ADW Draft 9/25/11

AP edits 9/29/11

Chapter 6. Organizational Choices

Sources Used in this Chapter:

RUPA (1997) §§ 101(6), 202(a), 301, 305, 306, 401, 405, 502, 601, 801, 802, 807

RULPA (1976/1985) §§ 101(7), 201, 302, 303, 403, 503, 504, 702, 801

RULPA (2001) § 303

ULLCA (1996) §§ 403, 404, 405, 501

RULLCA (2006) §§ 501, 601, 701

MBCA §§ 2.02, 6.22, 6.27, 6.40, 7.21, 7.28, 8.01

DGCL §§ 102, 141

Covalt v. High

Dreifuerst v. Dreifuerst

Holzman v. de Escamilla

Kovacik v. Reed

Lupien v. Malsbenden

Owen v. Cohen

Richert v. Handly

Water, Waste & Land, Inc., DEPA Westec v. Lanham

Concepts for this Chapter:

  • Basic choices for form of business association: partnerships, corporation, LLC
  • Essential aspects of each form:

–Formation

–Liability

–Management and control

–Financial rights

–Continuity

–Liquidity of ownership

–Combinations

  • Planning considerations

–Economics of choice

–Tax consequences

A. Alphabet Soup

Chapter 6 is the beginning of the third module of the book, which covers the mechanics of forming acorporation and taking corporate action. Chapter 6 compares the corporation to otherbusiness organization forms.

This chapter introduces a good deal of vocabulary. It explores the choice oforganizational form and its implications for people forming a business firm. The choice isimportant in allocating risks, and may determine the future of the business.

In teaching this chapter, we hope to accomplish four goals:

(1) identify the basic business organizational choices: partnerships, corporations and hybrids such as LLCs;

(2) describe the basic characteristics (and distinguishing features) of each organizational form;

(3) introduce the considerations a business lawyer must take into account in choosingone form over another in the planning stages of counsel; and

(4) introduce the tax attributes of each basic form.

Above all, we want students in this introductory course to see that organizational Organizational forms are not rigid and unique, but fluid and largely customizable. Firms can choose an organizationalform and then alter that form to closely resemble a different form, or they can reorganize and adopt a different form. A corporation, forexample, is not necessarily subject to double taxation if it chooses S-corporation status,thus achieving the “flow-through” tax treatment of a partnership and LLCs.

Note: We also point out that other courses in the curriculum -- such as Business Planning or Transactional Clinic – give students a chance to apply their learning about organizational choices presented in this chapter.

Question: What are the concerns or interests that cause people to choose one kind of business organization over another?

Answer: Parties are likely to be thinking about

  • The duration of their undertaking
  • Financial rights
  • Oversight powers
  • Management structure
  • Withdrawal (exit) rights
  • Allocation of liability, and even
  • Tax attributes

Hypothetical 6.1 (p.142)

Brandon, Anita and Charles are three individuals planning to start abusiness. [AP: the book hypo at page 142 does not include Charles – we should probably finesse this here]

  • Brandon is a manager. He brings to the table time, management skills andbusiness experience, but has little money to invest in the company.
  • Charles is an investor, or a classic capitalist. He has at his disposal a great deal of money, but little time or experience in the business. [AP: hypo 6.1 has no “Charles” – the slides do because we had three characters in the prior edition with Jeff Bauman]
  • Anita offers something in between Brandon and Charles. She has limited managerial skill, as a CPA, and limited capital, with some money available, to pledge to the firm. [AP: this is not the Anita of our hypo // my thought is we should simplify things here (and in the slides) and keep this chapter focused on straight-forward capitalist and straight-forward manager]

Question: What organizational form should they choose for “Your Green Home”?

Answer: It is too early to answer this question. Our three entrepreneurs would probably choose either an LLC or an S corporation, but first students should walk through the characteristics of each form and what groups of people they best suit.

Question: What does each individual expect to give to the business, and, in turn, receive from it? What organizational issues could arise based on these expectations?

