Chapter Fifteen | Sole Proprietorships and Partnerships

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Introduction

When deciding to create a business, the founder(s) must consider the purpose of the business and its short-term and long-term goals. Immediate issues for consideration when analyzing the different types of business organizations include ease of formation, management control, taxation, legal liability, ability to raise capital, governmental rules, transferability of ownership, and termination. Understanding the goals of the business will help the founder(s) determine which type of business organization to choose. Business organization choices in the United States include sole proprietorships, general partnerships, limited partnerships, limited liability partnerships, C-corporations, Sub-S corporations, and limited liability companies. Understanding and analyzing the advantages and disadvantages of each type of organization will help the business organizers to determine which type of organization is the best for their business.

Sole Proprietorships

The simplest form of business organization is a sole proprietorship. A sole proprietorship is the oldest and most traditional means to create a business in the United States. As its name implies, individuals, or sole proprietors, who wish to own and run a business by themselves will select this form of business organization. The sole proprietorship is merely an extension of its owner. No one else owns any part of the business. The sole proprietor has complete managerial authority and may employ as many individuals as are needed to run the business. Businesses that commonly choose this form of organization are retail establishments, service businesses, and those businesses involved in agriculture. In most states, a husband and wife may operate a sole proprietorship together, but will be considered as a single owner for legal and accounting purposes.

Formation

A sole proprietorship is not a separate business entity, but rather, it is an extension of its owner. Few legal requirements exist to establish a sole proprietorship, and those that do exist are not complicated. However, in most states if an individual is “doing business as” or “d/b/a” (ex: Edward Barnes d/b/a Ed’s Auto Body Shop), in a name other than his own (called a trade name), he or she must file a disclosure form with the proper state authority to identify that party as the owner of the business. For example, if a creditor sues Ed’s Auto Body Shop, owned by Edward Barnes, the creditor addresses the complaint to “Edward Barnes, d/b/a Ed’s Auto Body Shop.” Further, certain types of businesses and businesses hiring employees may be required to obtain special licenses or follow other legal or regulatory requirements. For example, a delicatessen must obtain a special operating license and adhere to strict health code laws. If a sole proprietorship hires employees, the Internal Revenue Service will issue an employer identification (EIN) number in order to have the income and social security taxes withheld from the employees’ wages properly credited. The owner will also be required to follow state laws regarding workers’ compensation and unemployment insurance. These general requirements are not specific to sole proprietorships alone; they apply to other business entities as well.

Taxation

A sole proprietorship accounts for business income and expenses on Federal Schedule C, the individual’s federal tax return (the 1040), and on the appropriate state income tax return. In addition, the sole proprietor is required to file Federal Schedule SE (self-employment tax) if the proprietorship makes a profit over the threshold amount.

Termination

A proprietorship will be terminated when the proprietor closes the business, sells the business, or upon the death, insanity, or bankruptcy of the proprietor.

Advantages

The creation of a sole proprietorship is a simple and inexpensive process. A sole proprietor normally will not have to pay any large fees for organizing his or her business as a sole proprietorship. The owner (proprietor) makes all the decisions and retains all profits accruing to the business. The net earnings are taxable as personal income and not subject to the corporate income tax. A sole proprietor may freely sell the business—including inventory and the good will of the business—to another individual. However, because a sole proprietorship is merely an extension of the individual owner, the sole proprietorship itself cannot be transferred from one person to another. The buyer must create his or her own form of business in order to conduct the business that has been transferred.

Disadvantages

As a sole proprietorship is not a separate legal entity from the proprietor, it cannot sue or be sued in its own name. As such, the primary negative aspect of a sole proprietorship is the liability assumed by the owner. Liability is complete and unlimited. The proprietor is personally liable for all of the obligations and debts of the business. If the assets of the business are not sufficient to pay the claims of creditors, creditors may seek payment directly from the owner’s personal assets. Therefore, the sole proprietor risks insolvency and may be exposed to personal bankruptcy. On the other hand, the proprietor must sue those who have caused damage to the proprietorship or who are debtors of the proprietorship in his or her own name.

The sole proprietor may be limited with regard to raising capital to run his or her business. Without any partners or the ability to sell ownership interests in the business, the sole proprietor’s capital is limited to available cash and assets, and the ability to obtain a business loan based upon the sole proprietor’s credit worthiness.

The sole proprietor who hires employees may be responsible for the torts or other wrongful acts of employees committed in the course of their employment. The proprietor is also liable for contracts entered into by an employee who has the authority to do so. The rules of agency apply in these situations. The legal theory termed Respondeat superior is used to determine the legal liability of a sole proprietor for the torts of an employee committed “within the scope of employment.”

A proprietor may argue that the tortuous act should not be imputed to him or her because the employee is an independent contractor. An independent contractor controls his or her own “methods and means” of work and does not work under the control of the proprietor. The employer may also claim that the employee was pursuing his or her own business or personal interests, under the “independent frolic” doctrine. Even if a court agrees that the employee was an independent contractor, the proprietor may still be held liable in his or her own right under a separate theory of “negligent selection” or “negligent hiring,” as where the employer fails to check employment records, or because the duty was “non-delegable.”

Partnerships

The Uniform Partnership Act (UPA) or the Revised Uniform Partnership Act of 1997 (RUPA) defines a partnership as “the association of two or more persons to carry on as co-owners of a business for profit.” The UPA and RUPA have been adopted by the majority of states and provide the basic law applicable to partnerships. The RUPA is composed of a set of rules that will apply to a partnership unless the partnership agreement states a provision contrary to that stated in the Act.

Essentially, a partnership requires that individuals will pool capital resources or professional talents in order to obtain a profit. For this purpose, a “person” may include a natural person, corporation, business trust, estate, trust, partnership, association, joint venture, government, governmental subdivision, agency, instrumentality, or any other legal or commercial entity.

