UPA 6(1): A partnership is an association of two or more persons to carry on as co-owners a business for profit.
Carry on control as co-owners, and
Share in profits.
UPA 7: Joint ownership does not by itself create a partnership. Sharing of gross revenues does not buy itself create a partnership. The entity must have been
Formed as a joint venture
For the purposes of carrying on control of business
To make a profit.
Need for a Written Agreement
Partnership may be enforced even without a written agreement.
However, a written agreement provides important rules for hashing out disagreements, deciding what to do on dissolution, etc.
Sharing of Profits and Losses
Usually allocated by way of the written agreement.
Default Rule - UPA 18(a): In the absence of a written agreement, all profits and losses are shared equally.
Inadvertent Partnerships
Profits Presumption – UPA 202(c)(3): A person who shares in the profits of a business is presumed to be a partner.
Martin v. Peyton: KN&K a brokerage house partnership in financial straits. Defendants enter into an agreement giving KN&K $2 million in securities in exchange for (1) large number of speculative securities, (2) 40% of the profits up to $500,000, (3) defendants could inspect the books and veto any major business decisions, and (4) defendants had an option to turn the loan into a contribution.
Issue: Is this arrangement a loan or a contribution turning the defendants into partners?
Holding: The arrangement is a loan because, although the defendants were entitled to share in profits, this was contemplated as security for the loan. And, although the defendants had a right to veto major business decisions, this also could be seen as security for the loan given the partnership’s poor prior judgment. Veto power alone does not rise to the level of “carrying on control of business.” Finally, if this were a contribution, why would it contain an option to make it a contribution?
Management of Partnership Business
Partner Agent of Partnership as to Partnership Business – UPA 9:
Every partner an agent of the partnership when acting on partnership business.
Partnership bound by the actions of any partner acting in the ordinary course of partnership business.
Exception: Partnership not bound by the actions of a partner (1) acting without actual authority, and (2) where no third party reasonable reliance on actual authority.
Partnership’s Liability for Partner’s Tortious Acts – UPA 13-14
Partnership liable for partner’s tortious acts committed during ordinary course of business.
Partnership liable for partner’s misappropriation of third party’s funds when acting under the apparent authority of partnership.
Nature of Partner’s Liability – UPA 15:
All partners jointly and severally liable for the tortious acts of a partner committed during ordinary course of business.
All partners jointly and severally liable for the debts of a partnership.
General partners cannot waive their liability to third parties!
However, partners can agree to indemnify each other for such liability in the partnership agreement.
Centralization of Management
Default: All partners have equal rights in the management and conduct of the business (UPA 18(e))
Executive Committees and Managing Partners: UPA 18 allows partners to agree to form an Executive Committee to control the operations of the business. Executive Committee can have a Managing Partner, similar in function to a CEO.
Duties of Partners to Each Other
Partner’s Fiduciary Duty – UPA 21
Partners have fiduciary duty to each other and to the partnership.
Partners have to hold any profits as trustees for the benefit of each other and partnership.
Meinhard v. Salmon: Plaintiff and defendant enter into a partnership agreement to own and operate a hotel. Plaintiff to contribute the funds; defendant to run the business. The partnership enters into a 20 year lease. The hotel makes a ton of money. Four months before lease ends, the lessor comes to defendant and solicits him about leasing the whole block of buildings. Defendant agrees and the lessor and defendant enter into a separate agreement to begin after the termination of the hotel lease.
Issue: Did the Defendant breach his fiduciary duty to Plaintiff by failing to inform him of the new lease opportunity to begin after the termination of the partnership?
Holding: Yes.
The new opportunity was created by the partnership’s success. Thus, the new opportunity was a potential extension and enlargement of the partnership.
When a new opportunity is created by a partnership’s activities, a partner has the fiduciary duty to disclose this new opportunity to the partnership and to allow the partnership the ability to take advantage of this new opportunity.
Contract Limiting Fiduciary Duty:
In some jurisdictions Partners can contract to limit their fiduciary duty to the partnership and each other through express agreement in the partnership contract. This allows a partner to enter into business arrangements that may conflict with the interests of the partnership.
Other jurisdictions refuse to allow partners to limit their fiduciary duty contractually.
Dissolution of General Partnerships
Defined – UPA 29: Dissolution is the change in the relation of the partners caused by any partner ceasing to be associated in the carrying on as distinguished from the winding up of the business.
