Why setting up a business with friends or family must have a contract

Are you considering partnering with a trusted loved one to start a business? Be careful: Getting financially involved with family and friends can be a path full of pitfalls. It can also lead to strained – if not ruined – relationships.

The best approach is to treat business affairs as you would with any other partner, down to written terms for the partnership. Money can split friends and family members apart, which is why a contract for business with friends or family simply isn't optional.

What is a partnership?

A partnership consists of between two and twenty people who decide to go into business together. General partnerships are the simplest: All partners are equally responsible for managing the businesses, and each has unlimited liability. Family partnerships are formed when at least two partners are related to each other by birth or marriage.

A limited partnership consists of general partners whose liability is unlimited, and limited partners, whose liability is set in proportion to how much money they have invested. The number of general partners is still capped at 20, but there can be any number of limited partners. Partnerships are governed by the Partnership Act 1958.

Partnership basics

You can operate under either your personal names, or a business name – which must be properly registered – and you must apply for an Australian Business Number (ABN). Your partnership will have its own Tax File Number (TFN) and lodge a separate tax return that will be assessed by the Australian Taxation Office (ATO). The partnership's profits or losses are divided among you and your partners according to the percentages laid out in your agreement.

You will then be required to add your share of the profit or loss to your personal income tax for further assessment by the ATO. As a partner, you won't be allowed to claim deductions for money drawn from these types of businesses, as profits received from partnerships are not considered wages for tax purposes.

However, if profits from such businesses are derived mostly from services related to your personal efforts, skills or expertise, you may be receiving personal services income (PSI). This may mean you will need to treat deductions about this money differently.

The partnership must be registered for GST if its annual GST turnover is $75,000 or more. If you and your partners decide to hire employees, even if they are friends and family of yours, you will also be liable for employee payroll tax and superannuation payments, as well as for fringe benefits and reporting. (A non-profit, meanwhile, will have even more tax rules.)

Registering a partnership

You'll have to decide how many partners you want to start your business with. All partners need to agree on key issues, including whether the partnership should be general or limited and who specifically should be a general or limited partner. Lay out who bears what level of liability proportion to their level of investment, how the business should be controlled and how any income or losses will be distributed.

You should think carefully and discuss this portion of partnership setup at length before naming business owners. It can be complicated to add or remove partners once you've completed your registration – in fact, it could mean having to dissolve the partnership completely and form a new one. By hammering out all of these details ahead of time, you avoid trouble later.

Your partnership agreement

Many people enter into business with family members or friends while eschewing a formal agreement. They may think that there is no need to formalise a business relationship, since there is presumably already a high level of trust between all partners. However, things can fall apart quickly, and dispute resolution may not be easy to come by.

Imagine an event planning business startup that tries to raise money by approaching other friends and family members on social media for investment funds and to attract sweat equity. Anyone who invests may now feel they should be a partner, regardless of the size of their investment. This type of family financing can lead to trouble.

However, failure to sign a contract can leave no way out of the harsh default provisions of the Partnership Act, and cause issues if the partnership is dissolved. It may also lead to strife between former friends or divide families, if one party feels there has been a breach of trust or that they've been cheated out of money.

A partnership agreement can help prevent misunderstandings and disputes when forming businesses. It clearly defines not only what each partner brings to the partnership, but also the specific percentage they are entitled to receive from the income of the business. If the profit or losses are not distributed equally among you and your partners, taxes are more complex, making a contract even more necessary.

You should use a partnership agreement when:

• You are planning to start a business or engage in joint ventures with one or more friends or family members
• You are putting your money into an existing business operated solely by another individual, or another individual is taking a share in an existing business operated solely by you
• You and other family partners are planning to formalise a partnership agreement for an organisation that has already existed for months or years
• You and other existing partners want to change the balance of financial control and ownership of a business

Failing to put a contract in place can be a huge mistake from a financial and personal standpoint. Having the protection of a contract for business with friends or family shouldn't be an afterthought, but rather one of the first things you pursue when you start thinking about engaging in a joint venture or investing in a startup.

For help with partnership strategy, turn to the specialists at WMC Accounting. We can help you plan your family partnership and ensure a proper contract is in place to help protect both your investment and your relationships.