Law, architectural, engineering, and accounting firms, as well as medical associations, will frequently operate as partnerships; however, a trend is emerging for such businesses to incorporate as professional corporations or to become limited liability partnerships, or limited liability companies. Retail and service businesses may use the partnership form, as well as many individuals who intend to hold and manage real property together. When discussing partnerships, it is important to differentiate among various types of partnerships: the general partnership, the limited partnership and the limited liability partnership. Partnerships may be “at-will,” established for an indefinite period of time; but if a partnership is established for a definite period of time or for a particular undertaking, there must be clear evidence of the intent of the partners to limit the time period or purpose of the partnership

Attributes of a General Partnership

The UPA defines a partnership as an “association.” Implicit in this concept is the voluntary nature of this business form. Therefore, a partnership is created by consent of the parties and is usually formed by executing a contract called the partnership agreement or “Articles of Partnership.” In some states, the partnership is treated as a distinct entity; for others, the partners are treated as individuals. In the former case, a partnership may buy, sell, and own property in the partnership’s name and the partnership will file a federal income tax return (the 1065) for informational purposes in its own name to account for the income generated. At common law, a suit could never be brought by or against a partnership in its own name; each partner had to sue or be sued. However, while this principle is still generally true, many states now provide that a partnership can be treated as an entity for purposes of suing others or for being sued or for filing bankruptcy. State law must be consulted on this important matter.

A basic element of the partnership form requires partners to carry on as co-owners of the business. This is demonstrated by sharing profits, joint ownership of property, making contributions of capital to the business, and joint participation in management decision-making. Each partner is also an agent of the partnership. Finally, the partnership must be formed for the purpose of making a profit. Therefore, businesses formed for religious, charitable, or fraternal purposes may not be a partnership. The RUPA also establishes broader protective measures for limited liability partners. Limited partnerships are not governed by the RUPA; rather, the provisions of the Revised Uniform Limited Partnership Act (RULPA) ally to these entities. Limited partnerships are discussed later in this chapter.

Formation of a Partnership

A partnership may be formed by the voluntary actions or agreement of the parties or implied by the conduct of the parties. The establishment of a partnership by voluntary means is usually most desirable because the rights and liabilities of each partner are best protected by specific agreement of the parties, found in the Articles of Partnership.  

 

Case Summary

Reilly v. Meffe

6 F. Supp. 3d 760 (S.D. Ohio 2014)

Facts

The Plaintiff, Brian Reilly, is a principal in the company Transact Partners International LLC (Transact). *** The Defendants, Domenick Meffe and Richard Hoffman, are principals in the company Wellington Resources LLC (Wellington). On January 31, 2011, Wellington and Transact, non-parties in the present suit, executed a co-brokerage agreement that promised Transact 2% of the total transaction price of the sale of Beck Energy Corporation assets if Transact identified and presented a successful buyer of those assets. Transact successfully procured a buyer for the Beck Energy assets.

Following the success of this transaction, the business relationship between Reilly, Meffe, and Hoffman (the parties) developed through the exchange of industry information and contacts. On May 31, 2011, the parties discussed creating a more formal partnership in which they would split profits from any transaction equally between the three members. The parties allegedly confirmed the partnership agreement through an exchange of e-mails.

After May 2011, the alleged partnership executed a number of business transactions involving the sale of oil and gas rights throughout Ohio. The Plaintiff worked to market the partnership deals among his industry contacts. During the course of 2011, the Plaintiff marketed twelve deals on behalf of the alleged partnership. Meanwhile, the Defendants solicited oil and gas leases from leaseholders and executed the sale of oil and gas leases owned by the alleged partnership. From May through November 2011, Defendant Meffe and the Plaintiff were in contact on a daily basis. All three members of the alleged partnership met in person or held conference calls at least twice a week to discuss partnership business and to calculate prospective profits that would be distributed to each member of the alleged partnership.

The alleged partnership’s first transaction involved the transfer of oil and gas rights for land in the City of Girard, Ohio. On November 26, 2011, the net proceeds from the transaction were split three ways between the parties. In the fall of 2011, the Defendants purchased oil and gas rights to approximately 4,400 acres of land in Monroe County, Ohio (the Massey Assets) from an Ohio limited liability company. The Plaintiff then marketed the Massey Assets and a number of smaller leases in Belmont County (the Belmont Assets) to a variety of oil and gas companies.

On December 19, 2011, the Defendants conveyed the Massey Assets to XTO/EXXON without notice to the Plaintiff. The sale of the Monroe County leases resulted in a profit of $7,321,107.00 for the alleged partnership. Also in late 2011, the Defendants sold the Belmont Assets without notice to the Plaintiff. The sale of the Belmont Assets resulted in a profit in excess of $600,000.00 for the alleged partnership. The Defendants did not split the profits from the sale of the Massey Assets or the Belmont Assets with the Plaintiff. After learning of the closing of the Massey Assets in January 2012, the Plaintiff confronted the Defendants regarding the distribution of the alleged partnership’s profits. Defendant Meffe informed the Plaintiff that he would not be paid a partnership share, which Defendant Meffe’s counsel subsequently confirmed after discussions with the Plaintiff.

On July 29, 2013, the Plaintiff filed a six count Complaint (doc. 2) against the Defendants alleging: (1) Breach of Contract; (2) Breach of Fiduciary Duty; (3) Conversion; (4) Intentional and/or Fraudulent Nondisclosure; (5) Unjust Enrichment; and (6) Accounting. In lieu of an Answer, the Defendants have filed multiple Motions to Dismiss. The Defendants move to dismiss the Complaint, arguing that: (1) the Plaintiff’s Complaint fails to state a viable partnership claim against the Defendants; (2) in the alternative, the present lawsuit is covered by a private arbitration agreement; and (3) in the alternative, the Southern District of Ohio is an improper venue for the present action.

Holdings:

The Defendants argue that the Plaintiff’s allegations are insufficient to establish a viable partnership claim under Ohio law. According to the Defendants, the Plaintiff has no written partnership agreement with them. In their view, the e-mails attached to the Plaintiff’s Complaint demonstrate “something far short of a ‘formal partnership’ document and only underscore *** the absence of any meeting of the minds on the essential terms of the alleged partnership agreement.”