Default Causes of Dissolution – UPA 31: Dissolution caused by
Express will of partner to dissolve partnership,
May be subject to damages, though, for breaking the partnership agreement.
If one partner leaves and the business continues technically a new partnership is formed.
When the partnership term specified in agreement runs out, or
By the expulsion of any partner, or
By death of any partner.
Survivorship Clauses: Usually partnership agreements contain an agreement to continue the life of the partnership in perpetuity.
What happens to the dead partner’s interest after his death?
Interest in partnership passes to his estate.
However, heir does not become a partner.
No person becomes a member of the partnership without the consent of all the partners. (18(g).
Heir receives a percentage of assets her husband retained; his “basis.”
Limited Liability Partnerships
Formation – UPA (1997) 101(7) & 1001 – 1003
Limited liability partnerships must be created expressly by filing a statement of qualification.
Limited liability partnerships require:
Vote necessary to amend partnership agreement
Filing of Statement of Qualification
Effective the later date of the filing date or the date specified in the statement.
Must have LLP after its name and must file an annual report with Sec. of State.
Liability
UPA (1997) 306(c): Any obligation incurred by the partnership, whether by contract, tort, or otherwise, is the sole obligation of the partnership.
Limited partners bear no personal liability!!
General Partners: General partners bear personal liability, however, for the obligations of the partnership; the partnership must have at least one general partner.
Varied Protection: Protection for limited partners varies in different states. Some states protect only for malpractice/negligence. Other states protect for contract debts as well.
Management & Control Exception: If a limited partner participates in management and control of the business he is liable to third parties who reasonably believe the limited partner is a general partner.
Fundamental Considerations in Choice of Entity Decisions
Limited Liability
Corporation: Corporate Veil - A corporation is a fictional legal entity. As such, shareholders and officers of corporation generally bear no personal liability for the debts of the corporation beyond their capital contributions.
General Partnership: All general partners are jointly and severally liable for the debts and obligations of the partnership.
Limited Liability Partnership: Only the general partner bears personal liability for the debts and obligations of the partnership beyond his capital contribution
Informality, Flexibility and Cost of Operation and Formation
A general partnership can act much more flexibly and be created much more cheaply than a corporation or limited liability partnership because it can be created by default.
However, the procedural requirements for creating a limited liability partnership or a corporation help to protect the owners/managers expectations.
Continuity of Life
Unless expressly stated in partnership agreement, a partnership ends when a partner dies or leaves.
Corporations generally have perpetuity of life because they are considered a legal entity completely distinct from their owners.
Centralization of Management
General Partners automatically have an equal right to share in the management and control of the business.
Limited Liability Partnerships centralize management in the general partner because a limited partner may potentially lose his/her limited liability if he/she participates too much in the business.
Corporations: Articles of Incorporation provide for centralization of management in particular executive offices and in the Board of Directors; separates management from control.
Free Transferability of Interests
The Corporation v. The Partnership: Reflecting on Certain Basic Federal Income Tax Considerations
Partnership Taxation
The IRS generally does not tax partnerships as a separate entity. However, it must file an informational return known as a Form 1065.
Flow Through Taxation: Partners, rather than partnership, taxed personally on their annual income gained from the partnership.
Partnership must provide each partner with a Form K-1 informing partner of his or hers share in respective income and deductions.
Partners must pay tax on any gain, regardless of whether or not the partnership actually distributed that gain to the partner.
Corporate Taxation
Incident of Double Taxation
C-Corporation Income Tax
Corporation taxed on its Taxable Income (TI) based on Corporate Tax Rates.
TI = Gross Revenues – Business Expenses/Credits/Deductions
Capital Gains Tax
Shareholders of corporations then taxed on any dividends received from the corporation. This tax is known as the Capital Gains Tax.
Capital Gains Tax: Taxes on gains from capital assets (assets held for profit making or investment purposes).
Capital Gains Tax Rate: 20%.
Retained Earnings: Retained Earnings are the amount of gain the corporation chooses to hold, rather than release in the form of dividends, after business expenses, corporate taxes and any dividends actually released have been allocated.
Taxation for S-Corporations
S-Corporation requires:
An affirmative election by the corporation;
75 shareholders or less, none of whom are artificial entities and all of whom are resident aliens of US;
Only one class of shares.
Taxed on a modified flow-through basis where S-Corp reports the earnings of attributable to each shareholder.
Strategies to Minimize Incidence of “Double Taxation”
Zeroing Out
Focuses on attempting to “zero out” C-Corporations taxable income.
