Table of Contents
What’s a general partnership? Here’s the definition: A general partnership is one in which all partners are general partners. The emphasis here is on general. Under UPA §§ 1-18, plus 40, there is joint and several liability on the part of all partners for the tort debts of the general partnership, and there is joint liability for all of the partners’ contract debts. When you read §§ 18 and 40 and put them together, you will find that you can sue not only the partnership for the assets it has, but if it doesn’t have enough, you can go after the individual partners and reach their personal estates. Ouch! That’s called the disadvantage of unlimited personal liability. It’s a big disadvantage…how come? No one with any sense advertently forms a general partnership today. For a lawyer to recommend it is malpractice per se. Why? We’ll find at the end of the course that in the last 25 years, the LLC has arrived and the Ohio LLC statute, O.R.C. § 1705, is excellent. The LLC, with proper drafting, will give the tax advantages of a general partnership with the limited liability advantage of a corporation.
So what is the great tax advantage of general partnerships? Corporations in this country historically have been subject to a double tax. It’s been modified a lot in the last 45 years, but big portions of it still remain. This is because a corporation is considered as a full-fledged legal entity separate from the shareholders for tax and other purposes. As such, historically, the corporation was subject to tax on what it earned, and then, when it paid dividends, the dividends were fully taxable again to the shareholder recipients. By the end of today, we’ll see that there have been two ameliorations of that, though to some extent it’s still true. The U.S. Supreme Court upheld the ability of Congress to do this even before the Sixteenth Amendment was passed. It was said that the government bestows the privilege upon people to set up an entity with limited liability, and thus Congress can levy a tax on that privilege.
A general partnership, because it has three strong non-resemblances to a corporation, is not subject to income taxes. The emphasis is on income taxes, because a general partnership is subject to excise taxes, it must withhold taxes on salaries of employees, it is subject to sales taxes but it isn’t subject to income taxes. How has Congress treated general partnerships since 1913? They have said that, in general, with some exceptions to follow later, the partnership is considered a non-entity for income tax purposes. The income and losses of the partnership flow through to the individual partners and is taxed to them. However, by statute, the partnership must file information returns with the IRS. Those information returns enable the IRS to collect from the partners.
As to employees of the partnership, they’re just like corporate employees. The partnership must pay and withhold Social Security tax. Partners pay taxes just like sole proprietors. Each quarter, they must file a declaration of estimated taxes for the year and pay one-fourth of it. When they file their final return, they “settle up”. If they paid too much, they’ll get a refund, and if they paid too little, they’ll have to write another check to the IRS. Until 1960, general partnerships were very popular in the service areas, for example, law, accounting, medicine, dentistry, and engineering. This is because there was no double taxation, and state statutes as to law, doctors, dentists and accountants provided that those professions had to practice as sole proprietors or general partnerships to expose to the world not only the assets the partnership owned, but also the personal property of the partners individually.
Congress discerned that there were three significant non-corporate attributes of a general partnership: (1) Personal liability of all of the partners for the debts of the partnership in addition to the partnership itself being liable. (2) §§ 18-32 of the UPA 1914 introduce us to the idea that a general partnership is easily dissolved. Dissolution is defined specially in the UPA as a “change in legal relationship among the partners”. The death, retirement, or bankruptcy of any general partner causes dissolution of the partnership, but not the death of the partnership. The party leaving the partnership by death, retirement, or bankruptcy is entitled to the amount credited to her capital account soon. Compare this to the situation of Jones Retail Store, Inc. It has four siblings working in the store. Upon the death of one of the Jones siblings, there is no dissolution, meaning that the widow of the dying Jones sibling cannot get the fair value of the shares from the company unless there is a specific contractual provision to the contrary. That’s just the opposite from a general partnership because the death, retirement, bankruptcy, or insanity of one or more shareholders of a corporation does not affect the ongoing life of the corporation. The corollary to that is that the same is true even if one or more or all of the shareholders assign all of their shares to somebody else. Thus, the corporation is guaranteed by law to have perpetual life! Whereas with the general partnership, death, retirement, bankruptcy or insanity cause dissolution. The guy who went crazy can withdraw his whole capital account. (3) With a corporation, unless there are valid reasonable restraints on alienation, any or all shareholders can sell any or all of their shares to anyone for any reason at any time. Needless to say, even the closely held corporation with a few shareholders is set up in such a way to sell its shares to the public if the public wants it. The general partnership, on the other hand, is set up for non-public ownership.