The Defendants also maintain that the parties’ course of conduct demonstrates the lack of a partnership agreement—the parties did not share profits, did not have mutuality of agency, did not have joint ownership of property, and were not treated as a partnership for tax purposes. Therefore, the Defendants conclude that the Plaintiff has failed to state a claim upon which relief may be granted.

In response, the Plaintiff asserts that the Defendants misrepresent Ohio partnership law. The Plaintiff cites the parties’ e-mails as evidence demonstrating the intent of the parties to form the alleged partnership. According to the Plaintiff, after the May 31, 2011 e-mail exchange, the parties “actively worked together on over a dozen deals for the next six months, never questioning the terms of the partnership up to and after the first consummated deal.”

The Court is not persuaded by the Defendants’ arguments. Under Ohio law, a partnership is “an association of two or more persons to carry on as co-owners a business for-profit formed under section 1776.22 of the Revised Code, a predecessor law, or a comparable law of another jurisdiction.” Section 1776.22 provides “any association of two or more persons to carry on as co-owners a business for-profit forms a partnership, whether or not the persons intend to form a partnership.” A partnership agreement is “[an] agreement among the partners concerning the partnership, whether written, oral, or implied.”

Courts consider a number of factors in determining the existence of a partnership, including: the sharing of profits, “the existence of a written or oral partnership agreement; the joint ownership and control of property; the ability of members to bind the business entity; and the nature of the tax returns filed by the business entity.” *** However, “‘[s]ince every business relationship is unique, no single fact or circumstance can operate as a conclusive test for the existence of a partnership,’ particularly when the parties have dealt casually with each other.”

Although the Defendants emphasize that there is no written partnership agreement in this instance, under Ohio law, a partnership agreement is not required to be in writing. *** (defining a partnership agreement as “[an] agreement among the partners concerning the partnership, whether written, oral, or implied.”).

The Defendants’ better argument is that the Plaintiff has failed to allege sufficient facts demonstrating a “meeting of the minds” and that therefore no partnership was formed between the parties. According to the Defendants, the Plaintiff’s Complaint and the e-mails attached as exhibits to the Complaint demonstrate the vague nature of any alleged partnership discussions between the parties. The Defendants point out that the parties “‘discussed forming a more formal partnership’—suggesting some future action to be performed in the future, which would be formalized.” *** Although the Plaintiff alleges that the parties confirmed their oral agreement through the exchange of written e-mails, the Defendants maintain that these e-mails “underscore *** the absence of any meetings of the minds on the essential terms of the alleged partnership agreement.” The Defendants note that Defendant Meffe’s e-mail referred to an agreement “between [the parties’] respective companies.” In contrast, the Defendants observe, the Plaintiff’s response referred to an agreement concerning a single transaction related to the Jefferson County leases and purportedly between the parties as individuals, rather than their companies. Based on this comparison, the Defendants contend that the parties did not agree to the essential terms of the alleged partnership agreement.

If the Plaintiff’s Complaint only included allegations of the May 31, 2011 phone call and e-mails, the Court would be inclined to agree with the Defendants’ conclusion. The Plaintiff alleges that on May 31, 2011, the Defendants called him and proposed forming a partnership and splitting the profits from that partnership equally. Although the splitting of profits is indicative of a partnership, ***, from the Plaintiff’s account of the phone call it does not appear that the parties agreed to other essential terms of the alleged partnership agreement.

The e-mails between the parties are similarly ambiguous. Shortly after the phone conversation on May 31, Defendant Meffe e-mailed the Plaintiff, stating, “Bryan [the Plaintiff], list of names which you will need to understand the map. Should we have an agreement between our respective companies?” Exhibit C at 2, doc. 18-3. The Plaintiff responded, “Dom, Rick [the Defendants]: This e-mail is to confirm our understanding that we intend to split the profits on this transaction (Jefferson County leases) equally 3 ways between us — Thanks — Brian.” While Defendant Meffe referred to an agreement between the parties’ companies (Wellington and Transact), the Plaintiff’s response purported to confirm an agreement to work together as individuals to complete a single transaction (the sale of Jefferson County leases) and split the profits equally. In short, the Plaintiff’s allegations concerning the May 31 phone call and the e-mail suggest a general intent to have an agreement between the parties, but the essential terms of that agreement are unclear based on the May 31, 2011 telephone call and e-mails.***

*** Nonetheless, as alleged by the Plaintiff, the parties’ course of conduct following May 31, 2011 is sufficient to demonstrate a “meeting of the minds” between the parties and to support the existence of an implied partnership agreement. *** (“A court may find an implied partnership from the totality of attendant facts and circumstances”). Under Ohio law, “‘[a] court can properly find a partnership exists from evidence that there has been a sharing of net profits from a continuing business operated by two or more persons, where each is capable of binding the business entity.'” *** Here, the Plaintiff explicitly alleges that, after six months of working together to buy, market, and sell oil and gas leases throughout Eastern Ohio, the parties split the profits from the City of Girard transaction. Significantly, “[a] person who receives a share of the profits of a business is presumed to be a partner in the business[.]”***

***Further, as alleged by the Plaintiff, the totality of facts and circumstances support a finding that the Plaintiff was a co-owner of a continuing business with the Defendants. Construing the Complaint in the light most favorable to the Plaintiff and accepting all well-pleaded material allegations in the Complaint as true as the Court must *** the parties worked together from June through December 2011 to buy, market, and sell oil and gas rights in Eastern Ohio. The parties communicated with one another on a daily basis to discuss potential business deals and to calculate prospective profits from those deals. While the Defendants bought and sold the actual oil and gas leases, the Plaintiff (1) marketed at least twelve oil and gas deals to various energy companies, (2) secured buyers for approximately eight of those deals, and (3) obtained multiple letters of intent from buyers on behalf of the alleged partnership. Most significantly, as the Plaintiff became more active in the alleged partnership, “[the Defendants] had very little or no direct contact with the leaseholders as [the Plaintiff] increasingly handled both sides of the transactions directly.” Drawing all reasonable inferences in favor of the Plaintiff, the Plaintiff’s conduct as described above, particularly handling both sides of various transactions, was consistent with that of a co-owner of a business.