Answer: The parties’ expected contributions and compensation are, of course, based largely on their resources.

Brandon expects to devote to the business his resources of time, managementskills and business experience. In return, he expects a steady salary and sufficientdiscretionary power to perform his job effectively. His salary is guaranteedcompensation for his time, and therefore entails little risk as long as the company is solvent. His less riskyinvestment also provides less upside.

Charles expects to contribute capital. In the event his contributed capital assists inmaking profit, he expects to receive some of it. He has much money, but littletime (or no desire to contribute time) or business experience to put his sizeablefinancial resources to efficient use. He expects to receive no guaranteed income from the venture, only a portion of its profits in the event it isprofitable. He also plays no management role, and therefore has no direct control over how his investment is used. His risk is considerable—he has put money on the line and will onlybenefit from it in the event that management performs profitably. [AP: again notice that there is no “Charles” in hypo 6.1 in the book]

Anita expects to offer a cross of the resources provided by Brandon and Charles.She brings to the business limited managerial skill, as a CPA, and limited capital,with some money available, to pledge to the firm. She therefore assumes a riskgreater than Brandon’s but less than Paul’s. [who is Paul?] If the company is successful, she will expect a payoff between thetwo as well. [AP: revert Anita to her role in hypo 6.1??]

Question: What organizational issues will arise?

Answer:The answer to this corresponds to the issues that will be used to describe the different organizational forms.

1. Formation of business - When does the investment begin and end?

• Formalities?

• Filing with state?

2. Liability for business obligations- Who is liable for the company’s actions?

• Non-recourse structure?

• Respondeat superior?

3. Management / Control -Who manages the investment?

• Voting rights?

• Ability to bind business?

4. Financial rights - What is the return on investment?

• Profits / losses shared?

• Taxation of entity / individuals?

5. Continuity - How can investors get out?

• Duration?

• Effect of withdrawal?

6. Liquidity (transferability)- What are investors’ responsibilities to others?

• Transfer only financial interests?

• Permission of others?

7. Combinations- How can the firm combine with other firms?

• Process of approval

• Protection of stakeholders

And where should the business be incorporated or organized?

Note: We point out that the issues presented in organizing a business parallel the structure of the book – and thus the course. We find that regularly pointing out to students the book’s structure helps them fit things into a bigger picture: Module III (business form - forming the business and corporate action); Module IV (financial rights – money in and out); Module V (corporate externalities - liability for business obligations); Module VI (corporate governance – management and control); Module VII (fiduciary duties); Module VIII (stock trading – liquidity and transferability of shares); Module IX (corporate deals – combinations); Module X (close corporations – continuity, along with all the other issues).

Partnerships

There are several types of partnerships, summarized in the table at the top of p. 144

  • General partnerships
  • Limited partnerships
  • Limited liability partnerships
  • Limited liability limited partnerships

Of these, general partnerships (GPs) and limited partnerships (LPs) are the most important. Limited liability partnerships (LLPs) and limited liability limited partnerships (LLLPs) enable the partners in a general partnership or the general partners in a limited partnership, respectively, to limit their liability to the amount of their investment (although liability for tortious conduct for which they are directly or indirectly responsible may remain).

Question: What is a general partnership?

Answer: A partnership is a voluntary association of two or more persons that runs a business for profit. Unless otherwise agreed, all partners participate fully in management and share equally in the profits and losses (although the partners’ monetary contributions may vary). The most basic type of partnership, the general partnership, does not shield partners from personal liability.

Question: What is a limited partnership?

Answer: A partnership composed of one or more persons who control the business and are personally liable for the partnership’s debts (general partners) and one or more persons who contribute capital and share profits but who cannot manage the business and are liable only for the amount of their contribution (limited partners).

Question: Where does partnership law come from?