These three differences led Congress to say that a general
partnership doesn’t resemble a corporation very much. When we get to the LLC, clever drafters at
the state level came up with a new animal from civil law countries like
We will primarily be studying the Uniform Partnership Act of
1914. The book has many references to
the Revised Uniform Partnership Act of the last 15 years. The Revised Act has notes that are very good
research tools; so does the original. In
Just what is a partnership?
Read §§ 1-8 and you get the picture.
Partnership is created when there is co-ownership
of a business for profit. If you’re
in the not-for-profit realm, look at R.C. Chapter 1702 and go to a
not-for-profit corporation! Never use
unincorporated business forms for a not-for-profit association! On the other hand, the definition of business in the cases is broad.
Partnerships come in two flavors: today and tomorrow we will discuss advertent partnerships. On Wednesday, we’ll talk about inadvertent partnerships. It is malpractice for a lawyer to recommend a plain vanilla UPA general partnership today! Use the LLC or a corporation! But aren’t a lot of law firms set up as LLPs? Those are general partnerships with some limitation of tort liability but no limitation of tort liability. That’s just wrong and bad! They should be LLCs instead. But don’t worry unless you’re going to become a partner. There is no such thing as an inadvertent LLC or corporation.
Richert v. Handly –
How does the statute of frauds apply to partnerships? A famous
If you are doing business under an assumed name, you are supposed to file an assumed name certificate. As to a partnership, the statute is especially demanding in that if you are a partnership and the firm name contains less than all of the names of all of the partners, the county recorder is not to accept real estate documents unless there is an assumed name certificate filed. If the firm name is Smith & Jones and there is only Smith and only Jones, you’re okay. But if you’re in Baker & Hostetler, there are a lot more partners than just Baker or Hostetler.
Partnership property can still be partnership property even
if it’s in the name of one of the partners.
You don’t want to run a partnership that way; you want to put
partnership property in the partnership name.
Before the Uniform Partnership Act of 1914, partnership property had to
be held in a cotenancy by partnership. The Uniform Partnership Act of 1914 says you
can clearly hold partnership property in the partnership name. Common name statutes in
We have a Paul Bunyan at the bar, and a capitalist comes up. He just bought a timber-cutting agreement. He says: “Let’s chop some wood!” Bunyan asks: “How much timber is there?” Bunyan looks, comes back and says: “You’re 30% too high.” But they agree anyhow, explicitly agreeing on a 50-50 profit split. They also explicitly agree that sweat equity (Bunyan) was to use his tractor and other equipment. He was to be paid “above the line”, that is, before computation of net loss, and he was to be reimbursed for the use of his tractor. Nothing was said about interest about capital, meaning that there shall be no interest on capital. Nothing was said about the partner’s salary.
Was this agreement void because it was not in writing? No, because it was fully performed
already. A general partnership was
created. The timber was cut and
sold. Each party had a capital
account. The capital account goes up by
the assets you contribute and by your share of the net profits. It goes down by your share of the net
losses. This was a partnership for one transaction: the timber under the
timber lease. The tax return was
prepared by a CPA, who gave copies to both parties. The partnership agreement may be subject to
amendment by conduct, including how the tax return is prepared. Either partner can sign, but the others are
entitled to a copy of the return and a statement of their distributive share of
all items. The CPA computed the return
and found that overall there had been a loss and that the loss is allocable
50-50 between the partners. Clearly, the
profits were to be divided equally. The
CPA, in effect, said that there was a negative balance in the capital account
of Sweat Equity. The purpose of the
partnership was completed. There was a dissolution. With a
general partnership, very often you have to use the traditional method of
accounting to settle up. There is a
major Ohio Supreme Court case from the 1980’s and a major
What was the problem?