The Court concludes that the Plaintiff has alleged sufficient facts to support his partnership claims. As alleged by the Plaintiff, the parties worked together on numerous oil and gas transactions and split the profits from the City of Girard transaction which creates the presumption under Ohio law that the Plaintiff was a partner in business with the Defendants. The totality of the facts and circumstances in this case buttress this presumption as the Plaintiff’s behavior was consistent with that of a co-owner. Consequently, the Court will deny the Defendants’ Motion to Dismiss for Failure to State a Claim. Outcome Defendants’ motions to dismiss denied; plaintiff’s motions to strike denied.

Management And Control

If, at the outset of a partnership, there is no written partnership agreement, partners determine their capital contributions and decide upon the duties each will perform. Without a written agreement, the default provisions of RUPA control and all partners will share equally in all partnership profits and losses. Therefore, without a partnership agreement, if the partnership consists of two partners and one does 70% of the work and the other only does 30%, or one partner provides 70% of the capital, and the other 30%, each partner will nonetheless receive 50% of the profits according to the RUPA, no matter what the two partners may have otherwise intended.

In order to avoid this and numerous other problems relating to management responsibilities, profit distribution, borrowing authority, etc., a comprehensive partnership agreement should be drawn up specifying each partner’s rights, obligations, and responsibilities. This agreement, called Articles of Partnership, fixes the expectations of the individuals by an express agreement between the parties.

Specific issues to consider in the creation of the partnership agreement run from the basic to the more complex: the name and address of the partnership, its purpose, the amount and type of investment each partner will contribute, managerial and voting power, dispute resolution, partner insurance (“key man” insurance), bookkeeping methods, banking responsibilities, borrowing rights, and employee issues.

A partnership can also be created involuntarily, i.e., when no express agreement exists and where the parties may not even call themselves partners. This is called a partnership by estoppel. In certain situations, a court may infer that a partnership exists despite the fact that the persons involved deny it. Courts will look beyond the form to the substance of the activities in making a determination and will refer to these persons as “purported partners.” Section 308 of the RUPA provides:

“If a person, by words or conduct, purports to be a partner, or consents to being represented by another as a partner, in a partnership or with one or more persons not partners, the purported partner is liable to a person to whom the representation is made, if that person, relying on the representation, enters into a transaction with the actual or purported partnership.” The purpose of finding a partnership by estoppel is to protect a third party that relied to their detriment upon the representations or actions of a purported partner.

Section 308 of the RUPA also deals with a partnership by estoppel from the standpoint of profit sharing. The fact that two or more parties share the profits of a business gives rise to the rebuttable presumption that a partnership exists. This presumption may be overcome by evidence that the receipt of profits was for the purpose of repaying debts, repayment of interest or other charges on loans, paying wages or rent, paying a widow or personal representative of an estate, or paying for business goodwill—and not as the result of any partnership relationship.

 

Case Study

In Re Ranch

492 B.R. 545 (Bankr. D. Or. 2013)

Procedural Posture

A creditor filed a motion to dismiss a Chapter 12 case on the grounds that it was not properly authorized because under Oregon general partnership law, Or. Rev. Stat. §§ 67.005-67.365, unanimous consent of the partners was required to authorize a bankruptcy filing on behalf of the partnership.

Overview

The bankruptcy petition was signed by one partner. Initially, the court determined that the partnership was a general partnership despite the fact that the partnership agreement identified certain partners as limited partners because no certificate of limited partnership was filed as required under Or. Rev. Stat. § 70.075. Pursuant to Or. Rev. Stat. § 67.140(11), the general rule was that actions outside the ordinary course of partnership business could only be undertaken on behalf of the partnership with the consent of all partners. Filing a voluntary bankruptcy case was a paradigm action outside the ordinary course of partnership business. However, pursuant to Or. Rev. Stat. § 67.015(1), partners could provide in a partnership agreement that decisions outside the ordinary course of business could be made with less than unanimous consent of the partners. No provision in the debtor’s partnership agreement generally authorized the partners to make decisions outside the ordinary course of partnership business by majority vote, and there was no specific provision authorizing the partners to approve a voluntary bankruptcy filing by majority vote.


Outcome

The court granted the motion to dismiss the Chapter 12 case.

 

Relationship of The Partners

The RUPA states that each partner has a fiduciary relationship to the partnership itself and to each other. Usually each partner has one vote with respect to the management of a general partnership. Routine decisions are commonly made by a majority vote. Major decisions, such as whether to dissolve a partnership, dissociate a partner, merge with another business, or change the form of organization, may require a unanimous vote of all of the partners. The following rights and duties of partners should be specifically addressed in a partnership agreement:

  1. The right to be repaid the partner’s contribution and to share equally in the partnership profits after partnership debts are paid;
  2. The duty to contribute toward partnership losses (capital or other), generally according to the partner’s share in the profits;
  3. The right to be indemnified respecting any personal liability reasonably incurred by a partner in the ordinary and proper conduct or preservation of the partnership business or property;
  4. The right to be repaid, with interest, any payment or advance beyond the amount of capital contribution;
  5. The right to manage the partnership along with the other partners;
  6. The right to use partnership property;
  7. The duty to keep partnership books and the right to inspect and copy such books;
  8. The duty to render information to co-partners regarding all matters affecting the partnership;
  9. The fiduciary duty to co-partners of the duty of loyalty and the duty of care (much the same as that owed by an agent to a principal) in good faith and fair dealing; and
  10. The right to a formal accounting of partnership affairs if a partner is wrongfully excluded from the partnership business or possession of its property by the co-partners; or if the right to an accounting is provided in the partnership agreement; or any other circumstances rendering an accounting just and reasonable.

Partnership Property and Partner Interests

Every partner has a right to possess partnership property in furtherance of the partnership. Each partner also has an equal right to the use or possession of the property in order to advance the partnership business. Therefore, each partner’s right in partnership property is not divisible; each has a full right in the whole.

