller businesses, but in many cases it’s simply overlooked as a formality. Thus, while they may seem more interesting, partnership agreements shouldn’t be thought of as unnecessary, and it’s essential to trust an attorney to either draft a proper agreement for your business or, at the end of the partnership, help you dissolve the partnership itself.
Legal Methods for Dissolving a Partnership
In the absence of a partnership agreement, there are still legal options for forcefully dissolving a partnership. Under the Revised Uniform Partnership Act (RUPA), many states have default laws in place to govern action when no partnership agreement exists. These state statutes consider both the reasons behind the dissolution and whether any partner objects. They also examine whether the partnership can be saved, such as in instances where the partnership will be profitable in the future.
Most state laws either allow a partnership to be dissolved if any partner petitions the court, or they set out the percentages needed to be dissolved against the objections of one or more partners. For example, the New Jersey Revised Uniform Partnership Act requires a partnership to be dissolved in the event of the occurrence of the following events, unless the partnership agreement states otherwise:
New Jersey also recognizes when a partnership can be dissolved even against the objection of one or more partners. Under RUPA, a partnership can be forced into dissolution whenever any of the following occurs:
Under RUPA, in most cases a partnership is not automatically dissolved when one partner withdraws or dies. The partnership can decide to dissolve, or the remaining partners can each choose to buy the partnership interest of the departing partner. Again, the details depend on the partnership agreement, and any buyout provisions indicated in the agreement will need to be followed. In the absence of a partnership agreement, the terms for the dissolution and buyout are governed by state laws in most cases.
Asking for a Dissolution by Negotiation
Both you and your partner must agree that it is truly the best of all bad options to dissolve the partnership. Once you have both landed on this conclusion, the real work lies ahead. You may think that it will be easy to agree because at least you both agree the business is dead. But the reality is there is almost always a loss to divide, and that’s where the real negotiation begins. One of the best ways to arrive at a dissolution agreement that works for both parties is through using a mediator or third-party neutral to help facilitate the negotiation and agreement. You may also consider using the company accountant to help sort through the financials and arrive at an equitable result.
Remember that just because one party is in control when the business commenced operations, does not mean that they get more or even equal value at dissolution. We all know that even the most brilliant entrepreneurs have bad ideas and those bad ideas can sink a business. The question therefore is this: did the partnership agreement say that no partner would take on any additional debt? If yes, then the allocation of losses between the partners is contractual, and these amounts should probably be deducted from each partner’s interest. However, if the partnership agreement was silent on the subject of debt, then not only did each partner presumably have the authority to take on debt without the consent of the other, they also may be entitled to take on debt without the consent of the other.
You should also consider other out-of-pocket expenses made by each partner "for the good of the company" or expenses that were really personal. For instance, if Jane was the driving force behind the business for the first few years, her partner John may be owed more for his time and services during that period and vice versa. The beauty of dissolving a partnership in which there is no agreement is that each partner’s contribution to the partnership for a given year as shown in the partnership tax filings should be paid the same amount proportionately.
There is, however, a very big exception to the above. Family and employment issues generally dictate that spouse and parent/spouse be paid a different amount for their time and energy or efforts than the other spouse/partner. And while divorce law and bankruptcy law can strive to not take into account what the family law court may award as an equitable interest or payment, much of the equity is personal and cannot easily be divided. Therefore, it is not uncommon for a family business to be divided in a manner that is disproportionate even to how much each spouse or parent has given the business – especially if the business is small, the children are still young, and there is a significant income disparity between the spouses. Therefore, when in doubt, the business should be divided in a tax neutral fashion equally.
Keep in mind and entertain that perhaps you can notify your general contractors (if applicable) that they must dissolve their legal entities before payment is made from the owner. If they do not, they may jeopardize personal liability. It is often the case that personal liability is the driving force in a household getting separated or divorced, and it is not uncommon for the owner of the company to insist on the dissolution of the other family owned business, thereby leaving them without employment and any way to meet their own expenses and obligations. While that is unfortunate for the family, the reality is that it is also your right.
Enlisting a Mediator or Arbitrator
Whether or not to involve a mediator or arbitrator to help the process, although typically it is costly and time consuming, can help keep a divorce amicable and limit legal confrontation. Many judges will actually order arbitration as a means of establishing an alternate form of dealing with the proceeding if parties cannot resolve the conflict on their own.
If parties are unable to resolve the issues, often the court itself will suggest the following third party to negotiate a settlement:
• A mediator
• An arbitrator
• A receiver
The key is how involved the parties would like to be in the decision making process. A mediator will only suggest options, the parties will have to decide on the outcome out of court and then the mediator will put that into the legal paperwork format so that a judge only has to review the paperwork for legality and appropriateness. The judge does not have to review the situation or grasp the particulars; each side compromises with input from the mediator, who is usually neutral and out of the situation.
If parties choose to go through an arbitrator, the situation requires a private pseudo-court procedure. While there is still less fighting, the arbitration can be expensive and the proceedings more formal. The parties will have to enter a contract agreeing that both sides will be bound to it and respect the arbitrator’s decisions.
Most mediators are attorneys with many years of experience in all parts of divorce and separation proceedings. Again, the process is usually unbinding in the sense that both parties have to agree on what the final agreements will be. There will be discussions about individual circumstances and some suggestions by the mediator to each party. The judge’s involvement is only limited to entering the final order once both parties have agreed on the processing and final determination.