Involves earmarking shareholder payments as expenses rather than deductions by making these payments in the form of rents, salaries, interest payments, etc.
Accumulation Bail/Out
Involves taking advantage of the lower capital gains rate.
Allow profits that would otherwise be distributed as dividends to accumulate in the business.
Then, when the shareholder wants to get out, he can sell his stock for not less than the amount accumulated in the business; the profit incurred is then taxed at the lower capital gains rate.
Combination of Forms of Business Organizations: Evolution of the Modern Limited Partnership with Corporate General Partner
Corporations as General Partners
Most state statutes consider corporations legal “persons.” Thus, corporations may serve as general partners of a limited partnership.
To what extent, then, can limited partners serve as executives of a corporation/general partner and still retain their limited liability?
Limited partners lose their limited liability if (1) they exercise substantial control over the business and (2) third party relies on the limited partner as a general partner.
California: Third party must have had actual knowledge of the limited partner’s participation in and control of the business for the limited partner to lose his limited liability.
Delaney v. Fidelity: Fidelity a limited partnership with Interlease Corp. as its general partner. Crombie, Sanders and Kahn are all limited partners of Fidelity; they are also the President, Vice President and Treasurer of Interlease. Crombie executes a lease on behalf of Fidelity with Plaintiffs in his capacity as President of Interlease. Fidelity defaults on the lease.
Issue: Do limited partners bear personal liability for the obligations of the limited partnership where they serve as the officers of the corporate general partner and where they executed the contract on behalf of the limited liability partnership?
Holding: No.
Limited partners can be liable if they exercise control over the business.
However, the purpose of this statute is to protect ignorant third party investors. Here, the Plaintiffs had actual knowledge the limited partnership had a corporate general partner. As a sophisticated legal entity, it also knew the corporation would bear sole liability for the debts of the partnership. As such, it assumed the risk that the corporation would be undercapitalized.
Mount Vernon v. Partridge Associates: MIW Investors is a limited partner in Partridge Associates, a limited partnership. MIW created Partridge Associates and controls 50% of its interest. The President of MIW also participated in operational meetings of Partridge Associates.
Issue: Did MIW Investors participate in the operations and control of Partridge Associates such it would lose its limited liability under the management and control exception?
Holding: No.
A limited partner loses its limited liability if it participates in the control of the organization such that it has substantially the same exercise of powers as the general partner.
Limited partners do not have to act as passive investors. They can have a say in company affairs, including participating in regular operational meetings, as long as their word is not effectively the last.
Master Limited Partnerships
What are Master Limited Partnerships?
Extremely large entities with a vast amount of partners who hold interests in the partnership that are freely transferable, much like stock.
Used as a tax savings device by taking advantage of flow-through status.
Revenue Act of 1987: Master Limited Partnerships are treated as corporations for tax purposes if:
Partnership interests are traded on an established securities market; or,
Partnership interests are readily tradeable on a secondary market.
“Check the Box” Regulations
Entity classified as a corporation if:
Created under a statute that describes or refers to the entity as incorporated, a corporation, body corporate or body politic;
If it is not classified as corporation and has at least two members, it can be classified as a corporation for tax purposes by election at the time it files its first return;
If it has only one member, it can elect to be taxed as a corporation or as a sole proprietorship, i.e., as individual income.
Scope of Fiduciary Duty in Modern Limited Partnership
Directors of a corporate general partner of a limited partnership owe a fiduciary duty in their dealings with the limited partnership to act in the best interests of the limited partnership.
In Re USACafes, LP: USACafes, LP is a limited partnership. USACafes General Partner, Inc. is its general partner. The Wyly’s are the sole shareholders of USACafes General Partner, Inc. and also on its Board of Directors. They also own 47% of the limited shares in USACafes, LP. The Wyly’s direct a sale to Metsa, Inc. of all of the assets in USACafes, LP. In return, they receive $72.6 million for the partnership, as well as side payments totaling $14-15 million for covenants not to compete.
Issue: Did Wyly’s, as directors of the corporate general partner of a limited partnership, violated their fiduciary duty to the limited partnership by taking side payments and by, allegedly, selling the limited partnership’s assets for less than market value?
Holding: Yes.
Directors of corporate general partner of a limited partnership owe a fiduciary duty to the limited partnership during transactions involving the interests of the limited partnership.