Capital contributions are the initial funds (or property) invested by the partners and comprise the partnership property. Additional property acquired during the existence of the partnership is also partnership property. The intent of the parties determines if a partner owns an item personally or if the property is owned by the partnership. According to RUPA, “property acquired by a partnership is property of the partnership and not of the partners individually.” RUPA provides two rebuttable presumptions regarding property that property purchased with partnership funds is presumed to be partnership property regardless of title; and property acquired in the name of a partner or partners without the use of partnership funds is presumed to be the individual’s property, even if used for partnership purposes.

A partner’s interest in the partnership must be differentiated from partnership property. The partner’s interest is a personal property interest that is owned by the partner. It may be sold or pledged as collateral to a creditor. Personal creditors may attach a partner’s interest in order to collect debts.

The transfer of a partner’s interest affects the partnership in several ways. Such a transfer, however, does not cause the transferee to become a new partner in the business because all existing partners must agree to the addition of a new partner. Also, the transfer does not exempt the transferring partner from personal liability. Nor will a transfer of an interest eliminate individual liability to the partnership’s existing creditors.

The partnership agreement may state limitations and restrictions on transfers of property. The partnership may have a “right of first refusal” if a partner wishes to transfer his or her interest in the business to an outside party.

Sharing Of Profits

Unless otherwise stated in the partnership agreement, partners share profits and losses equally. This may be modified by agreement of the partners where, for example, partners may share profits in proportion to the individual capital contributions made to the partnership. The same principle may be applied to the losses incurred, if any; losses are normally shared in the same proportion as are profits, but the partnership agreement will control in this situation.

Normally, partners do not receive a “salary” unless the partnership agreement specifies the contrary. This holds even if one partner performs most or even all of the work in running the business. A partner who is responsible for winding up (ending) the partnership is entitled to reasonable compensation for performing these services.

 

Case Study

Sriraman v. Patel

761 F. Supp. 2d 7 (E.D.N.Y. 2011)

Procedural Posture

Plaintiff asked for an accounting. Defendant claimed income from a chief of medicine contract at FH-ICU was not partnership property because defendant never considered the income to be partnership property, defendant retained the contract as his own property, and plaintiff had not proved he had any intent or reasonable expectation to the contrary. Both parties intended that the revenue from two other contracts would be a partnership asset, and plaintiff rendered services under them. Plaintiff claimed he did not receive his full share of profits and sought an accounting upon the dissolution of the partnership. Under N.Y. P’ship Law §74, the claim accrued as of the date of dissolution and was timely.

Overview

In the instant case, there can be no dispute that plaintiff, as a partner, became entitled to an accounting upon his withdrawal from the partnership and its dissolution thereupon as a matter of law. *** (“New York law provides that partners are entitled to an accounting of a partnership following its dissolution.”). The first step is therefore satisfied. The remaining issue for this Court is to reconcile the individual partners’ accounts to make sure that each receives the distribution to which he is entitled. *** The question whether or not personal property owned or acquired by a partner has been contributed by him or her to the firm so as to become partnership property depends on the intention of the parties as revealed by their conduct; by the provisions of the partnership agreement or agreement preliminary thereto; by the terms of written instruments relative to the transfer of the property to or for use of the firm; by entries in the firm books; and by the use of the property in the firm business, although the mere fact that property is used in the firm business will not of itself show that it is firm property. *** Where there is no oral or written partnership agreement, the partnership’s profits are split equally and all the partnership property is considered an asset. *** (“[i]n settling accounts between the partners after dissolution … subject to any agreement to the contrary … [t]he assets of the partnership” include the “partnership property”). This includes any secret profits a partner earned over the course of the partnership.

[The] FH-ICU Contract was, in fact, originally drafted so that all of the partners at that time — Chadha, Silverman, defendant, and plaintiff — were supposed to be signatories, and that was only changed because Silverman and Chadha left the group. Indeed, even though defendant was the only signatory to the final agreement on the doctors’ side, the short-hand reference to him was “the Group,” just as it had referred to the partnership in the initial draft. The agreement itself clearly contemplated its performance by more than one physician; it expressly required 24/7 coverage in the ICU, which could only be performed by more than one doctor. Plaintiff, in fact, did render services under that agreement, unlike the Chief of Medicine Contract. The objective indicia of intent thus indicate that both parties regarded it as a partnership asset, and I therefore find that both parties intended the revenue from that contract to be partnership income.

Outcome

Clerk directed to enter judgment in favor of plaintiff in the amount of $222,300.

 

Disassociation of Partners

A partner can leave or withdraw from a partnership in three different ways: voluntarily; disassociation according to the terms of the partnership agreement; or involuntarily. Involuntary withdrawal may be accomplished through expulsion upon the vote by the other partners or pursuant to a judicial decree; personal bankruptcy; executing an assignment for the benefit of creditors; a partner’s incapacity or death; the termination of a partner that is in the form of a trust, estate, or other business entity (such as a partner that is corporation that loses its corporate charter).

Taxation

The partnership as a separate entity does not pay income taxes. Instead, the income or losses incurred by it are “passed through” the partnership to the partners. Therefore, partnerships are called “pass-through” entities. Each partner is responsible for paying his or her portion of the taxes due on the profits received or may take deductions on his or her portion of losses incurred. An individual partner will receive a document called a “K 1” reflecting their individual share of partnership income or loss based on the partnership agreement.

Liability

RUPA states that the partnership is liable for

“(a) the for loss or injury caused to a person, or for a penalty incurred, as a result of a wrongful act or omission, or other actionable conduct, of a partner acting in the ordinary course of business of the partnership or with authority of the partnership. (b) If, in the course of the partnership’s business or while acting with authority of the partnership, a partner receives or causes the partnership to receive money or property of a person not a partner, and the money or property is misapplied by a partner, the partnership is liable for the loss.”

All partners are jointly and severally liable for all obligations of the partnership. This means that a creditor may sue all of the partners together in case of an unpaid debt or may choose one partner (“tag you’re it!!!!) as a defendant. It would then be up to that partner to implead his or her other partners under a doctrine called the “right of contribution.” Partners are not liable for any obligations that arose prior to becoming a partner. General partnerships may provide for the liability of partners for partnership debt in the partnership agreement, but all such provisions must be clearly stated. Judgments obtained against the partnership are not effective against individual partners’ assets unless the judgment is also against the individual partners.