Answer: Partnership law is state law. As explained in the breakout box on p. 143, National Conference of Commissioners on Uniform State Laws (NCCUSL) has promulgated a series of uniform laws in order to promote uniform rules for unincorporated businesses. General partnerships are the subject of the:

  • Uniform Partnership Act (1914), and the
  • Revised Uniform Partnership Act (1997) (“RUPA”)
  • Adopted (frequently with changes, e.g. New York) by 2/3 states
  • Remaining 1/3 states use UPA 1914 (except Louisiana)

I thought that the 1914 version was “UPA” and the 1997 version is “RUPA,” but I think that you all are using “UPA” for the 1997 version. I have “RUPA” in this text but if I am right about what you all have already done, should I change the references in this text to “UPA” Shall we call them “UPA (1914)” – not mentioned much – and “UPA (1997)”? [AP: My impression is that we should generally go with “UPA”, unless we need to distinguish between the 1914 version and the 1997 version. This is how the National Conference of Commissioners on Uniform Laws now does it. And most states, about 34, have adopted UPA (1997), UPA (1914) should be mostly an afterthought. ]

Question: How does the Revised Uniform Partnership Act define a partnership?

Answer: In §101, the RUPA provides:

Revised Uniform Partnership Act § 101- Definitions

(6) “Partnership” means an association of two or more personsto carry on as co-owners a businessfor profit formed under Section 202, predecessor law, or comparable law of another jurisdiction

Question: What is an association?

Answer: An association is an organized body of persons who have some purpose in common.

Question: How is a general partnership created?

Answer: By agreement among the partners to carry on as co-owners a business for profit. Note that forming a general partnership does not require a filing with the state.

Revised Uniform Partnership Act § 202 Formation of Partnership

(a) the 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

Question: What is a “person” for these purposes?

Answer: “Persons” may include:

  • individuals,
  • corporations, or
  • other partnerships

with the capacity to contract (because the partnership agreement is a contract)

Question: What does it mean “to carry on as co-owners a business”?

Answer: According to RUPA § 202, Comment 1, “ownership” involves the power of ultimate control. To state that partners are co-owners of a business is to state that they each have the power of ultimate control. A “business” is defined in RUPA 202, Comment 1, as“a series of acts directed toward an end.”

Example 6.1 on p. 146 illustrates this principle. Jane has hired Keith as a receptionist, but controls the business and contributed almost everything to the shop. Even though Keith was given a share of the profits as a wage increase, they are not co-owners. Jane is the employer and Keith is the employee. Calling themselves “partners” does not make them “partners.”

Question: Why does it have to be for profit?

Answer: Because this is about ownership. Partners are owners, and ownership is defined in terms of profit (and liability), and therefore control. Not-for-profits, by definition, have no owners. Consider the difference between unincorporated associations or trusts in which the charitable purpose is the beneficial “owner,” and corporations which have shareholders. “To carry on as owners a business” not for profit would be a contradiction in terms.

RUPA § 202, Comment 2, explains that an unincorporated nonprofit organization is not a partnership under RUPA, even if it qualifies as a business, because it is not a “for profit” organization.

Question: Can a general partnership be formed unintentionally?

Answer: Yes. RUPA § 202, Comment 1, explains that a partnership is created by the association of persons whose intent is to carry on as co-owners a business for profit, regardless of their subjective intention to be “partners.” Indeed, they may inadvertently create a partnership despite their expressed subjective intention not to do so.

Question: How is a general partnership governed?

Answer: Each partner has an equal voice in the management (regardless of capital contribution). Ordinary decisions are made by majority vote, although certain decisions such as adding a new partner or amending the partnership agreement must be unanimous. Of course, this is the default rule, and many partnership agreements provide that a partner’s voice will be in proportion to his capital contribution, or some other formula.

Revised Uniform Partnership Act §401 Partner’s Rights and Duties

(f) Each partner has equal rights in the management and conduct of the partnership business

* * *

(j) A difference arising as to a matter in the ordinary course of business of a partnership may be decided by a majority of the partners. An act outside the ordinary course of business of a partnership and an amendment to the partnership agreement may be undertaken only with the consent of all of the partners.