If the parties cannot reach an agreement then the appointment of a receiver may be the wisest choice. In this case, a lawyer or accountant would be appointed to manage the business during the dissolution and may even make the final decisions if the situation is not one that can be agreed upon. Typically the appointed director of the business will have the last say after everything is prepared and presented to the judge for approval.
Documenting the Dissolution Process
Even if you and your partner did not have an agreement that established any kind of procedure for dissolving your partnership, the dissolution of your partnership may have several aspects worth documenting. And even if the actual dissolution goes smoothly enough, you and your partner might later disagree about who agreed to which terms. This is especially likely if those terms are detailed, as in establishing a payment schedule or selling shared assets. This is why it is crucial that you both document all essential elements of the partnership dissolution process, even without an existing contract. Whether you didn’t have a formal agreement or just wish to supplement your existing one, there are a few key points and details that should be recorded. If you haven’t formed any clear plan, this is the time to do so. The information you should keep in writing includes: The written documentation should have original signatures from everyone involved. It’s important that you both sign copies of the same document rather than have each other sign separate, identical copies of the document. If you are forming some sort of business entity to take the place of your partnership , you might have to file the document with your secretary of state or other government agency. If you and your partner have a formal agreement in place that does cover the dissolution process, be sure you follow it. If one or you or both of you are unable to meet the requirements of the agreement, you will likely need to make amendments to the document to address the changes. Whatever the case, it is best to document any changes. Then take the appropriate next step to file the revised document, or otherwise ensure that copies of the revised document are distributed to the relevant parties. If you attempt to revise an existing partnership agreement, this could be grounds for invalidating the entire agreement. The partnership agreement that is created and signed does not have to be on any official form or written in any specific style. However, any change that would normally require a certain type of form (e.g. for limited liability companies, corporations, etc.) would still need that form even if your partnership agreement hadn’t specified the requirement in the first place. If you have a formal agreement or have filed any relevant paperwork in the past, amend your partnership agreement as specified by that paperwork.
Treating Finances and Assets in the Dissolution
When there is no Partnership Agreement, the assets of the partnership may be divided according to the law where the partnership was formed, so it makes sense to refer to that state for guidance. If there is no law specifically addressing partnerships and "dissolution," the Uniform Partnership Act (the "UPA") will govern.
The UPA provides that all property owned by the partnership is partnership property. In cases where there is no agreement among the partners as to how the property of the partnership should be divided, the partnership property must be divided evenly upon its termination so that each partner receives a proportionate share of the partnership property.
All debts of the partnership must be paid before assets can be divided. After subtracting the total debts from total liabilities, the remaining assets are to be divided evenly among the partners to the partnership. Although the partners may not have a specific arrangement for the division of partnership property, the partners may agree on a share in the assets of the business. Generally however, upon dissolution, partners without an ownership interest will be entitled to a return of their capital contributions to the partnership. Partners who own partnership property are entitled to receive any agreed upon distributions of profits as well as receiving the reasonable value of the services or labor they provided the partnership.
The dissolution of the partnership does not necessarily settle the division of partnership property. Once again, absent an agreement between the partners as to how the partnership property is to be divided, each partner is entitled to a proportionate share of the property. This rule applies to real property, improvements to land, vacant land (or "air rights") above cities, buildings, fixtures, furniture, office supplies, tools and equipment, intangibles such as good will, accounts and negotiable paper, merchandise and inventory, leases, vehicles, equipment, machinery, machinery, buildings and fixtures, raw materials and finished goods or work in progress, books and papers, and cash.
Risks and Legal Defenses
When a partnership dissolves without an explicit agreement, the potential for legal exposure increases significantly. In the absence of a written agreement or even a written letter of intent to dissolve the company, both of the partners can be at risk for liability on many fronts, including unresolved debts and tax liabilities.
Therefore, in addition to the issues that commonly arise in a formal bankruptcy proceeding, as a result of the dissolution process, there are a significant number of unknowns when dissolving a partnership without an agreement.
To minimize the risk of legal exposure, it is important that you take deliberate steps to determine the extent of the debts owed by the partnership, both to the IRS and to third-party creditors. You should also give adequate notice to any potential creditors and provide them with the process by which they can file a claim with the partnership.
Best practice dictates that the partnership file for bankruptcy under Chapter 7. As a result, all parties involved in the bankruptcy have notice of the proceeding, and third-party creditors have an opportunity to file their claims with the bankruptcy court for payment. If a partnership files for bankruptcy, and specifically states the intention to dissolve the partnership, the bankruptcy court will appoint a trustee to wind down the assets of the partnership in accordance with the United States Bankruptcy Code.
Future Conflict Prevention Steps
Going forward, partners should draft an agreement in connection with any new business venture. Like a good marriage, partnerships don’t always work and although they can be a wonderful experience, like a marriage, the dissolution of a business partnership can be cost-prohibitive and unpleasant .
If the relationship begins without an agreement, document, or term sheet, the best way to prepare for a future break up is by maintaining clear communication and e-mail between partners and by ensuring that accounting and tax records provide sufficient detail regarding the income and expenses of the business as well as distributions from the business.