Dissolution and Termination of the Partnership

A partnership does not exist in perpetuity, as may a corporation. A partnership can terminate as the result of voluntary or involuntary actions. A partnership will dissolve on the withdrawal of a partner in a partnership at will; the conclusion of a period of time in a fixed term partnership; the achievement of the purpose for which the partnership was specifically created; the occurrence of an event agreed upon in the partnership agreement; or the occurrence of an event that makes it illegal to continue the partnership.

The Revised Uniform Partnership Act (RUPA), however, provides that a partnership does not automatically dissolve if a partner dies or if a partner leaves (disassociates from) the business. The structure of the partnership changes, but this may or may not affect the business itself. The partnership may reorganize and continue without the exiting partner. RUPA also specifies fiduciary duties of the partners during the dissolution; and establishes a formula by which partnership interests may be valued in a buyout or dissolution. Also, if a partnership is created for a fixed term (two years, for example), and the partnership continues beyond the term without any express agreement, the UPA declares that the rights and duties of the partners remain the same as before the expiration of the stated term.

The process of terminating a partnership is called dissolution and winding up. Dissolution begins the process of winding up and precludes the commencement of new business. Winding up ends all business activity, resulting in the payment of outstanding debts and the liquidation of assets; the remaining amounts, if any, are distributed to partners to reimburse capital contributions followed by the distribution of any profits and assets that remain.

Dissolution by Agreement

The partnership agreement may include a limitation on the duration of the partnership. At the end of the time period, the partnership is dissolved. Without such a limitation, or if no partnership agreement exists, the partners can unanimously consent to dissolve the partnership. In international business, parties frequently enter into relationships, termed “joint ventures,” which are organized for a set time period and for a limited, specified purpose. At the end of that period or at the attainment of the purpose for which the joint venture was formed, the joint venture may be terminated.

Dissolution by Operation of Law

Certain events may occur that cause dissolution. As noted, the death of one partner no longer automatically dissolves a partnership. The partnership buys out the deceased partner’s interest with an amount paid to the estate of the deceased partner. Bankruptcy of the partnership will dissolve the partnership, but the bankruptcy of an individual partner does not. Laws on partnership dissolution vary from state to state and should be consulted concerning these issues. “Buy-sell” agreements, sometimes funded by the purchase of so-called “Key Man” insurance, are often concerned with the dissolution of the partnership.

 

Case Study

Laplace v. Laplace

Civil Action No. 03-4291 (JAG), 2006

U.S. Dist. LEXIS 768 (D.N.J. Jan. 11, 2006)

Procedural Posture

Plaintiffs, the wife and daughter of a deceased partner, sued defendant, the only remaining partner in a family partnership, claiming that the deceased partner’s estate was entitled to a larger share of the partnership than a $100,000 share that was stated in the partnership agreement for buyout after death of a partner. The remaining partner filed a motion for summary judgment.


Overview

This case involved whether to enforce the buyout provisions of a partnership agreement, and how those provisions should be interpreted. The agreement, first signed in 1959, provided for a $100,000 buyout at the time of death of any partner. The wife and daughter [claiming that the buyout was worth $3.5 million] however, contended that the buyout provision was unenforceable due to the provisions of the New Jersey Uniform Partnership Act (RUPA), ***. The court held that the partnership agreement clearly showed that the partners contemplated and provided for the eventuality of a partner’s death and therefore, pursuant to N.J. Stat. Ann. § 42:1A-4(a), the agreement terms governed. The court further held that there was insufficient evidence that the partners had adopted a course of conduct that waived the agreement’s buyout terms. While the estates of certain partners in the past received more than $100,000, the provisions were made pursuant to a decision of the remaining partners, as provided for in the agreement. Finally, there was no basis for the argument that the buyout provision’s reference to “partnership business” did not include the partnership’s real estate assets.

Outcome

The court granted the motion for summary judgment filed by the remaining partner.

Dissolution by Judicial Decree

If members of the partnership are no longer able to work together, they may petition a court for dissolution in the interest of preserving their investment and the property of the partnership.

Limited Liability Partnerships

Depending on the jurisdiction, a limited liability partnership (LLP) is a partnership in which some or all partners have limited liability. A partnership must file a certificate of limited liability partnership with the Secretary of State. Rules and regulations on limited liability partnerships vary from state to state. As a hybrid vehicle, an LLP exhibits characteristics of both a partnership and a corporation. In a standard LLP, one partner is not responsible or liable for another partner’s misconduct or negligence. In an LLP, some of the partners enjoy a form of limited liability similar to that of the shareholders of a corporation. Unlike corporate shareholders or limited partners, LLP partners have the right to manage the business directly. An LLP will also be taxed as a pass-through entity, generally under rules established for partnership vehicles—thus avoiding double taxation. The LLP is well suited for businesses where all investors are professionals and who may wish to take an active role in management. LLPs are discussed further in the Chapter on Corporations.

Limited Partnerships

The primary law governing limited partnerships (LPs) is contained in the revised Uniform Limited Partnership Act 2001 (ULPA), adopted by almost every state, either in total or revised format. Limited partnerships (LPs) may be created for any lawful profit-making purpose. According to the Commission on Uniform Laws, limited partnerships “targets two types of enterprises that seem largely beyond the scope of LLPs and LLCs:

  • sophisticated, manager-entrenched commercial deals whose participants commit for the long term, and
  • estate planning arrangements (family limited partnerships).”

The ULPA assumes that, more often than not, people utilizing this form will desire:

  • “strong centralized management which is strongly entrenched in the business, and
  • passive investors with little control over or right to exit the entity.”

LPs are created when partners in a general partnership accept investments from one or more parties, called limited partner(s), and file a certificate of limited partnership with the appropriate Secretary of State.

As with the general partnership, the partnership agreement controls the legal relationship among the partners, and between the partners and the partnership. Unlike the general partnership, it is characteristic of the LP to have two classes of partners and to have at least two partners. An LP must have a least one general partner and one or more limited partners. In addition, the words “limited” or “L.P.” or “LP” must be spelled out or abbreviated in the partnership’s name. The partnership name may also contain the name of any partner.