Taking side payments to reduce the total price of the limited partnership’s assets constitutes a breach of fiduciary duty.
History of the Corporation
Race of the Lax: Competition for State Incorporation Business
Implications of the Separation of Ownership from Control
Corporations originally created by charter for specific purposes with specific powers granted. Relatively small; owners played a large part in operations.
As the incorporation laws became more lax, corporations incorporate for a vast array of purposes and hundreds of thousands of shareholders. This creates (1) a separation of ownership from management that creates incentive for management abuse, and (2) huge corporations that tend to dominate the state and hold the state and its citizens hostage to their interests.
Pre-Eminence and Influence of Delaware Law
Delaware law is very popular because it tends to favor the interests of the corporations over its shareholders.
Plus, due to the fact so many corporations incorporate in Delaware and thus so many corporate cases are litigated in Delaware, the Delaware judiciary is considered particularly adept at handling corporate law cases.
Internal Affairs Doctrine and California Corporations Code § 2115
Internal Affairs Doctrine
The law of the state where you incorporate governs a corporations internal affairs.
Internal Affairs: Director elections, dividend disbursements, fiduciary duties, etc.
California Corporations Code § 2115
A foreign corporation that maintains “significant contacts” with California will be treated as a California corporation. Publicly Traded Corporations are exempt from this provision.
Foreign Corporation: Any corporation incorporated out-of-state.
“Significant Contacts”: More than 50% of payroll, sales and property revenue generated from California.
The Future
Sarbonnes-Oxley
A federal statute that imposes a broad new set of rules on the way a corporations organizes financially.
Conflicts with the Internal Affairs Doctrine by imposing federal law on internal affairs.
The Incorporation Process and Its Pitfalls
Incorporation Procedures: Formation of a Corporation
Where to Incorporate
Have to take into account the costs of incorporation and the advantages and disadvantages of the state’s substantive law.
For closely held corporations, almost always preferable to incorporate in the local state due to the fact the corporation could be sued in its state of incorporation.
How to Incorporate
Filing Articles of Incorporation
MBCA § 2.01: One or more people can incorporate by delivering the articles of incorporation to the Sec. of State for filing.
Any person can incorporate.
Other corporations can serve as incorporators because they are considered legal persons.
California § 200(a): Same.
Secretary of State’s Duties
MBCA § 1.25
SS’s duty ministerial; if the Art. of Inc. comply with the statutory requirements in model act, the SS has to file it.
If the SS files the documents, the documents considered filed as of the day of receipt, unless the document proscribes another time.
California Corporations Code § 110
SS’s duty discretional; SS ensures compliance with the law, as a whole (not just the procedural requirements).
If accepted, filed on the date of receipt.
What goes into the Articles of Incorporation?
Mandatory/Discretionary Provisions
Mandatory – MBCA § 2.02(a)
Name;
Number of Authorized Shares;
Street Address of Initial Registered Office and Name of Its Registered Agent; and,
Name and Address of Each Incorporator.
Discretionary
Purpose or purposes for which the corporation organized;
Provisions managing the business and regulating the affairs of the corp;
Provisions defining, limiting and regulating the powers of the corporation, its board of directors, and shareholders;
A par value for authorized share or classes of shares; and,
The imposition of personal liability on shareholders for the debts of the corp.
Name
Similar Names - MBCA § 4.01/Cal Corps Code § 201: Name must be distinguishable upon the records of the Secretary of State from other corporate names.
“Confusion in an absolute or linguistic sense” is the standard, rather than the effect on the competitiveness of other corporations.
Corporations may conduct business under an alias, just like a person.
Reservation of Names
MBCA § 4.02/: Person can reserve a name for the use of a yet-to-be created corporation; reservation lasts for 120 days.
Cal Corps Code § 201(c): Can reserve for 60 days only and only twice.
Duration
MBCA § 3.02/Cal Corps Code § 200: Unless otherwise set out in its Article of Incorporation, every corporation has perpetual duration.
Corporate Powers
General Powers
MBCA § 3.02: Unless otherwise provided in its Articles of Incorporation, a corporation has the same powers as an individual to do all things necessary or convenient to carry out its business and affairs.
Cal Corps Code §202(b)(1): Same default rule.
Cal Corps Code § 202(4): No reference to corporate powers other than by way of limitation.
Limitations Provisions
Although it is no longer necessary to include a provision limiting the corporate powers, it may be desirable in a closely held corporation as a means of ensuring compliance with corporation objectives.
