Partnership Outline


Table of Contents


Introduction. 2

Assumed name statutes. 5

Partnership property. 5

Partnership management 7

Fiduciary duties of partners to each other. 9

Dissolution of the partnership. 10

Wrongful dissolution. 10



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 Mexico: the LLC, which had limited liability.  The Clinton Administration was persuaded that most unincorporated business associations, if they “checked the box” on their first return saying that they wanted to be treated as a general partnership for tax purposes, then they’ll be treated that way.  (Subchapter K is the subchapter of the internal revenue code that deals with partnerships.)


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 Ohio, our Act is close to the old one with one maddening change: the numbers in the O.R.C. are one off!  Partnerships and LLCs are deep jello.  Your client can get screwed very, very fast.  We will make analogies to corporations, which Shipman proposes are much more logical.


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.  Ohio cases in the last thirty years have applied the statute to lottery tickets, for example.  Jack says to Jill: “I’m going to buy some lottery tickets with this number.”  Jill says: “Buy one for me too.”  He buys two $5 tickets, and they win!  Jill, in most states, can assert partnership law and get half of what those two tickets are worth.  In addition, in a Mississippi case after World War II, a brother wanted to engage in a business operation.  His sister sent him some money that looked like a loan.  The operation took off like gangbusters, and it was held that the brother and sister were 50-50 partners and the brother had to split with the sister.  If there had been a big tort liability, the sister would have argued that opposite: that she was a mere creditor.


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 Houston lawyer got out of the issue on the basis of the statute of frauds.  If it involves real estate, here in Ohio we have strong partial performance doctrines that may well override a lot of the authority other places.


Assumed name statutes


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


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 Ohio and most states say that if you’re suing a partnership simply to bind the partnership assets, the statute will come to your aid if it’s not a very big deal.  Likewise, a partnership can use the Ohio common name statute to sue with just one signature: that of the managing partner.  That’s true in most American states, though it’s not so in three or four states.  Do partnerships ever issue stock certificates or anything similar?  No, it’s the partnership agreement that governs.  There are no stock certificates.


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 Arizona case from the 1970’s to the contrary.  Accounting is always in equity.  The partnership and all partners are parties.  Most often, the cost of the accounting is borne by the partnership itself.


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 California, the courts will usually reach a different result.  In some other states, they might reach a different result if they can find no partnership.  If there’s a loss, and there is sweat equity, in some states they will say that no partnership was formed.  But this is the minority rule.


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 New York, there is no payment during the year.  They wait until January, and then write a check.  During the year, the partners must write checks for estimated tax, and they’ll have no idea how much to pay and no money to pay it with.  Skadden Arps only distributes 83% in any year, though you pay tax on 100%.  That’s because they want to build up their internal finances.  When you retire, you have several million dollars in the capital account that you have already paid taxes on.  Don’t borrow money for partners’ draws!


Bane v. Ferguson – Here we have non-qualified, unfunded pension plans for partners of law firms.  They are becoming less common because they tend to create a strain between the younger partners and the older, retired partners.  Most law firms today just set up the H.R. 10 plan for the self-employed and encourage partners to contribute to it.  This plan is not nearly as liberal as the provisions under § 404 for a qualified pension plan.  A partnership cannot have a qualified pension plan, but a corporation can.  If you want the other fringe benefits like Blue Cross/Blue Shield, disability, or long term care, you must go to a Sub C corporation.  There are a few law firms that do it, but it is more common physicians for some reason.  The question in the case was the non-qualified plan provided that it ended when the firm ended.  The plaintiff was a retired who had moved to Florida and was getting $27,000 a year out of the pension plan.  The firm entered into a disastrous amalgamation with another partnership, became insolvent, and went out of business.  The plaintiff sued, claiming that somehow, either in tort or contract law, he had the right to keep the firm going.  But the plan itself provided that it terminated if the firm went out of existence.  There was no fraud or bad faith.  There is also no wrongful, intentional interference with a contract.  The court holds that the partnership will not be kept open.