The general partner(s) manages the partnership and assumes responsibility – unlimited liability- for the debts of the partnership. The limited partner(s) contributes cash or other property and owns an interest in the business, but does not participate in its management. Limited partners are essentially passive investors who do not incur unlimited liability in the partnership: they are not personally liable for the debts of the partnership beyond any amount invested—termed their ca[pital contribution. Some family owned businesses are created as family limited partnerships (FLPs) in order to keep the business within the family or to manage a family investment asset. For some families, FLPs are often used for estate planning purposes.

With the exception of the treatment of limited partners and the need for adherence to state law in the formation of limited partnerships, general and limited partnerships function in much the same way.

Creating a Limited Partnership

Forming a limited partnership requires a formal and public proceeding and adherence to the legal requirements of a specific statute. Its existence requires state approval. The partners must sign a certificate of limited partnership that includes information similar to that found in a corporate charter. The certificate is then filed with the appropriate state official, usually with the Secretary of State. The certificate is public information, subject to open inspection. The certificate must contain the following information:

  • The name of the limited partnership, which must include the words “limited partnership” or “limited” or “L.P.” or “LP” without any abbreviations;
  • The address of the limited partnership’s principal office;
  • The name and address of a statutory agent of the partnership;
  • The business address of the general partner; and
  • The latest date for dissolution of the partnership.

Limited Partners: Liability

General partners are personally liable to the partnership’s creditors for partnership debt. Limited partners are not. For this reason, at least one general partner is necessary to form a limited partnership. The limited liability protection afforded to limited partners may be forfeited if a limited partner engages in the “management and control” of the business. Each state provides definitions of “management and control” and safe harbors defining when limited partners are not considered to be participating in the management and control of the business. The fact that limited partners avoid personal liability for the debts of the business provides the main advantage of a limited partnership over that of a partnership. Note that the 2001 revision to the ULPA, if adopted by states, eliminates this “management and control” analysis and provides full limited liability to limited partners.

Today, many companies address issues surrounding the unlimited liability of a general partner by creating an LLC or a corporation to serve as the general partner. As the LLC or corporation has limited liability because of the rules of incorporation, no one in the limited partnership would have personal liability, unless state law provides to the contrary. However, this creates additional expense. In response, currently half of the states in the U.S. have adopted laws that create a business entity called a limited liability limited partnership (LLLP) which gives all partners—both limited and general — the protection of limited liability. LLLPs are currently used most often in real estate and the entertainment and communications industries. Cable News Network, LP, LLLP (CNN) is an example. The revised Uniform Limited Partnership Act (2001) also recognizes LLLPs. Whereas the advantage of limited liability protection in the LLLP for general and limited partners is obvious, business owners should also be aware of the disadvantages. These include increased complication in creating this format, increased cost in filing fees, and the potential for incurring unplanned tax consequences such as state taxes and federal taxes (relating to passive income vs. earned income).

Limited Partners: Rights and Liabilities

The rights of limited partners are very much the same as those of general partners. Limited partners have a right to review the books of the partnership and to an accounting of the partnership business. Upon dissolution, limited partners have a right to the return of their capital contributions in accordance with the partnership certificate. Limited partners may assign their interest, subject to specific provisions in the certificate.

In some jurisdictions, courts have recognized the absolute right of limited partners to sue, individually or on behalf of the firm, for economic injury to the firm caused by the general partners or outsiders. In order to protect the limited liability of the limited partners, there are several additional requirements, in addition to the creation of the entity discussed above. Some states may require a specific dollar amount to establish an LP. The limited partners cannot take part in the management of the firm. The limited partners cannot use their individual names in the name of the partnership, otherwise giving the wrong impression to outsiders and resulting in the possibility of creating a general partnership by estoppel.

The RULPA has eliminated the limited liability that attaches to limited partners when a limited partner performs duties ascribed generally by general partners. Under such circumstances, the liability of a limited partner would extend to those persons who are led to believe that, by the conduct of the limited partner, he or she is in fact a general partner.

However, a limited partner may perform the following duties and activities without losing the protection of limited liability:

  • They may be employees of the general partnership;
  • They may consult with or advise the general partner;
  • They may act as a surety or guarantor for the limited partnership; and/or
  • They may vote on amendments, dissolution, sales of property, or assumption of debt.

Limited partners who follow these rules and who do not engage in the “management and control of a business” will be liable up to the amount of capital contributed to the limited partnership. A pledge to pay a certain amount as capital over a time period causes a limited partner to be liable for the full amount pledged.

 

Case Summary

Bartlett v. Pickford

Civil Action No. ELH-13-3919, 2014

U.S. Dist. LEXIS 178682 (D. Md. Dec. 31, 2014)

Facts

This intra-family dispute pits siblings against each other with respect to valuable real estate located in Talbot County, Maryland. Christy Pickford Bartlett, as General and Limited Partner of Pickwick Farm Limited Partnership, Trustee of the Patricia Pickford Revocable Trust, and Co-Trustee of the Stephen Pickford and April Pickford Trust; Barbara “Bobbe” P. Mundt; and Judith “Gigi” Pickford Barse, plaintiffs, filed suit against defendant Cecile E. Pickford, as General Partner of Pickwick Farm Limited Partnership. At the center of the controversy is a 76-acre farm (“Farm”) located in Maryland, owned by the Pickwick Farm Limited Partnership (“Pickwick Farm LP”).

From its inception, Pickwick Farm LP has been managed by its two general partners, Bartlett and Pickford. Barse and Mundt, as limited partners of Pickwick Farm LP, do not have responsibility for the management or operation of the entity’s business. With respect to any sale of the Farm, such a transaction requires, inter alia, joint consent of Pickwick Farm LP’s two general partners. ***

In May 2013, the Pickwick Farm LP “received an offer” of $2.7 million for the purchase of the Farm. Despite the desire of Bartlett, Barse, and Mundt to pursue the sale, Pickford withheld her consent and effectively blocked the transaction.

