How Does a Partnership Agreement Work?

A partnership agreement is a legally binding contract that sets forth all of the administrative, managerial and other duties that the limited partners and general partners are subject to. The agreement typically is submitted along with other registration documents upon the partnership's formation to the relevant secretary of state, and contains a list of all limited and general partners, along with the amounts of the capital each has contributed.

The amount of capital each limited partner contributes dictates his ownership interest, and typically, profit-sharing interest. The general partner often does not contribute capital, but receives sweat equity in exchange for managing the partnership. This includes filing partnership tax returns, preparing correspondence, and performing more complex management duties, depending on the scope of the partnership's underlying business. Some partnerships function as mere holding companies, holding marketable securities in connection with partners' estate planning needs. Other times, limited partnerships are the parent entity for large operating businesses. General and limited partners can be individuals, corporations or other partnerships.

In general, partnership agreements establish the following procedures:

  • Purpose - The agreement discloses the partnership's name and address, and the scope of its operating activities. The provision detailing the partnership's purpose_ often is intentionally vague_, so as to not be too restricting with respect to any potential business activities that may become attractive subsequent to the partnership's formation.
  • Transfers of interests - The agreement details the procedures and restrictions on transfers of partnership interests. These are often very restricting and can contain a "right of first refusal" in which any partnership interest offered for sale must first be tendered to the partnership at the same price. Transfer restrictions often list specific individuals who may or may not purchase partnership interests, as well as what kind of documentation must be prepared and the time frames involved. It is also common for partnerships to completely restrict transfers altogether.
  • Profit sharing - The agreement details how ordinary income is calculated and defines distributable income, and when it must be paid.
  • Dissolution of partnership - The agreement sets forth the life of the partnership, which can be perpetual, and how the partnership's dissolution may be triggered. This may be by a vote of limited partners, or in the event of the death of certain limited partners or the general partner. A well-prepared agreement provides detailed instructions for the winding down of partnership operations.
  • Elements of Control - A well-prepared agreement provides a very detailed description of what constitutes a majority, and also what partnership actions require partnership votes. The agreement may also set different majority thresholds for different partnership actions. For example, a simple majority (50.1 percent of outstanding partnership units) may be required to approve a partnership's request to transfer his interest, while a super-majority (two-thirds of outstanding partnership units) may be required to admit new partners. This is particularly important in order to reduce the chances of litigation occurring later on.