Partnership management


Rouse v. Pollard – Here we had a very prestigious New Jersey firm.  A partner decided he wasn’t making enough from the firm alone.  He started confidential conferences with rich old ladies and told them he was running his own private investment operation on the side.  He wanted the checks made payable to him alone.  This did not appear on the law firm time records.  No one else at the firm knew or had reason to know of his activities.  Note that for purposes of the securities laws he was selling an investment contract.  Most law firms absolutely prohibit anything approaching this.  If he had taken the money and made a profit for the clients, probably no one would have sued.  But people who do this kind of thing are probably more or less perpetrating a fraud, and this fellow was no exception.  He embezzled his clients’ money.  He got caught and went to state prison.  The old ladies were out a lot of money.  They had an action again him, of course, for the breach of his fiduciary duty, but he had spent all their money already.  Then they sued the law firm.  They latched onto §§ 9-18 of the Uniform Partnership Act of 1914, which impose a respondeat superior regime upon acts in the ordinary course of business.  Since the dealings never got on the firm records, the checks were made out to the individual attorney, and there was no evidence that the other partners knew or had reason to know of his dealings, the court holds that the law firm is off the hook.


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 Europe for three months.  She went to the partner that she usually dealt with and told him that she would put his signature on her bank account.  She wanted him to pay her bills while she was out of the country.  This conference was entered on the time records of the firm.  The firm billed her for the work that the partner did.  She came back from Europe and, at first, everything seemed okay.  He had paid all of her legitimate bills.  Later, however, she found out that the partner had paid the expenses of her husband’s lover while she was gone.  She was very mad!  The partner died, either by suicide or an accident.  She clearly had a cause of action against his estate, but the CPA firm itself was much more inviting.  The CPA firm would have had a general liability policy and a malpractice policy.  Both of these policies probably excluded anything dishonest, criminal, malicious, or intentional.  But the firm was big enough that the assets of the firm plus the personal assets of all the partners were large enough to support a judgment.  Note that this came years before the LLP.  The court held that the partner’s actions were in the normal course of business.  What should the lady have done?  She should have required the signature of both her CPA firm and her lawyer for checks while she was gone.


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 Ohio will tell the bank if it wants to levy on a general partnership interest that it may well have the same liability for the partnership debts and obligations as their debtor has.  The law is not clear on this.  Was there any tax impact upon the formation of this partnership?  It was before the federal income tax was enacted, but let’s presume this happened in the present.  The Internal Revenue Code says that if the person contributing property has his capital account credited for the fair market value of the property and if Sweat Equity doesn’t receive an addition to his capital account because of services, then the transaction will be tax-free.


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 New York City to Sweat Equity.  Most of the money was going to be borrowed.  Sweat Equity formed a corporation, of which he owned 100% of the stock, to run his end of the development.  After the end of the partnership, the capitalist finds out about this and gets really mad.  Cardozo holds that Sweat Equity had a duty to inform Capitalist of the opportunity.  Cardozo said that Capitalist can have 49% of the stock of the property for what Sweat Equity paid per share.  Sweat Equity will run the business, and Capitalist must sign the guarantee with Sweat Equity.


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.


Wrongful dissolution


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 California cases, where a definite term isn’t specified but a project is specified, there is an implied term of years for the time needed to do the project.  Another case held that where one party theoretically can rightfully dissolve at will, fiduciary duty override applies if dissolution would be unfair to the other partner.  According to §§ 31-32, another “out” is when the business can no longer be carried out at a profit.  Under Texas law, dissolution itself is in equity, but Capitalist joined claimed for money damages.  In Texas and federal courts, there will usually be a jury and the jury findings on the damage claims (at law) will be collateral estoppel (issue preclusion) on the judge when he sits in equity.


