This article has been written by Anchal.

This article has been edited and published by Shashwat Kaushik.

Introduction

This article explains the intricacies of drafting a partnership agreement & delves into the essential components of a partnership agreement. In the absence of a formal agreement, conflicts may arise, jeopardising the business operations. It demarcates the roles and responsibilities of each partner involved in a particular business, along with the shares of profit they will receive. It provides a clear framework for decision-making, profit-sharing, conflict resolution and dissolution of partnerships.

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What is a partnership agreement    

A partnership agreement is an agreement between two or more individuals to run a business together, as it will set the rules by which the internal business of a partnership is to be conducted. For an agreement to be valid, it must fulfil the basic requirements of a valid contract under the Indian Contract Act of 1872.

Before moving forward, let’s take a quick glance over, “What are a partnership, partner, firm and firm name in legal terms?”

Key elements of a partnership agreement:

  • Partner roles and responsibilities: The agreement should clearly define the roles and responsibilities of each partner, outlining their individual contributions to the business. This includes specifying the tasks each partner will undertake, the areas of expertise they will bring to the table and the level of involvement they will have in the day-to-day operations.
  • Profit and loss sharing: A crucial aspect of any partnership is the distribution of profits and losses. The agreement should specify how profits will be shared among the partners, taking into account factors such as initial capital contributions, individual efforts, and the level of responsibility each partner assumes. Similarly, the agreement should outline how losses will be apportioned, ensuring a fair and equitable distribution of financial burdens.
  • Decision-making processes: The agreement should establish clear procedures for making important business decisions. This includes specifying how decisions will be made (e.g., by majority vote, consensus, or based on specific areas of expertise), who will have the authority to make certain decisions, and how disagreements will be resolved.
  • Dispute resolution: It is inevitable that conflicts and disagreements will arise within a partnership. The agreement should include provisions for resolving disputes in a constructive and amicable manner. This may involve mediation, arbitration, or other forms of alternative dispute resolution.
  • Exit strategies: The agreement should outline the procedures for a partner to exit the partnership, whether through voluntary withdrawal, retirement, or unforeseen circumstances such as death or disability. This includes provisions for the valuation of the partner’s share in the business, the transfer of ownership, and the settlement of any outstanding financial obligations.

Definition of partnership, partner, firm and firm name

According to Section 4 of the Partnership Act of 1932, “partnership” is the relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all.

Persons who have entered into partnership with one another are called individually “Partners” and collectively “a firm” and the name under which their business is carried on is called the “firm name”.

If someone has to start a business in partnership, ‘“what type of partnership he/she must enter into?”

Types of partnership

  • General partnership- It is the most common type of partnership in which all partners have total liability and participation in managing the business and the capacity to agree to business contracts and loans on behalf of the business. General partnerships can easily be formed as well as dissolved.
  • Limited partnership- In limited partnership (LP), there are some general partners who have the responsibility of day-to-day business operations. While other partners who have capital contributions but are not an active part of decision-making. 
  • Limited liability partnership- Limited liability partnerships (LLP) are not so common as compared to general or limited partnerships, as in limited liability partnership partners are responsible for regular business operations, responsibilities and legal liabilities but not for errors made by other partners. For example, bad decisions or malpractice committed by one member shall not be borne by other partners.
  • Limited liability limited partnership- In limited liability limited partnerships (LLLPs), most of the functions operate like LPs but limit the general partner’s liability. As in an LP general partners are responsible for the day-to-day working of business but they have liability protection just like limited partners do.

After knowing about types of partnerships, one might be flabbergasted about entering into a partnership or a corporation so here are the differences mentioned between the two.

How is a partnership different from a corporation

Formation: It is easier to form a partnership than a corporation, as in the case of a partnership only a business license or filing a “doing business as”. But to form a corporation, a series of papers and formalities are needed, as it starts by filing Articles of Incorporation and business licence along with permits by concerned states and municipalities. 

Ownership: In a partnership, general partners or limited partners are the owners and make decisions for day-to-day functioning, while in a corporation, shareholders are the owners but they appoint a board to steer the company and make business decisions.

Taxes: In a partnership, taxes are paid on the personal income tax of partners, while in corporations, taxes are paid on both corporate tax returns as well as personal tax returns for shareholder’s dividends from the company.

Liability: In a partnership, being a general partner is like putting assets at risk unless the business type is eligible for an LLP. However, in a corporation, the owners and the company work separately; hence, the owner can not be held liable personally.

Maintenance: In a partnership maintenance is not something that bothers but in a partnership it is. As in the case of a partnership, paying an annual fee or tax to maintain the structure would be enough. But in the case of corporations, board and shareholder meetings needed to be held regularly and those shall be documented carefully with official minutes. And shareholders must fulfil other requirements for recording and reporting business activity and must abide by the company’s bylaws.

