Tag: partnership

3 Reasons to have a Partnership Agreement

June 21, 2016 Business planning, Tax Planning Comments Off on 3 Reasons to have a Partnership Agreement

If you have your own business or are thinking about starting your own business, this article was written for you, particularly if you currently have or are considering having a business partner(s).  Some business owners are hesitant to mention to their business partner(s) the importance of having a written partnership agreement, but this an important step to a healthy business relationship.  Even if you’ve been in business with the same business partner(s) for years, if you don’t have a written partnership agreement, it’s never too late to get one.  Aside from the common reasons you might think someone should have a partnership agreement, such as to set forth what is expected of each partner, what each partner gets in return, and procedures for decision-making, this article is going to discuss three more crucial reasons to have a partnership agreement.

But first, for the sake of clarity, the term partnership agreement as used in this article is simply intended to mean an agreement between business partners.  I’m not suggesting your business should be a partnership; in fact, your business may be an LLC or some other entity type.  Regardless of what entity type you select for your business, if you have one or more business partners, you should have a partnership agreement in some form or another.  Also, if your business operates as an LLC, it is possible or even likely that you have an operating agreement, but an LLC operating agreement is not necessarily synonymous with a partnership agreement.  Typically the purpose of the LLC operating agreement is to help establish the legitimacy of the LLC as a separate legal entity from the owner(s)/member(s) of the LLC and to set forth some minimum standards in terms of management decisions, member meetings, etc.  In any case, you should have your operating agreement reviewed because, depending on your situation, you may want to amend your operating agreement, or you may decide to have a separate partnership agreement in order to make sure you’re properly protected.  You also may decide to have a separate agreement on just one of the items addressed below, i.e., a buy-sell agreement.  Each business partnership is unique and accordingly, the set of documents of the business should be unique and should fit the business arrangement of the partners.

With those caveats out of the way, here are three crucial reasons to have a partnership agreement:

  1. Restrictive Covenants. You have worked hard and put in many hours over the years to build your business.  How would you feel if your business partner left the business to setup shop down the street from you to become a competitor?  How would you feel if they took confidential and proprietary information of the business and used it in the new business?  What if they took clients away from the business for their new business?  Restrictive covenants can protect the legitimate interests of the business and prevent a business partner from taking such actions.
  • There are three main restrictive covenants: a non-compete, a non-disclosure, and a non-solicit.  A strong partnership agreement will contain all three restrictive covenants.  A non-compete can restrict a departing partner from competing with the business for a certain period of time, and within a certain geographical region, as appropriate.  A non-disclosure can restrict a departing partner from taking confidential and proprietary information and disclosing it to third parties or using it in an adverse manner to the business.  A non-solicit can prevent a departing partner from taking clients of the business.
  • Each state’s laws will vary as to what is a sufficient amount of restriction to protect the legitimate interests of the business.  Also, keep in mind that these provisions are like a double edged sword, i.e., you can use them to restrict your business partners but they can do the same to you, so it’s important to not get carried away and make certain the restrictions are reasonable.  Admittedly, it can be difficult to discuss these matters with your business partner(s), but it’s better to talk with them now and put it in writing rather than fight with them later in court over clients, etc.
  1. Buy-Sell Agreement. This can be a stand-alone agreement or drafted within the partnership agreement.  The purpose of the buy-sell provisions is to have a mechanism or procedure to address a situation such as when a business partner dies, or becomes disabled, etc.  Mark Kohler often times refers to the “four D’s”, death, disability, dissolution, and divorce.  You can even include in the buy-sell other situations sometimes known as “triggering events” such as bankruptcy.
  • Have you considered what would happen to your business upon your death or disability?  What if your business partner died, would you want to be “stuck” in the business with your partner’s spouse?  What if something happened to you, how can you be sure your spouse/family is fairly compensated given your ownership interest in the company?  The result of a well drafted buy-sell is that upon the happening of a triggering event, e.g., death of a business partner, the ownership interest of the business partner is bought back by the business or the surviving business partners from the deceased partner’s estate/heirs at a pre-determined price and upon the terms decided upon and set forth in the buy-sell.
  • The benefit of the buy-sell is that it eliminates having to make those decisions in the stress of the moment, when death, disability, divorce, etc., has occurred; it is easier to make those decisions before the crisis/event occurs.  You and your business partner(s) can put forth a mechanism or procedure for establishing the value of the business which will determine the purchase price.  You can also decide how the purchase price will be paid, e.g., lump sum, installment payments, etc.  In the context of death and disability, an insurance policy can be utilized to provide liquidity to pay for some or all of the purchase price.  It is never fun to talk about death or disability, but it is better to address it now rather than later when the event has already occurred, which can be difficult when emotions and stress levels are high.

