Partnership Outline
Table of Contents
Fiduciary duties of partners to each other
Dissolution
of the partnership
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
deduction. In
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
Bane v.
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.
Fiduciary duties of partners to each other
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
Dissolution of the partnership
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.
In
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.
8182 Maryland
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