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 Ohio, about five years ago a statute was passed saying that there is no fiduciary duty in formation, but there is a 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.  New York passed a statute saying that, upon dissolution, unless otherwise agreed, the amount paid out would be book value.  There arises a case where a lawyer dies who is a partner.  The partnership agreement is silent.  Not only did they not use fair market value, but they cut the guy’s widow out of his share of the unrealized receivables completely.


Adams v. Jarvis – In this case, we have a medical partnership on the cash method.  The partnership agreement provided for what a rightful or wrongful withdrawing partner would get: if the partner pulls out five months into the year and has a one-fourth profit interest, then he will get his pro-rata income for the year: 5/12 times ¼.  He will also get what is in his capital account at book value.  Thus, the Cauble result of fair market value (and possibly some goodwill) is precluded.  The problem is that they’re using the cash method, and as of May 31st, there may be up to $500,000 coming in as accounts receivable.  The departing partner could be forfeiting $125,000 by leaving early!  On a very literal reading, this squares with the first sentence of § 38.  But we’re nervous because all the parties are fiduciaries with each other, and the law generally abhors forfeitures.  All dissolution and accounting proceedings are equity proceedings!  The court says something that Shipman claims is only half true: the partners defined this as a non-dissolution and that’s okay because § 38 allows you to do that.  But the court is overreaching, according to Shipman.  If you read between the lines, this case says that this penalty is good policy because it tends to make people live up to their contracts.  In a later case in California, they make this point explicitly.  The book indicates that the situation in New York is just the opposite.  New York cases have held that any Adams v. Jarvis clause works a partial forfeiture of property and, as such, is per se against public policy.


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 New York case from the 1940’s in the corporate context involving the question of whether at-will employees, while on the company payroll, may use company time and resources to entice clients away after they leave.  One of the big mid-level ad agencies in New York City was incorporated.  It was started by the old man, who, at his best, was superb.  But he was getting older and losing it.  The top people under him who were all at-will employees, thought they had worked out an arrangement by which they would purchase the old man’s stock and he would retire.  But there was a real business problem here: at the last minute, the old man refused to sign.  Without informing him or getting his consent, they plotted a walkout day.  They set up a new shop on company time while drawing company paychecks and solicited clients.  They walked out, taking a lot of clients with them.  The old corporation and the old man sued under agency and corporate law saying that these people had violated their duty of loyalty, duty of care, and duty of full and fair disclosure up-front to the company and the old man.  The court answered that it was still the majority rule in the corporate world that the at-will employees could not participate in this type of activity.


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 Kansas City around 1984, we have a fast-growing mid-sized law firm.  One of the lawyers did financial work.  They saw growth in the area and decided to sign a long term lease under the “last erection” principle, which comes from the S & L crisis of the early 1980’s.  You could tell that an S & L was going out of business when they spent hundreds of millions to build new skyscrapers.  So the partnership signed a long term lease.  This was a general partnership; the case shows the dangers of not using an LLC or corporation.  Acceleration clauses in these documents, at least in non-consumer leases, are fully valid.  The lessors will hire good lawyers to put “good” acceleration clauses in.  What happened?  Legal business was great for a while in the 1980’s, then it turned sour in the late 1980’s for about four years.  When that lawyer left, what was the effect on the dissolution of the firm?  The UPA tells us that the firm continues until winding up occurs.  In a contracts sense, that will mean that all contracts that were on the books are paid for.  The court holds that the rising star guy is liable!  Don’t use general partnership or LLP?  Some states have the broad form LLP that covers contract as well as torts, but most states have LLPs that don’t cover contracts or embezzlement.  An action for embezzlement can be pleaded as tort or contract.  The lessor failed to ratify or adopt in this case.


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 Ohio, a limited partnership can make an LLP election, in which case the general partner of the limited partnership has some shield against tort liability, though it’s not worth a lot.  The job of the general partner of a limited partnership is to supervise and manage.  Don’t be an individual general partner of a limited partnership: form an LLC or a corporation.