Bunyan thought that the deal that had been cut was “profits: 50-50 and
losses: 100-0”. Could that deal have
explicitly been made as between the parties up-front? Sure, under § 18, which merely gives you
default rules. If the parties had expressly so agreed up-front and
there had been a tort liability, would that bind the injured third party? Would it have bound contract creditors? No.
Just read § 18 and you’ll see that it will not bind those third
parties. But if all creditors have been
paid and there are no tort liabilities, then this is merely between the
parties. The Supreme Court holds that §
18 is clear: you agreed on the profit ratio while your
handshake agreement was silent on the loss ratio. In that situation, the loss ratio is the same
as the profit ratio. Bunyan isn’t
happy! But he does get a tax
Many law firms have a “draw” against profits. They set up a formula by which the partners
can periodically draw out about half of what the firm estimates will be the
profits for the year. Note that if the
draw against profits is greater than what the profits turn out to be, the
partner will get a note from the senior partner asking for his check within ten
days. If the draw is less, as it usually is, within about two
weeks after the end of the year, the partner will get the difference from the
firm. Cautious law firms never borrow
money to pay partners’ draws. With one
big law firm in
Rouse v. Pollard –
Here we had a very prestigious
Roach v. Mead –
Here we have different facts. This case
cites an earlier case of the Oregon Supreme Court, Croisant. The partnership here was an accounting
partnership. One of the partnership’s
clients was a wealthy businesswoman who planned to go to
The facts of Roach itself are as follows: there was a two person general partnership long before there were LLPs. One of the partners did some real estate speculation on his own and lost his shirt. One of his clients who he serviced was rich and the lawyer hit him up for a personal loan. The check was made out to the partner in his personal name. The loan was never repaid, and that partner is judgment-proof. The client gets a different lawyer, of course. Could the client sue the one lawyer alone and get his partnership interest? No, because §§ 15-38 of the Uniform Partnership Act of 1914 state that an individual creditor of a partner can levy upon the partnership interest, which allows a kind of weird remedy: a charging order on his earnings from the partnership. Shipman thinks this would include both a guaranteed salary and a share of profits. He’s pretty sure that the restrictions on wage garnishment would not apply because a partner’s earnings or salary are not wages. This is different than a share of stock: you can’t cause the interest to be paid over and cause a dissolution. Furthermore, the other partner or partners can redeem the partner’s interest. Shipman says that it’s not a great remedy. Partnership or LLC interest is basically not good collateral.
The lawyer sued the partnership under §§ 1-18 and 40 saying that there was negligence in what the partner did, and that the negligence led to the client’s loss. He served both partners individually as well as the law firm. He claimed that the partnership itself was liable as was the innocent partner. Negligence was used to dig into the malpractice policy of the law firm. He claimed that what the lawyer did was negligence only. What rules of professional ethics were violated? Canon 5 and the rules thereunder tell us that one of the stupidest things a lawyer can do is enter into personal or financial relationships with clients. It is clear that a lawyer must give all kinds of warnings of the dangers of a personal loan to the client. Here, the lawyer did not inform the client that he ought to insist on a first mortgage on the lawyer’s house. The rule is even stricter with trustees. The court holds that the partnership and the other partner are on the hook.
Meinhard v. Salmon – This is a partnership
opportunity case. There was a capitalist
and sweat equity who get together around 1900.
Sweat Equity is a real estate expert.
Sweat Equity wants Capitalist to advance some money. They plan to go 50-50 on earnings. All the assets were put in Sweat Equity’s
name. Capitalist was a “secret partner” of the general
partnership. Most people think that
secret partners are just as liable as regular partners. Sub-partnership leads to the same result:
Smith is a general partner in a construction firm. He goes to his brother and he and the brother
enter into a sub-partnership in Smith’s share of the partnership. It is generally held that Smith’s brother
will be held liable just like any other general partner. Many lawyers in
Over 12-15 years there were rocky times, but Sweat Equity
generally did well. The only problem was
that Sweat Equity didn’t have a lot of money.
