Much of our work revolves around providing end-to-end legal services to multi-owner businesses, from planning the initial structure of the business partnership and drafting the partnership agreement, through safeguarding the growth of the company, and finally to ensuring a profitable exit strategy.
Yet, if I were asked which of those three stages I thought was the most important to a successful multi-owner business venture, without hesitation I would say the first.
If the initial structure isn’t done right and a comprehensive partnership agreement isn’t in place, the partners may have difficulties growing the business, resolving potential disputes, and eventually selling the business. (Fortunately, I’ve gone on at length in many places, like here, here, and here, about the need for and the benefits of a partnership agreement). In other words, successful growth and a profitable exit strategy are often dependent on a solid partnership agreement.
As the parable goes, a house built on sand will get washed away in the rain.
But, let’s assume your new multi-owner business venture took care during stage one to create a comprehensive partnership agreement. This piece is going to extend the partnership-agreement-as-business-foundation metaphor and explain what you should and shouldn’t do with the partnership agreement after that.
Ron Popeil Was Wrong!
One of the most common mistakes I see partners make with their partnership agreements (after not having one) is taking a “Ron Popeil” approach. If you don’t know, Ron Popeil is a (semi-)famous inventor and infomercial host, who coined the catch phrase “Set it and forget it!” for his Showtime Rotisserie.
Pushing in-home and in-office gadgets and software that let customers automate tasks and everyday chores is a huge industry in America. And I understand. The world is a hectic place. Automating certain tasks can drastically increase one’s sanity and productivity in the workplace, and it’s an attractive proposal, especially for busy entrepreneurs.
However, the worst thing you can do with your partnership agreement is “set it and forget it.” As your business grows and evolves, the partnership agreement ought to grow and evolve with it. The same careful planning that was put into the original partnership agreement—the nuanced choice of business entity, delicate discussions of equity division—needs to be put into ensuring the agreement continues to provide tailor-made protections for your business.
Would you add a wrap-around front porch to your house without first building additional foundation? Would you build a second-story apartment above your garage without checking to see if the foundation could bear the extra load? Hopefully not.
In the rest of the piece, we’re going to discuss three reasons you need to update and revise your partnership agreement regularly. If you don’t, all the hard work and effort you put into ensuring your original partnership agreement would protect your multi-owner business might get washed away like a house built on sand.
Reason One: Changes to Your Business
As a basic rule of thumb, businesses can be built to grow quickly or grow slowly, and they can be dependent on the goodwill of the business itself or the goodwill of the owner(s).
The plot graph shows examples of businesses on the basic growth-goodwill dichotomy and how changes to the business model can push a company into a different section of the chart.
So, how does this affect you and your partnership agreement?
As I said at the beginning, it’s important to tailor your partnership agreement to your business when you’re starting your new multi-owner business. The type of partnership agreement you need will vary depending on where your business is currently situated on the plot graph. A group of friends opening a local BBQ restaurant will have different concerns and needs than a multi-owner tech startup. The restaurant has business goodwill, but the tech startup probably relies heavily on the know-how and goodwill of the founders.
More importantly, though, a partnership agreement written for a business when it’s in one quadrant of the graph will not work for that same business once it moves to a new quadrant. When the group of friends decide to franchise their restaurant concept, the “local restaurant” partnership agreement between the original partners becomes obsolete; it simply can’t address the unique business issues of owning a multi-location franchise.
The same situation exists for your business. The type of business you have now will determine the type of partnership agreement that is appropriate for you now. Changes to your business model will necessitate changes to the partnership agreement too.
Your business will inevitably grow and evolve. This evolution could take any number of forms—e.g. a pivot in business services or products, changes to the overall business model, or simple growth and expansion. Regardless, you need to be sure that the partnership agreement matches the current circumstances of your multi-owner business.
Reason Two: Changes to State and Federal Laws
Another reason it’s absolutely vital to maintain and update your partnership agreement is that the federal and state laws in effect when your agreement was first written can and will change. As you may hear some lawyers say: Ignorantia juris non excusat (loosely translated, “Ignorance of the law is not an excuse.”)