Legal structure

  • Title and recitals- The title of the agreement is mentioned that is ‘Partnership Agreement’ along with other recitals like date, nature of the agreement. 
  • Declaration of partners -it involves the identity of partners, their legal names, roles and responsibilities within the partnership. 
  • Partnership structure and management- There shall be a clause that clearly defines the roles, responsibilities and decision-making process for each partner.
  • Financial arrangements- The agreement has a mention of sums invested by the respective partners which can be in any form be it bond, property, assets or any other resource as per the partners’ choices. Specify the guidelines for drawings, reinvestment strategies and financial report requirements. Address issues related to insurance, indenificationand liability limitations.
  • Aims & objectives- There are always some aims and objectives of a partnership for which it is made, which shall be clearly enumerated in the partnership agreement. 
  • Profit and loss distribution: It has a mention of a formula for proportional distribution of profit and loss to be incurred by the partners. 
  • Partnership term- It must specify if the partnership is for a fixed term or at-will.
  • Duties and obligations- The fiduciary duties and obligations of each partner shall be clearly outlined; it shall also include confidentiality, non-disclosure and non-compete provisions. Specify the consequences of breach or misconduct
  • Meeting and voting- It states the essential elements for meeting and voting such as a quorum for making decisions. Outline the protocols for decision making, record keeping and reporting.
  • Withdrawal or death of a partner- It constitutes the procedure for exit or withdrawal of a partner including how their share is valued and transferred. In the event of the death of a partner, his heirs or legal representatives shall have the rights to the share of the deceased partner. 
  • Remuneration clauses- The agreement may include clauses for specification of remuneration to be paid to partners for their services.
  • Dispute resolution- The partnership agreement provides a reference point for resolution of dispute in order to make the process of dispute resolution smoother as well as legally binding. 
  • Confidentiality provisions- The agreement addresses sensitive business information and also sets terms for confidentiality of the same. 

If any one of the partners violates the terms of agreement, hence the kinds of breach of agreement and mechanism for redressal of such non-compliance shall be understood carefully .

There are two kinds of breach of agreements:

  • Active breach- It includes the performance of actions that go against the agreement, it involves the decision that serves as a contradiction to the terms of agreement.
  • Passive breach- It involves the non-compliance with the duties and responsibilities adhered initially in the agreement.

 Partnership agreement: mechanism for non-compliance

  • Enforcement action: This mechanism ensures that the defaulting partner adheres to the terms and conditions outlined in the agreement. This may involve legal action, such as a lawsuit or arbitration, to compel the partner to fulfil their obligations. Additionally, it could include imposing financial penalties or other sanctions as stipulated in the contract.
  • Recovery of damages: This action requires the party in breach of the agreement to compensate the aggrieved party for the losses incurred due to the breach. The amount of compensation will depend on the extent of the damages and the terms of the contract. This may include direct financial losses as well as indirect losses such as lost profits or business opportunities. Legal action may be necessary to recover damages.
  • Termination of agreement: This is a drastic step that is typically reserved for situations where the breach of contract is severe and irreparable. It involves ending the partnership agreement and ceasing all business activities between the parties. This may result in significant financial losses for both parties and could damage their reputations. Termination should only be considered as a last resort when other remedies, such as enforcement action or recovery of damages, have failed.

Current scenario and challenges

The rise of technology-driven businesses has brought several changes to partnership agreements. Some challenges emerge with the modern business environment, which can be listed below as under:

  • LLP’s and hybrid structures : The LLP’s have made the process for limiting the liabilities more flexible. Many entrepreneurs give preference to Llp’s because of their hybrid nature, i.e a combination of partnership and corporate benefits.
  • Cross-border partnerships: With the progression of globalisation, now cross-border partnerships are formed and in some cases tax implications and dispute resolution mechanisms must be handled with additional care.
  • Evolving tax laws: The emergence of new tax laws, especially GST (Goods & Services Tax) and income tax, requires ongoing compliance and transparency.

Case laws related to partnership agreement

Dwarkadas Khetan & Co., Bombay v.Commissioner Of Income Tax, Bombay City, Bombay: The agreement of partnership may be oral or written, and both will hold equal effectiveness. In this case partnership was executed by four person , one was Dwarkadas Khetan, two other major partners and the third was a minor Kantilal Keshardeo. The partnership agreement was executed by both the minor and his natural guardian, i.e., father. Hence the tribunal comes to the conclusion that in this partnership deed a minor is made a partner, therefore it is void.

Badrinath Shankar bhandari vs. Omprakash Shankar Bhandari (2024): The Supreme Court decided that in the absence of a written partnership, the courts shall rely on the conduct of parties and nature of business. It serves as a reminder of a well drafted agreement.

Narayanappa vs. Bhaskara Krishnappa (1966): It stated that on dissolution of partnership the property of the firm vests in all the partners and each partner shall incur the beneficial interest. The case throws light on importance of clear exit and dissolution clause in a partnership agreement.

V.Subramaniam vs. Rajesh Raghuvendra Rao (2009): The case emphasised on interpretation of partnership agreements and reaffirmed that courts must give respect to the clear terms of a partnership agreement. It clarified the necessity of precision while drafting a partnership agreement to avoid such legal battles.

Procter vs. Procter: This case is about the share of a retiring partner. As in the partnership agreement there was no mention about retirement, the retiring partner filed a case demanding a proportionate share (one quarter) of the assets and income of the partnership. The case highlights the absence of provision for a retiring partner leading to expensive and unpredictable litigation, which would otherwise not happen for a partnership agreement with a retirement clause.

Best practices for drafting a partnership agreement

For drafting partnership agreements, best practices would include:

  • Clarity and simplicity: The language of the agreement should be clear and simple and complex legal jargons shall be avoided so that partners can understand the agreement easily.
  • Tailor the agreement: Avoid using generic templates without any modifications; it shall be customised as per the demand of partnership.
  • Addressal of risks: The partnership agreement shall anticipate future contingencies and potential risks like changes in market conditions, new business strategy or the introduction of new partners.
  • Dispute resolution: The agreement shall include alternative dispute resolution instead of litigation which can be costly and time-consuming as well.
  • Review regularly: The partnership agreement must be reviewed regularly in order to meet the demands of the partners according to business, market and new laws.

Conclusion

A partnership agreement shall be drafted well in order to avoid any conflict in the future by clearly defining every aspect of the partnership and outlining the roles, responsibilities, and expectations of each partner. The partnership agreement is made in order to foster trust, minimise disputes and support sustainable growth for the partnership. A robust agreement strengthens the legal foundation of business by safeguarding the interests of all parties.

References

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