People who he’s dealt with in real estate believe that he is the sole
owner of the property. The partnership
with the capitalist may have been a handshake deal, and it wasn’t known by many
people. Just before the end of the term
of the partnership, a third party proposed a massive redevelopment project for
Read §§ 14-38 carefully to understand dissolution. Two of the key sections are §§ 31-32. When you read them, you find a big split between two kinds of dissolution: (1) rightful and (2) wrongful dissolution. Fiduciary duties are very important in either case and can cause some odd results. The first question is: can you, by contract, create a partnership for a term that cannot be dissolved during that term? In other words, can you create a true agency coupled with an interest that is irrevocable? No, you definitely cannot. Another way to put it is that you can’t go into court and get a mandatory injunction forcing people to stay with the partnership if they want to leave.
Collins v. Lewis – This case illustrates that there is such a thing as wrongful dissolution. If there is a wrongful dissolution, two bad things happen to the wrongdoer: (1) the bad guy loses all of his interest in the goodwill of the business and (2) he is subject to an action for breach of contract by the other partners. In this case, Sweat Equity met with Capitalist with the idea of building a big new cafeteria. Sweat Equity didn’t have any money, but he had ideas and experience. Capitalist had a lot of money. A deal like this today would be set up in the LLC form and it would be malpractice per se for a lawyer not to force the actors into this form. The deal was that there was a partner’s salary for Sweat Equity because Sweat Equity needed money to live on. The partnership agreement said that during phase one, the building, no loss of the partnership would be allocated to Sweat Equity. That’s clearly legal and this type of agreement is a typical way to do it. In phase two, when the cafeteria starts running, Sweat Equity’s salary continues, while all profits are allocated to Capitalist until he has recovered all the losses that were allocated to him in phase one. In phase three, the partnership salary continues, but both profits and losses are equally distributed. At that point, Sweat Equity is bearing, indirectly, one-half of the salary to him.
Capitalist had good lawyers and a mortgage on Sweat Equity’s
partnership interest as well as many other legal protections. Capitalist got mad and wanted to dissolve the
partnership. When you read §§ 31-32, you
find that if no term is specified for a partnership, either party can get
rightful dissolution at any time. But
that “out” is not available to Capitalist.
According to several
The special issues submitted to the jury were the following: (1) Can this business be successfully carried on at a profit? (2) If not, whose fault is it? The jury found that the business could not be carried on at a profit and that it was Capitalist’s fault. The trial judge, based on these special issues, entered an order that there was no ground for rightful dissolution. The case goes to the Texas Court of Civil Appeals, which affirms. Capitalist claims that there is no such thing as a partnership that cannot be dissolved. But the Court of Civil Appeals says that all the trial judge held was that there were no grounds for rightful dissolution. He could still take a stab at wrongful dissolution, but the jury findings in the case will be collateral estoppel and place all fault on the Capitalist. Capitalist would lose his interest in the goodwill of the business and would be liable in damages to Sweat Equity!
Cauble v. Handler – This is also a Texas Court of Civil Appeals case. We have a 50-50 partnership between two partners in a profitable business. There is no partnership agreement except for the agreement on the 50-50 split on profits and losses. One partner dies. He left all of his property to his widow. The living partner loved the business and wanted to keep it operating. The bank signature cards allowed either partner to sign and thus there was no practical problem with continuing the business. What are the widow’s options at this point given the lack of a formal partnership agreement except for the 50-50 split? Either the widow or the living partner could force an immediate auction block sale of the partnership’s assets. However, such sales sacrifice value, so they are rarely used. If the widow and living partner wanted to negotiate with the widow in the place of the dead partner, they could do so, but the widow didn’t want to. The business could simply be continued, and if the living partner treats the widow as a substitute for the dead partner and vice versa, then under Blumer Brewing, they will be considered 50-50 partners, with the widow taking the position of her husband.