Here is a great video on this topic by a partner in our firm KKOS Lawyers, Mark J. Kohler:

  1. Partnership Allocations. You and your business partner might have different financial situations, such that it is preferable to allocate partnership items of loss, income, etc., to you and your business partners in a manner other than based on the ownership/interest percentage in the business.
  • For example, your business partner might be in a high income tax bracket in a certain year and desire to claim disproportionately large items of loss, if any, to help reduce his or her income tax liability.  However, the IRS will not recognize such allocations unless they have a “substantial economic effect”.  Particularly, with a real estate based business in which there is the item of depreciation, the partners may want to be strategic about how to allocate depreciation among the partners.  Again, the IRS will not recognize those allocations unless they have substantial economic effect.
  • A well drafted partnership agreement can address these allocations to help the business partnership keep a proper accounting of the financial arrangement of the business so that such partnership allocations will be recognized by the IRS.  Even if the business doesn’t intend to make such allocations, a well drafted partnership agreement will address related matters such as contributions, distributions, etc.

These are just three reasons to have a partnership agreement.  There are many more.  Each business is unique and likewise each partnership agreement should be unique and should fit the business like a well-tailored suit.  If you and your business partner(s) don’t have a partnership agreement that sufficiently addresses these issues, I invite you to call our office.

The Operating Agreement: An LLC Owners Best Friend

November 10, 2015 Asset Protection, Business planning, Law, Small Business Comments Off on The Operating Agreement: An LLC Owners Best Friend

Perhaps no other innovation is as indicative of America’s particular devotion to (and knack for) creative capitalism as the limited liability company (“LLC”). Born in America’s smallest state (Wyoming) in 1977, the LLC combines the pass-through taxation of a partnership or sole proprietorship with the limited liability protections of a corporation.

This unique combination of liability protection and pass-through taxation explains why the LLC was quickly adopted in all 50 states, and why it is easily America’s most popular corporate form today. In 2012, more than 2.2 million LLCs filed partnership tax returns, and current estimates are that 55% of LLCs are single-member entities that file no tax returns at all, which means that there are probably somewhere in the neighborhood of 5 million LLCs in existence in America today. Approximately 3,000 new LLCs are created each month … in Utah alone (our home-office state and one of the best LLC laws in the country!).

The big mistake!! Another reason why LLCs are so popular is that they are easy to form, however, this can also be their downfall. Unfortunately, there are thousands of entrepreneurs who believe hitting “submit” and receiving back stamped Articles of Organization from the state completes the formation of the LLC.

In most states an LLC can be established by clicking through a government website and paying a filing fee. Technically, that puts the LLC on the ‘radar’ of the State. However, smart business owners and investors know this is really where the formation process begins.

Every LLC, whether it has one member, five members, or 100 members, should have an Operating Agreement and there are several important reasons why.

First, the Operating Agreement establishes the asset protection veil and the ‘formality’ of signing the Operating Agreement and the initial minutes is critical to show a court and a plaintiff that you took the LLC formation seriously.

Second, is the fact that your LLC Operating Agreement is your chance to write the “law” for your LLC. This is why the LLC is such a great choice for partnerships. The Operating Agreement gives partners the ability to delineate roles, rights, and responsibilities for the LLC owners, and to make specific plans for what happens if a partner dies, becomes incapacitated, or gets divorced.

What happens if you don’t have an Operating Agreement? Well, in their wisdom, the various state legislatures have planned for this, and each state LLC statute provides a set of “default rules” for how LLCs are to be governed if and when the LLC owners don’t take the time or effort to make those decisions for themselves.

However, awith most statutory language, these default rules can be difficult to decipher. In addition, the rules can and do change when the LLC statutes are amended, and all 50 states have different rules within the same framework. To boot, sometimes a state’s particular default rules just don’t make sense.

To illustrate, Utah adopted a new LLC statute in 2013. This statute becomes fully operational, applying to all existing and newly-formed LLCs, on January 1, 2016. While I’m sure the legislature and the governor had good intentions in passing the law, it certainly contains some provisions that create surprising outcomes.

For example, the new statute says: “A manager may be removed at any time by the consent of a majority of the members without notice or cause” (U.C.A. §48-3a-407(3)(d)). It does not say “a majority of the ownership” or “a majority of the profits interests.” This means that in an LLC with three owners, where one owner is the manager and owns 90% of the company, and the other two owners each own 5% of the company, the two 5% owners can get together and vote out the 90% owner as manager … as long as the LLC has no Operating Agreement and the statutory default rules apply. If the LLC does have an Operating Agreement, then the provisions of the Operating Agreement trump the default rules from the statute.

The moral of the story is that if you don’t want your LLC to be subject to potentially odd default rules that can be adopted and changed at the whim of state legislators who have never owned or run their own business, then your LLC needs an Operating Agreement and you need to know what that Operating Agreement says.

Do not create an LLC that does not have an Operating Agreement, and if you have already made that mistake, fix it by having one drafted and adopting it retroactively to the date your LLC was established.

Jarom Bergeson is an associate attorney with Kyler Kohler Ostermiller, and Sorensen, LLP (“KKOS Lawyers”) in its Cedar City, Utah office and has extensive experience in helping client register their trademark and protecting their brand identity. He can be reached at jarom@kkoslawyers.com or by phone at (888) 801-0010.