How are drawings treated in a partnership?

Being offered partnership is an exciting opportunity in any professional career. It typically brings with it participation in the success of and (some) involvement in the running of the business and more favourable tax treatment. But it can also bring potential liability and additional duties and obligations so it is worthwhile making sure you understand what you are entering into.

Making partnership

Making partnership has different implications depending on whether there is a formally incorporated Limited Liability Partnership (LLP) or a traditional partnership. The key features are that traditional partners have unlimited personal responsibility for the liabilities and losses of the firm and owe a “duty of good faith” to each other. In contrast, the liability of LLP members is limited and the members’ obligations are generally governed by a partnership (members) agreement, which usually includes a duty of good faith to each other or to the LLP (which has a separate legal personality).

However, for employees being offered partnership for the first time, partnership will mean fewer statutory rights and higher levels of responsibility with greater obligations placed on them.

Understanding partnership rights and obligations

Typically, most obligations of general partners and LLP members are set out in the partnership agreement and usually cover:

Profit share: Partners are entitled to a share of the profits (and in the case of traditional partnerships, losses) but how they are shared depends on the agreement. Some share profits based on merit, rewarding individual performance and introductions, whilst others divide profits according to a lockstep points system under which entitlement to profit share depends primarily on length of service. Or there may be a hybrid;

Drawings: Partners will generally expect some monthly income so there is likely to be a clause providing for drawings to be paid out (and set off against future profit share). This may spell out whether the drawings can be decreased by the firm, whether they must be paid back if a set level of profit is not achieved, whether excess drawings are rolled forward and what happens on termination.

Capital contributions required (and the partner may also want to ascertain the associated financing options).

Role/right to take part in management: The general rule is that all partners are permitted to take part in management but in larger partnerships the agreement usually sets out the levels of responsibility and roles of different partners.

Restrictive covenants: These will usually be more onerous than in an employment contract and more readily enforceable due to the equality of bargaining power in the relationship.

Other “employment” rights: In larger partnerships, the agreement may provide for rights such as holiday, maternity/paternity leave/pay.

Ownership of assets (in a traditional partnership): As it does not have separate legal personality, it cannot own assets in the way that an LLP can. So, there is usually a clause dictating how ownership of assets will be divided and whether any are held personally.

Resources & Whitepapers

It is important to do some due diligence on the firm – prospective partners will usually want to review the annual accounts for the past three years, the current management reports, details of any planned major expenditure (particularly capital), any current major claims/disputes and details of the professional indemnity insurance.

As many of these arrangements may be unfamiliar to the prospective partner, a thorough review of the agreement terms is vital and partners should also be aware that there is a statutory overlay and ensure they get to grips with their duties and responsibilities.

‘Employment’ rights of partners

Although partners are covered by anti-discrimination laws and LLP members at least by whistleblowing and working time legislation, a genuine partner will not benefit from most key employment protections.

In some cases, genuine partner status is clear, such as an equity partner with an equal share in the business and involvement in management. But the status of a partner can vary greatly between businesses and can be highly contested – particularly “fixed share partners” and partners who are treated the same as employees of the business. Some of the key points to consider when assessing if partners are employees or genuinely partners are whether they:

1. Receive fixed remuneration or participate fully in the profits and losses of the firm.
2. Contribute capital contribution to the firm and at what level.
3. Are entitled to a share of the firm’s surplus assets.
4. Have rights to participate in management decisions.

If in fact they are employees they may benefit from statutory employment protections such as unfair dismissal and parental rights. Based on similar tests, their tax position is also likely to be less beneficial.

Exiting a partnership/LLP

Generally, a well drafted partnership agreement will cover arrangements for the exit of a partner. A partner in breach of obligations on an exit could be liable to account for profits earned or losses suffered and their capital or profit share could be at risk. The following should be considered:

1. Notice periods, any other restrictions on leaving and any garden leave provisions.
2. The firm’s right to expel or remove the partner, and the precise mechanics required.
3. Repayment of capital, payment of profit share and release of any tax reserve.
4. Express and implied ongoing duties, including the duty of good faith, and the duty to provide full information which will continue during any notice period, garden leave and in some cases beyond. Taking clients from one firm to another can be problematic, particularly if this involves sharing any confidential information. Exiting partners should avoid talking to clients without the firm’s consent during this time and should be wary of talking to other partners or employees about moving with them, as this is also likely to place them in breach.
5. Restrictive covenants (and any offset against garden leave) – more onerous restrictions are likely to be enforceable in the case of a partnership than employment. Partners should not assume that they are permitted to take clients who they have introduced – it will depend on the terms of the restrictions. Clients are valuable assets and it is not uncommon for firms to enforce restrictive covenants against partners (and their new firms) through the courts.
6. Release from any liabilities, including overdrafts, loans and premises.
7. Whether the exiting partner needs an indemnity from the firm against any losses they may suffer as a result of their involvement and any breaches whilst they were a partner. This may be covered in the partnership agreement.

In summary, with greater power comes greater responsibility and prospective partners are advised to ask questions, check the partnership agreement and carry out due diligence. For a genuine partner, there is a trade-off between the opportunity of higher financial reward and control and greater risk and the loss of employment protections.

Jane Amphlett is a partner and head of employment at law firm Howard Kennedy LLP.

Please note that this an overview for general purposes only. Advice should be sought in relation to any specific queries.

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