The possibility that comes out here is that the living partner continues the business, but the widow forces him to send out letters to everybody saying that the dead partner is dead and that the living partner is continuing the business. This is done because you don’t want the widow getting sued as an apparent partner. § 31-38 contemplates this possibility. The Act says that she will not be liable as a partner. She has a creditor’s claim on the assets, but that claim is subordinated to the regular old creditors of the partnership. This is true even if the old name is continued (as is often the case with law firms). Within a reasonable time, the partnership must pay off the widow with the value of the capital account. There are two big issues: (1) do we use book value GAAP figures based on historical costs, or (2) do we use fair market value figures? The court holds that in the absence of an agreement (which would be binding under the Act), it was held that fair market value would be used. The ruling implies that goodwill will be computed and included in the equation because a store that has been around for a long time creates goodwill. It may be different for lawyers.
The case is troublesome in a way. The Texas Supreme Court had a case called Mattie Carruth Bird. She was the general partner in a real estate limited partnership. Her capital account had a negative balance. How could this be? If you’re using GAAP historical cost figures and you take out a second mortgage on real estate and then distribute the proceeds to the partners, you’ll have negative capital account balances. That doesn’t mean the business is in trouble. The limited partner sued to force her executor to pay into the capital account. The court interpreted the Uniform Partnership Act of 1914 and Uniform Limited Partnership Act literally and agreed with the limited partner. The second big holding was that the executor of the deceased partner has the option to take interest from the date of death until payoff, or if they elect to do so in a timely matter they can get their share of profits for that period. Early on, the lawyer made the correct election, because this was a very profitable partnership. Note that under § 38, a partnership agreement providing for book value over two, three or four years would prevail over §§ 31-38. The provisions of the Uniform Partnership Act of 1914 are default provisions that can be trumped by an agreement to the contrary.
Accounting is crucial. In Cauble, if the original agreement had provided that the payout to the widow of the deceased partner would have been in three or four equal annual installments that it also would have held up. Sometimes the capital accounts are huge and there is no way the remaining partners can have a check written quickly for the capital account. In Cauble, because of the way § 38 of the Uniform Partnership Act of 1914 reads, if the parties had agreed up-front that the widow’s profit interest would have terminated at her husband’s death and that there would have been no interest (or interest at a non-usurious rate) that also would have held up.
Some finance overview
In the mid-1950’s, there were seven or eight dominant Wall Street securities firms. At that time, they were all partnerships. Their capitalization (by today’s standards) was amazingly small: only $25-30 million. It’s still small even when you adjust for inflation. The big firms now have billions in capital. But there were problems: they soon realized that now and again even the best run brokerage goes broke. Also, among your partners, you will have some with very large capital accounts, to the tune of several million. How do you deal with the widows of the partners as they die? If you did nothing and went with the UPA, the widow will get her money in a few months, just as it says in Cauble. First, they switched to limited partnerships and tried to talk the widows into transferring their capital accounts to limited partnership status at a good fixed rate (like 9%). Then they discovered that they had to make the same deal with retired partners. These problems also crop up in close corporations. People fail to consider the possibility that someone will die or retire.
Within limits, you can specific when, how, and how much the payout will be upon dissolution. But if the sections say that something is a dissolution, you can’t specific that thing as a non-dissolving event. For example, you can’t agree that death constitutes dissolution. It’s only half true that you can contract to determine what dissolution is. You can specify that there will be events of dissolution in addition to what the statute deals with.
The fiduciary duty override will sometimes conflict with
literal contract or statutory provisions and working out the conflict is not mechanical. The RUPA deletes the provision that there is
a fiduciary duty in formation. They
still leave the fiduciary duty in operation.