Florida Revised LLC Act
Here at the state level, 2013 saw a full-blown rewrite of the Florida LLC statute, which was first adopted back in 1982. The new statute (F.S. Ch. 605) went into effect in January 2014, and the old statute was fully repealed in January 2015. The adoption of the new LLC statute brought with it particularly significant changes to what can and can’t be included in operating agreements (the LLC-specific version of a partnership agreement).
Two important things to note are:
- Old LLC operating agreements were not grandfathered in, and
- The new statute is considered the default statute.
So, if your operating agreement was written according to the pre-2014 statutes and hasn’t been updated since, you’re at risk. Any provisions that aren’t in compliance with the updated LLC act are currently unenforceable. Furthermore, the default law for those provisions is the revised LLC statute. That means your business could be governed by laws that you don’t even know about!
Partnership Audit Rules
New laws can be passed at the national level too that require updates to your partnership agreement!
In November 2015, President Obama signed the Bipartisan Budget Act of 2015, which included new audit rules for partnerships and entities taxed as partnerships. Though signed into law in 2015, the new rules only went into effect January 1, 2018.
In short, the new audit rules allow the IRS to impose any outstanding tax liability directly on the partnership instead of adjusting and allocating it to the partners during the tax year under review. This could give rise to a situation where a partnership entity consisting of partners A, B, and D is liable for an outstanding tax liability from a tax year when the partnership consisted of partners A, B, and C.
There are complicated and nuanced (and still evolving) regulations on the new Partnership Audit Rules, who is subject to them, and who can make so-called “Push-out Elections,” but the biggest change where your partnership agreement is concerned is the replacement of the “tax matters partner” with the designation of a “partnership representative.”
This partnership representative doesn’t have to be an actual partner, but he or she is the one who will make the decisions on tax matters for the partnership going forward. You’ll want to be sure that your partnership agreement has been updated to reflect these new Partnership Audit Rules.
Reason Three: Changes to Tax Codes
Last, but definitely not least, The Tax Cuts and Jobs Act (TCJA), signed into law on December 22, 2017, overhauled the corporate tax code. Some of its more memorable changes are that it reduced the reduced the corporate income tax rate to 21% and provided certain pass-through entities a 20% qualified business income deduction (QBID).
To reap the maximum benefits of these various changes, partners in multi-owner businesses need to reconsider what’s best for their business. If you’re a pass-through entity, does your current setup allow you to fully benefit from the 20% QBID? Would it be better at this stage in your company to take advantage of the lower corporate tax rate by converting to a C corp. or revoking your “S” election, or vice versa?
Due to the massive changes introduced by the TCJA, at the very least you should review your partnership agreement with a professional advisor to decide whether your current business and legal arrangements allow you to take full advantage of the TCJA. Then, you and your partners can make the necessary changes and updates to your partnership agreement to be sure the agreement continues to complement your business.
Partnership Agreements are Living Documents
I’ve presented three (hopefully) compelling reasons for you and your partners to have your partnership agreement reviewed and updated regularly. These are by no means the only reasons, but keeping an eye on changes to your business model, changes to the state and federal laws, and changes to tax codes is a good start.
You’re probably thinking, “Ed, there’s no way I have the time or the legal background to keep up on all that!” You shouldn’t have to. You should have trusted legal advisors and tax advisors that inform you of changes in their relative areas of expertise. These advisors should communicate with you regularly and in different media.
Your Path to a Successful Business Partnership
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Building Better Business Partnerships
Here at Alexander Abramson, we focus exclusively on business-related legal matters. We have advised business owners and entrepreneurs for over 25 years on partnerships and partnership agreements, and we have distilled that knowledge into our Partnership Design System.
Our unique 4-step system will:
- Guide a discussion of the 21 key partnership parameters,
- Build a strong foundation for your new business partnership,
- Create a comprehensive written agreement understood by all the partners,
- Increase the chance of success for your business partnership!
Help ensure you can start and grow your business successfully now and protect the business and your investment in the future. Call us at 407-649-7777 or email a team member to schedule a Partnership Design Session now.