Because of Ms. Pickford’s unwillingness to sell the Farm and the failure of Pickwick Farm LP to operate with a profit, plaintiffs filed suit against defendant. The Complaint contains four counts: Count I, “Specific Performance”; Count II, “Declaratory Judgment – Injunctive Relief”/”Sale of the Farm”; Count III, “Declaratory Judgment – Injunctive Relief”/”Removal of Cecile as a General Partner”; and Count IV, “Judicial Dissolution [of Pickwick Farm LP],” as an “alternative to the relief sought in Counts I and II.”

Currently before the Court is plaintiffs’ pre-discovery Motion for Summary Judgment. In support of the Motion, plaintiffs submitted a Memorandum (collectively, “Motion”), and five exhibits. Defendant filed an opposition to the Motion and appended the Affidavit of Ms. Pickford as well as a copy of the LP Agreement. Plaintiffs Bartlett and Barse filed a Reply, along with a Supplemental Affidavit of Christy Pickford Bartlett.

Holdings

Plaintiffs rely, inter alia, on Section 10-802 of the Corporations and Associations Article (“Corps.”) of the Md. Code ***. *** In plaintiffs’ view, dissolution is appropriate because of the deadlock as to whether to sell the Farm. Similarly, they argue *** that removal of Ms. Pickford as a partner is an appropriate remedy under Corps. § 9A-601(5), which states, inter alia, that “expulsion” of a partner by judicial determination may be appropriate “[o]n application by the partnership or another partner,” if the partner to be expelled “engaged in conduct relating to the partnership business which makes it not reasonably practicable to carry on the business in partnership with the partner.”

In her Opposition, Ms. Pickford contends, among other things, that summary judgment is inappropriate, because she has not had an opportunity to complete discovery. According to Ms. Pickford, when plaintiffs filed the Motion, “the parties served, but had not yet responded to, written discovery and the parties had not yet taken any depositions.” Therefore, she maintains that the record is incomplete, and insists that a “full record” must be developed.

Based on the record before the Court, it does not seem that the Court can yet make a determination as to whether dissolution of the partnership or expulsion of Ms. Pickford is appropriate. In particular, it remains unclear if it is no longer “reasonably practicable to carry on the business in conformity with the partnership agreement” as required by Corps. §10-802. The LP Agreement describes the purpose of the partnership as “managing, operating, developing, and otherwise dealing with the [Farm] for the production of profit.” *** And, according to Ms. Pickford, the parties “vigorously dispute[ ]” whether the Farm is able to produce a profit. ***

Summary judgment is ordinarily inappropriate “where the parties have not had an opportunity for reasonable discovery.” *** The Fourth Circuit has explained that “[s]ummary judgment before discovery forces the non-moving party into a fencing match without a sword or mask.” *** However, “the party opposing summary judgment ‘cannot complain that summary judgment was granted without discovery unless that party had made an attempt to oppose the motion on the grounds that more time was needed for discovery.'” ***

Outcome

The Motion has been fully briefed and no hearing is necessary to resolve it. *** For the reasons that follow, I will deny the Motion as premature.

 

Taxation of Limited Partnerships

The same tax rules apply to limited partnerships as to general partnerships: both are pass-through entities — profits and losses pass through to the individual partners. Limited partnerships will file informational returns with the federal and state governments, and the individual partners report the income and losses on their individual income tax returns and pay their proportional share of taxes, based on the partnership agreement.

Termination of Limited Partnerships

Termination of a limited partnership can happen upon the following: the occurrence of an event in the LP agreement; the consent of all general partners and of limited partners owning a majority of the rights to receive distributions as limited partners at the time the consent is to be effective; the dissociation of a person as a general partner; administrative dissolution (the signing and filing of a declaration of dissolution by the Secretary of State); or judicial dissolution (obtaining a court decree upon the application of a partner).

Dissolution of the limited partnership does not occur if a limited partner dies or assigns his or her interest to another. Bankruptcy of a limited partner will not dissolve the partnership unless it results in the firm itself becoming bankrupt. The death, mental incompetence, illegality, expulsion, or bankruptcy of a general partner does not cause the dissolution of the partnership if the business has one or more general partners or there is a unanimous vote to carry on the business. If a general partner retires or dissociates, dissolution does not automatically occur. The partnership agreement usually provides for such eventuality and, if not, the law provides for the remaining general partners to continue with the business.

Upon termination of the limited partnership, the partners go through the process of winding up and liquidation of all the assets. The RULPA provides that money from the sale of the assets be disbursed as follow: creditors (including partners, but not with respect to distributions), partners and former partners for distributions owed to them, and for return of capital contributions; and the balance divided according to the partnership agreement. Thereafter, the general partner must file a certificate of termination with the Secretary of State.

 

Ethical Considerations

Liability for Debts
In a sole proprietorship, the proprietor is liable for all debts of that “business.” What are the ethical implications in the law requiring a sole proprietor to continue to be liable for debt when a member of a limited liability company can simply “walk away” from a similar obligation? Does this make sense?

Joint and Several Liability
In applying the rule of “joint and several liability,” a partner who owns just a small percentage of a partnership may nonetheless be requited to shoulder the entire amount a a partnership debt. Is that “fair” to that individual partner? How might this be alleviated?

 

Questions

  1. Identify the factors that a business owner must take into consideration when determining what type of business organization to choose.
  2. What is the purpose of a sole proprietorship?
  3. Explain some advantages / disadvantages of this form of business entity.
  4. Explain the concept of “respondeat superior.”
  5. What is an independent contractor?
  6. Is the proprietorship an entity for legal purposes?
  7. Describe how a partnership is created.
  8. Discuss the rights and duties of partners in relation to the partnership and to other partners.
  9. What impact does the transfer of a partner’s interest have on the partnership?
  10. Explain how a partnership may be dissolved.
  11. Differentiate between a general partnership and a limited partnership.
  12. Explain the taxation of a general partnership and a limited partnership.
  13. How is a limited partnership created?
  14. How can a limited partner engage in the “management and control” of a firm?