GAAP accounting is accrual accounting. If you sell something on credit, you take in the income and you increase the capital account immediately. In other words, you accrue immediately. For tax purposes, any business using an inventory must use the accrual method. What does the Internal Revenue Code provide as to professionals? For service professions, regardless of income, you can use the cash method, that is, accounts receivable are neither an asset nor income until they are collected. The capital account will not reflect unrealized receivables. If you are on the accrual method, the capital account will reflect such receivables. Independent CPAs will certify statements on the cash method, but they will put legends on the statements saying that a non-GAAP method is being used. The pure cash method is not a traditional GAAP method.
All lawyers and doctors use the cash method because, from a business
standpoint, their cash flow runs far behind the provision of services. This may not always have been true,
especially with doctors. They may have
taken cash at the time of service. For
other businesses, once you reach a certain size, you must use accrual
accounting. This is mainly a matter of
the political power of lawyers and doctors.
Very commonly, whenever a law partner rightfully withdraws, retires or dies, he will get a pro-rata share of that year’s income, the amount in his capital account computed by book value, but no goodwill. The capital account payoff is often over the course of several years. Why is it done this way? Under Internal Revenue Code, if the agreement provides that no part of the continued profit participation is for goodwill, then the recipient includes that payment in income. But the good news is that the other partners get to deduct or exclude that payment. Subchapter K is the only part of the Internal Revenue Code where you can buy out a business with after-tax income. You can’t do it any other way. As to the return of the capital account, if, for example, it goes to a widow, the payment will be tax-free because taxes have already been paid.
There is an old Court of Appeals of
Meehan v. Shaughnessy – This is an unusual partnership agreement in that it lumps rightful and wrongful dissolution together and provides what is going to happen. The court looks at the agreement and basically ratifies the agreement. It sees no conflict between the agreement and the UPA. In this case, some of the partners went to young associates and solicited business for their new firm. They held that the old per se rule of setting up shop while being employed didn’t apply to a law firm because at a law firm the main parties to be protected are the clients, and the clients can’t get good service unless there is work up front. The court found a violation, holding that the old partners had a right to have their solicitation sent to the clients at the same time that the departing partners sent theirs. Note that you can’t forcibly take clients with you.
Associates, Limited Partnership v. Sheehan – In
What happens when there is a joint judgment against all those partners plus the partnership? In the case of Wayne Smith from the Ohio Supreme Court, it is held that where there is joint liability in contract, you must first try to get satisfaction at the partnership level, meaning that your suit is both against the partnership and all partners, because if you omit one partner you can’t go back later and get ‘em. In tort, you can move “sequentially”. Later, it was held that when you go to the two 50% partners, the creditor should try to get 50% from each, but if one is a turnip, then after trying to divide it 50-50, you can get 100% from the other. We’re into guaranty and surety again. If you are a creditor of a partnership and you let one partner off, some cases will hold that you have released everyone. Furthermore, if the partnership has to pay something by June 1st and you get that date pass without suing them, then in many states the partner who has ditched is released under surety and guaranty law. If there are former partners you want to reach, then before you extend the due date of the partnership, get all twelve partners to consent. Otherwise, if you extend as to the four that you will try to reach on surety grounds then you will screw up.
Along the same lines, there was a big case from the 1960’s from the California Court of Appeals dealing with tort liability. There was a general partnership for the practice of law. Smith was a general partner. While he was a partner, Jones, another partner, brought a personal injury client in. Smith did not know about it. After he left, Jones mishandled the case and let the statute of limitations run. The client sues the partnership, current partners, and Smith, the retired partner. Smith says he wants out! He argues that the old firm was dissolved and the negligence occurred after he left. The UPA tells us that the old firm continues until winding up, and for a tort client, that’s not until you’ve completely finished a case, which may be 10-12 years later!
How do you protect yourself on torts if you’re a retiring partner? The firm today is usually an LLP. If you didn’t bring the client in and you
didn’t supervise or screw up, you’ll have a defense under the LLP statutes. The other thing that you do is in the
retirement agreement with the firm you get the firm to agree to have the
malpractice policy cover not only current partners and employees but former partners
and employees too. If the firm won’t do
it and it’s not an LLP, go buy yourself tail coverage. In