Example 6.5 on p. 149 illustrates this principalprinciple. In a general partnership, the decision of the majority governs, and if there is an impasse, and the partnership cannot function, the ultimate remedy is to dissolve the partnership. A good partnership agreement will include dispute settlement mechanisms.

Example 6.5 draws on the Covalt v. High case.

Covalt v. High (675 P.2d 999 (N.M. Ct. App. 1983))

Facts: One partner, Louis Covalt, brought action against his co-partner (William High), seeking damages for High’s failure or refusal to negotiate and obtain an increase in the amount of the rental of the partnership’s property. The tenant in the property was a corporation in which originally both Covalt and High had an interest, but later only High. Covalt alleged that High had breached his fiduciary duty as a partner resulting in a loss of potentially increased rental income. The District Courtentered judgment for Covalt, and High appealed.

Issue: Did the trial court err by ruling that High breached a fiduciary duty of fairness to his former [AP: is this right?] partner Covalt by failing to negotiate and obtain an increase in the amount of rental for the partnership realty? Can a partner (Covalt) recover damages against his co-partner (High) for the High’s failure or refusal to negotiate and obtain an increase in the amount of rental of partnership property?

Holding: No. The Court of Appeals reversed the district court ruling, holding that in the absence of an agreement between the partners to increase the rent of the partnership realty, one partner could not recover damages for the failure of the copartner to acquiesce in a demand that he negotiate and execute an increase in the monthly rentals of partnership property. The remedy in such a case is dissolution.

Reasoning:

  • “The status resulting from the formation of a partnership creates a fiduciary relationship between partners. The status of partnership requires of each member an obligation of good faith and fairness in their dealings with one another, and a duty to act in furtherance of the common benefit of all partners in transactions conducted within the ambit of partnership affairs.”
  • “Except where the partners expressly agree to the contrary, it is a fundamental principle of the law of partnership that all partners have equal rights in the management and conduct of the business of the partnership. As specified in the Uniform Partnership Act adopted by New Mexico, where there is a difference of opinion between the partners as to the management or conduct of the partnership business, the decision of the majority must govern . . .Covalt was legally invested with an equal voice in the management of the partnership affairs . . . neither partner had the right to impose his will or decision concerning the operation of the partnership business upon the other.”
  • “Where the partnership consists of only two partners there is ordinarily no question of one partner controlling the other and there is no majority. The rights of each of the two partners are equal. If the partners are unable to agree and if the partnership agreement does not provide an acceptable means for settlement of this disagreement, the only course of action is to dissolve the partnership.”

Question: How are the assets of a partnership managed?

Answer: Each partner contributes something of value to the partnership, and then is deemed to have his/her own “account” on partnership books. A running “account balance” is kept by:

ADDING his/her contributions

ADDING his/her share of the profits

SUBTRACTING money distributed to him/her

SUBTRACTING his/her share of the losses

Revised Uniform Partnership Act § 401. Partner's Rights and Duties

(a)Each partner is deemed to have an account that is:

(1) credited with an amount equal to the money plus the value of any other property, net of the amount of any liabilities, the partner contributes to the partnership and the partner's share of the partnership profits; and

(2) charged with an amount equal to the money plus the value of any other property, net of the amount of any liabilities, distributed by the partnership to the partner and the partner's share of the partnership losses.

(b)Each partner is entitled to an equal share of the partnership profits and is chargeable with a share of the partnership losses in proportion to the partner's share of the profits.

Question: How can partners enforce their rights to profits or loss-sharing?

Answer: Through a judicial accounting proceeding.

Revised Uniform Partnership Act § 405. Actions by Partnership and Partners.

(a) A partnership may maintain an action against a partner for a breach of the partnership agreement, or for the violation of a duty to the partnership, causing harm to the partnership.

(b) A partner may maintain an action against the partnership or another partner for legal or equitable relief, with or without an accounting as to partnership business, to: