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Sole Proprietorships and Partnerships 28

Beginning with this chapter, we will explore the most common forms of business organization in order to understand their fundamental makeup and examine the benefits and liabilities of structuring a business under each distinct form of business organization. One of the first deci-

sions that must be made by anyone seeking to establish a new business is what organizational form to choose. The most common types of business organizations are:

1. Sole proprietorships; 2. Partnerships; 3. Limited partnerships; 4. Corporations; and 5. Limited liability companies (LLCs).

As we will see, each type of business organization offers certain benefits as well as drawbacks that should be carefully weighed before deciding which form is best suited to the new venture. Table 28.1 provides a comparison of the different types of business entities. The requirements for starting a business under each of the available forms of business organization vary widely. For example, individuals who start a business under their own name alone or in traditional partnerships will have very few organizational formalities, whereas those who wish to organize a new business as a limited partnership, corporation, or limited liability company (LLC) will need to strictly follow the requirements of their state’s limited partnership, corporation, or LLC acts. Consult the office of the secretary of state in your location for registration requirements.

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Table 28.1: Business entity comparison

Sole Proprietorship General Partnership Limited Partnership

TYPE OF ENTITY SOLE PROPRIETORSHIP PARNERSHIP CORPORATION

DEFINED A business owned and run by one person.

An association of two or more people for a profit.

An entity that is created by permission of the state whose ownership is represented by shares of stock.

ADVANTAGES No meetings; run the business by yourself; no disagreements with others about how to run the business; liable only for own mistakes.

Have two or more people to help in running the business and share the liability. Have others to discuss the business plan with and share ideas for the business.

Limited liability of the owners and tax advantages.

DISADVANTAGES Taxed on income like regular income; have all of the liability; have no one else to contribute ideas.

Taxes. The profits of the partnership are taxed as personal income on each partner’s individual tax return, but the entity must file Form 1065 with the IRS.

Expensive and complicated to create; must follow state rules and comply with state and federal filing laws.

WHO OWNS The sole proprietor. The partners. The shareholders.

HOW FORMED Many states require a business certificate to be filed at the county clerk’s office; some also require an EIN (federal) number.

Many states require a business certificate to be filed at the county clerk’s office; as between the partners, the agreement can be informal and oral.

Preincorporators must file Articles of Incorporation with the secretary of state; state must issue charter. Other forms required. If public, must comply with federal and state law regarding the initial issuance of shares of stock.

WHO OPERATES The sole proprietor. The general partners, but they can turn over day- to-day management to a managing partner.

The corporate officers.

LIABILITY OF OWNERS

The sole proprietor’s assets, personal and business-related, are all subject to a lawsuit.

All the partner’s assets (personal and business) are subject to a lawsuit.

Liability is limited to one’s investment (i.e., in shares of stock).

HOW TAXED As personal income on Form 1040.

Income is reported on Form 1040 as personal income and paid at the personal rate, but the partnership also has to file Form 1065.

At the state’s corporate rate.

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28.1 Sole Proprietorships

The oldest and simplest form of business organization is the sole proprietorship. Under this form of business organization, the owner of a business personally oper- ates and is solely responsible for all aspects of the enterprise. A sole proprietor who

is hired by another to perform services may also be an independent contractor. An indepen- dent contractor usually performs one job and works at his or her own discretion. Thus, if ABC Corporation hired Fisher Painting, a sole proprietorship owned by Martha Fisher, Martha would be both a sole proprietor and an independent contractor. (For other employ- ment issues relating to sole proprietorships, see Chapter 21, Establishing the Employment Relationship, and Chapter 27, Principal–Agency Law.)

Formation of a Sole Proprietorship

The greatest benefit of the sole proprietorship form of business organization is that few formalities are required for its formation. To a certain extent, people wishing to go into business for themselves in a business that carries their own name can start the enterprise at any time without the need to seek state or local approval.

Creating a Tax Entity The first step in starting a sole proprietorship is to open a bank account so that the busi- ness can receive money and pay debts, either with checks or electronically. To open a business account, the bank will require a federal tax identification number (TIN). This nine-digit number could be the proprietor’s Social Security number or an employer iden- tification number (EIN) that the IRS assigns the business (in the format 12-3456789) and is used for filing tax returns. (All the information to obtain the federal tax number can be found at GovServices, http://www.taxid-gov.us.)

All sole proprietors do not need to set up an EIN. If a sole proprietorship does not have employees, it is not required to have an EIN. In fact, the IRS generally prefers that sole proprietors use their Social Security number. However, employers with one or more part- time or full-time employees, no matter how small their business, must have one. Also, if they plan to use an EIN to differentiate between personal and business finances, they should have an EIN before applying for business permits. In addition, if they pay subcon- tractors or others for services valued at more than $600 in a calendar year, they may need to get an EIN. Anyone who registers as a limited liability company, corporation, partner- ship, or joint venture must have an EIN.

Before a sole proprietor can collect any money from sales, the state tax division will require that the business register for permission to collect sales tax. This process may take months, so planning ahead is essential. Once the federal TIN and state tax collection permission have been acquired, there are no other formalities to go through before business can begin.

Licensing Some types of businesses require licenses to do business, such as bars (liquor license) or real estate firms. So a sole proprietorship must comply with all state and federal regula- tions applicable to business concerns. While there may be few formalities for actually forming the business, it is not as simple as simply setting up a lemonade stand.

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Doing Business As Persons who wish to do business under an assumed name must apply for a permit from the appropriate state office in their state (typically the secretary of state’s office) and pay a nominal fee for the privilege of doing business under a trade name. The primary purpose of this requirement is to prevent different persons from doing business under the same name in the same area, which might cause consumers confusion, and to have on record the names and addresses of the owners of these businesses so that they may be readily found and held accountable for any civil or criminal transgressions. Thus, Rick Carpenter generally needs no special permission to start a carpentry business under the name Rick Carpenter or Rick Carpenter’s Carpentry Service, but he would need to get what is com- monly termed a Doing Business As (DBA) certificate from the appropriate office in his state if he wanted to call his business Good Homes Carpentry, Expert Carpentry Works, or any other assumed name.

Benefits of Sole Proprietorships

As already discussed, there are few formalities to launch a sole proprietorship, and as a result, persons starting a business often choose this form to begin with. Other types of businesses, such as limited partnerships, corporations, and LLCs, require the drafting and filing of specific forms and approval from government officials before the business can get off the ground—a process that requires an investment of time and money to complete.

Autonomy If you ask a sole proprietor what the other greatest advantage is to this form of business, he or she will most likely reply that it is not having to share the management with anyone else. The sole proprietor does not have to ask for anyone’s permission, wait for votes or meetings, or seek others’ approval. Business decisions can occur quickly. Partnerships and corporations, on the other hand, require the members to reach a consensus and, in the case of corporations, sometimes onerous formalities before major business decisions (e.g., the sale of substantial portions of the assets of the business or the acquisition of business property) can be made. These processes can interfere with the smooth operation of some businesses and make instituting major changes slow and often tedious.

Freedom From Vicarious Liability of Co-Owners Just as important as the autonomy that the sole proprietorship permits the business owner is the freedom from liability for the negligent acts or bad business decisions of oth- ers. General partners in a partnership are deemed to be agents of the partnership and of one another under the common law of partnership (see Chapter 27 for a full treatment of principal–agency law). Thus, if there are partners A, B, and C, and only C is negligent, A and B will also be liable. In a corporation (discussed in Chapter 30), directors and officers of a corporation are deemed to be agents of the corporation they serve.

Under the law of agency, principals can be bound by the authorized acts of their agents and are liable for the negligent acts of their agents committed during the course of the agency. Thus, partners in a partnership can be held liable for contracts entered into on

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behalf of the partnership by any other partner as well as for the negligent acts of any part- ner that injures a third party. Likewise, a corporation can be held liable for the authorized acts of its officers and directors, as well as their negligence. Sole proprietors, however, need never worry about being responsible for the bad judgment, negligence, or bad faith of a co-owner, since they are the only owners; they are responsible only for their own acts and for the acts of their agents.

Cost Savings There are significant financial advantages for the sole proprietorship in terms of tax sav- ings and lower administrative costs. Unlike most corporations, the sole proprietorship does not pay federal, state, or local income taxes as a business entity; instead, all income earned by the business is taxed as simple income to the owner. This means that if the business makes $250,000, then that figure is reported on the sole proprietor’s tax return as income (on a Schedule C form). Because bookkeeping and legal formalities for the business are simplified, the administrative costs are usually lower than for other forms of business organization. For example, the sole proprietorship often has less need for legal and accounting services compared with other business organizations.

Drawbacks of Sole Proprietorships

While there are many benefits rooted in the simplicity of the sole proprietorship, a num- ber of tangible drawbacks stem from this form of business organization. Chief among these is the unlimited personal liability of the sole proprietor for all debts incurred by the business. The sole proprietorship is not recognized as a separate entity from its owner; as a consequence, the debts of the business are deemed to be the personal debts of the owner, and the sole proprietor has unlimited personal liability for all the debts, contractual obli- gations, and legal judgments the business incurs. If the business fails, its owner not only can lose the capital invested in the business but can also face the prospect of having his or her personal assets raided to satisfy business debts if the business assets are insufficient to cover business debts. Consequently, the business failure of a sole proprietorship often means personal bankruptcy.

Another downside of the sole proprietorship is that the owner must rely solely on his or her own assets and expertise in running the business, including dealing with profits and losses. While the business owner need not share profits or consult with others on business decisions, neither can the sole proprietor count on others to lend their expertise, share business losses, or shoulder part of the responsibilities for the business’s daily operation. Such assistance can be obtained in the form of hiring employees, but individuals who draw a salary are seldom as committed to the enterprise or as motivated to ensure its success as those whose fortunes are tied directly to the success or failure of the business. Further, the lack of co-owners of a business enterprise can be a particularly important drawback when the business owner needs to raise capital to expand or to cover extraor- dinary expenses.

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Property Status and Transferability of Sole Proprietorships

A sole proprietorship is considered personal property (see also Chapter 19). As such, it can be transferred in whole or in part at any time by its owner through sale or testamentary gift (through a will). If a business concern that is organized as a sole proprietorship is sold or otherwise transferred by its owner, its nature can change, depending on both the terms of its transfer and the wishes of the new owners. A sole proprietorship transferred to a single person who continues to run the business as a sole proprietor, for example, retains its previous status, whereas one transferred to two or more persons as joint own- ers becomes a partnership. A sole proprietorship can also be reorganized as a corporation if its new owner so desires. The type of business organization can also be changed by a present owner by reorganizing the business from a sole proprietorship to a partnership, corporation, or any other business organization recognized by the state.

Termination of the Sole Proprietorship

If there are few formalities for starting a sole proprietorship, there are none for ending one. The sole proprietorship can terminate as a business concern at any time at the will of its owner. Alternatively, it can end by operation of law—upon the death, incapacity, or bankruptcy of the owner. Consistent with this business form, when the business ends, its owner will remain personally liable for the completion of any outstanding contracts and for meeting any other outstanding business obligations. If the business ends owing to the death or incapacity of its owner, the owner’s estate or guardian will be responsible for paying creditors out of estate funds.

28.2 Partnerships

When two or more people wish to start a business together, the sole proprietor- ship is not a viable entity, and they must consider another form. One of the more popular (and less expensive) businesses to begin is a partnership. There are two

types of partnerships: general partnerships (discussed here) and limited partnerships (dis- cussed in Chapter 29).

Partnership law differs from state to state, but all states have adopted (in one form or another) the Uniform Partnership Act (UPA). Because there are 50 different states, you need to consult individual state law to ascertain the most current version. All states define partnership as “an association of two or more persons to carry on as co- owners a business for profit . . . .” (§ 101(6) Uniform Partnership Act (1997)). Any time that two or more individuals are engaged in a business as co-owners with the intent to make a profit, a partnership arises automatically (de jure, or by law), and the rights and responsibilities of each partner will be dictated by the law of partnership in the state where the partnership was formed.

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The contractual provisions contained in the agreement define the relationship as well as the rights and responsibilities the partners owe to one another. In the absence of a partner- ship agreement, or in cases in which the partnership agreement fails to define key rights and responsibilities, the state’s common law of partnership (and, where applicable, the state’s partnership act) will define these rights and obligations.

Formation of a Partnership

Like the sole proprietorship, the partnership form of business organization does not require specific formalities for its creation. Oral and written agreements to enter into a partnership are generally equally binding. A partnership can also arise by operation of law even absent a specific agreement: Any voluntary association by two or more persons to conduct a business for profit as joint owners automatically results in the creation of a partnership by operation of law, whether or not the joint owners specifically intended it. This holds true if two people start to sell a product but decide between themselves that they are not partners or they don’t consider themselves a partnership.

One would think that people contemplating going into business together would want to put their understanding in writing. That way, if any disputes or misunderstandings arose, the agreement could serve as a guide. In far too many cases, however, partners do not execute a written partnership agreement. This may be because of the cost of hiring an attorney, or mere laziness or aversion to discussing the minutiae of the agreement. It may also result from the partnership being a close family relation or friend with whom they don’t foresee conflict. Whatever the reason, it is a poor excuse, because forming an agreement is easy and the forms are available online. The consequences of not setting forth the terms of the partnership can be dire—the loss of the business, personal debt, and damaged personal relationships. It pays to be ready for the worst (dissolution, divorce, creditors, and personal problems of a partner) in order to protect the interests of all parties involved. See Figure 28.1 for a sample partnership agreement.

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Figure 28.1: Sample partnership agreement

PARTNERSHIP AGREEMENT

AGREEMENT made July 4, 2012, between Wendy Uhlinger of 100 Bucolic Dr., Slippery Rock, PA 16057-1014 and

Enrique Garcia of 10 Country St., Newton, NJ 07860.

1. NAME AND BUSINESS.

The parties hereby form a Partnership under the name of W&E Computer Consulting to engage in the business of

providing general computer consulting services and computer hardware and software sales. The principal office of the

business shall be in One Technology Drive, Middletown, NY 10940.

2. TERM.

The Partnership shall begin on August 4, 2012, and shall continue until terminated as herein provided.

3. CAPITAL.

The capital of the Partnership shall be contributed in cash by the partners as follows: $50,000 (Fifty thousand dollars)

by each partner. A separate capital account shall be maintained for each partner. Neither partner shall withdraw any

part of his capital account. Upon the demand of either partner, the capital accounts of the partners shall be maintained

at all times in the proportions in which the partners share in the profits and losses of the Partnership.

4. PRINCIPAL PLACE OF BUSINESS.

The principal office of the business shall be in One Technology Drive, Middletown, NY 10940.

5. BUSINESS AND PURPOSE.

The business and purposes of the Partnership are to manage, and operate, a computer consulting and repair

business, or interest therein.

6. WITHDRAWAL OF CAPITAL CONTRIBUTION.

Except as specifically provided in this Agreement, or as otherwise provided by and in accordance with law to the extent

such law is not inconsistent with this Agreement, no Partner shall have the right to withdraw or reduce his or her

contributions to the capital of the Partnership.

7. PROFIT AND LOSS.

The percentages of Partnership Rights and Partnership Interest of each of the Partners shall be as follows:

Partner 1: 50%

Partner 2: 50%

8. LOSSES.

Net losses shall be borne equally by them. A separate income account shall be maintained for each partner. Partner-

ship profits and losses shall be charged or credited to the separate income account of each partner. If a partner has

no credit balance in his income account, losses shall be charged to his capital account.

9. TAXATION.

For purposes of Sections 702 and 704 of the Internal Revenue Code of 1954, or the corresponding provisions of any

future federal internal revenue law, or any similar tax law of any state or jurisdiction, the determination of each

Partner’s distributive share of all items of income, gain, loss, deduction, credit, or allowance of the Partnership for any

period or year shall be made in accordance with, and in proportion to, such Partner’s percentage of Partnership

Interest as it may then exist.

10. DISTRIBUTION OF PROFITS.

Generally, gross cash distribution, in proportion to Partners’ percentages of Partnership interest, will be made based

on the scheduled payments of processors or within 60 days of payments being made.

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11. OPERATING EXPENSES.

Generally, operating expenses will be shared at the time those expenses are realized in proportion to Partners’

percentages of Partnership interest. While each purchase will not require an accounting of Partnership interest,

reimbursement to the payor, based on share, will be resolved every 30 days.

12. SALARIES AND DRAWINGS. Neither partner shall receive any salary for services rendered to the Partnership.

Each partner may, from time to time, withdraw the credit balance in his income account.

13. INTEREST. No interest shall be paid on the initial contributions to the capital of the Partnership or on any subse-

quent contributions of capital.

14. MANAGEMENT OF THE PARTNERSHIP BUSINESS.

14. A. All decisions respecting the management, operation, and control of the Partnership business and determi-

nation made in accordance with the provisions of this Agreement shall be made based upon a majority share of

the Partnership in favor of the decision. Majority owner Partner 1 has the full intention of increasing the responsibil-

ity and stake of Partner 2’s management, operation, and control of the Partnership. Succession of such powers

will take place, at first on a day-to-day basis. Later, based on performance, a management agreement will be

incorporated into this Partnership.

14. B. Nothing herein contained shall be construed to constitute any Partner or the agent of another Partner,

except as expressly provided herein, or in any manner to limit the Partnership to the carrying on of their own

respective businesses or activities. Any of the Partners, or any agent, servant, or employee of any of the Partners,

may engage in and possess any interest in other businesses or ventures of every nature and description, indepen-

dently or with other persons, whether or not, directly or indirectly, in competition with the business or purpose of

the Partnership, and neither the Partnership nor any of the Partners shall have any rights, by virtue of this Agree-

ment or otherwise, in and to such independent ventures or the income or profits derived therefrom, or any rights,

duties, or obligations in respect thereof.

14. C. The Partners shall devote to the conduct of the Partnership business so much of their respective time as

may be reasonably necessary for the efficient operation of the Partnership business. That will include a significant

amount of time during peak sales season in Partnership business. At this time, both partners expect to contribute

approximately 2,500 hours annually. To the extent that partners cannot devote adequate time to the business due

to health, outside ventures, jobs, or other reasons, said partner will be responsible for finding replacement labor

and covering the costs of said labor.

15. BANKING.

All funds of the Partnership shall be deposited in its name in such checking account or accounts as shall be

designated by the partners. All withdrawals therefrom are to be made upon checks signed by either partner.

16. BOOKS.

The Partnership books shall be maintained at the principal office of the Partnership, and each partner shall at all times

have access thereto. The books shall be kept on a fiscal year basis, commencing August 1 and ending July 31, and

shall be closed and balanced at the end of each fiscal year. An audit shall be made as of the closing date.

17. VOLUNTARY TERMINATION.

The Partnership may be dissolved at any time by agreement of the partners, in which event the partners shall proceed

with reasonable promptness to liquidate the business of the Partnership. The Partnership name shall be sold with the

other assets of the business. The assets of the Partnership business shall be used and distributed in the following

order: (a) to pay or provide for the payment of all Partnership liabilities and liquidating expenses and obligations;

(b) to equalize the income accounts of the partners; and (c) to discharge the balance of the income accounts of the

partners.

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Agency Rights and Duties of Partners

When partners act within the scope of their authority, they are agents of the partnership and of each other. As such, they bind the partnership to any contracts they enter into on the partnership’s behalf within the regular course of business. As is true of all agents, partners have fiduciary duties to the partnership and to each other. As co-owners of the business, partners also have the interests of principals in the enterprise; since each partner is both an agent and a principal of the partnership, each partner also owes every other partner the duties of a fiduciary. As such, partners must place partnership interests above their own personal gain and must execute their duties as partners with the utmost good faith. (See Chapter 27 for a list of fiduciary duties of agents and principals.) Table 28.2 illustrates these relationships.

18. DEATH.

Upon the death of either partner, the surviving partner shall have the right either to purchase the interest of the

decedent in the Partnership or to terminate and liquidate the Partnership business. If the surviving partner elects to

purchase the decedent’s interest, he shall serve notice in writing of such election, within three months after the death

of the decedent, upon the executor or administrator of the decedent, or, if at the time of such election no legal

representative has been appointed, upon any one of the known legal heirs of the decedent at the last known address

of such heir.

(a) If the surviving partner elects to purchase the interest of the decedent in the Partnership, the purchase price

shall be equal to the decedent’s capital account as at the date of his death plus the decedent’s income account as at

the end of the prior fiscal year, increased by his share of Partnership profits or decreased by his share of Partnership

losses for the period from the beginning of the fiscal year in which his death occurred until the end of the calendar

month in which his death occurred, and decreased by withdrawals charged to his income account during such period.

No allowance shall be made for goodwill, trade name, patents, or other intangible assets, except as those assets have

been reflected on the Partnership books immediately prior to the decedent’s death; but the survivor shall nevertheless

be entitled to use the trade name of the Partnership.

(b) Except as herein otherwise stated, the procedure as to liquidation and distribution of the assets of the Partner-

ship business shall be the same as stated in paragraph 17 with reference to voluntary termination.

19. ARBITRATION.

Any controversy or claim arising out of or relating to this Agreement, or the breach hereof, shall be settled by arbitra-

tion in accordance with the rules, then obtaining, of the American Arbitration Association, and judgment upon the

award rendered may be entered in any court having jurisdiction thereof.

In witness whereof, the parties have signed this Agreement.

____________________________

___________________________

Wendy Uhlinger Enrique Garcia

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Table 28.2: Partnership relationships

PARTNER 1 PARTNER 2 PARTNER 3

Principal of 2 and 3 Principal of 1 and 3 Principal of 1 and 2

Agent of 2 and 3 Agent of 1 and 3 Agent of 1 and 2

The general duties owed by agents to their principals, discussed in Chapter 27, apply to each partner in the partnership. Thus, partners owe the partnership and one another:

• The duty of loyalty; • The duty of obedience (they must carry out the rightful requests of the majority

of the partners); • The duty to exercise reasonable care and diligence in the exercise of their partner-

ship duties; • The duty to notify the partnership of any facts learned that are relevant to the

partnership; and • The duty to make an accounting to the partnership of any benefits derived from

conducting partnership business as well as any expenses incurred on the partner- ship’s behalf.

By the same token, the partnership owes each individual partner:

• The duty of reimbursement and indemnification; and • The duty of cooperation.

Contractual Rights and Duties of Partners

Although all partners are duty bound as agent and principal, they are generally free to control the nature of their relationship to one another and the duties they owe one another and the partnership by drafting the partnership agreement. This is true as long as they do not violate the law or the public policy of the states in which they do business. Unless there are provisions to the contrary in the partnership agreement, partners have an equal right to manage the business and to share in its profits. The mere fact that one partner makes a greater capital contribution to the partnership will not give that partner a greater voice in the management of the business or a greater share in its profits unless it is provided in the partnership agreement. Similarly, partners must share in the losses of the business in accordance with the share of profits they receive from it. Thus, if partners share profits equally, they will also share losses equally. If, however, the partners adopt a formula for the unequal allocation of profits among themselves, the same formula will apply to the (unequal) sharing of losses between the partners unless they agree otherwise.

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Limitations on Partners’ Ability to Define Their Rights and Obligations

Although partners are generally free to define their obligations to each other and to the partnership in the partnership agreement, some acts are specifically forbidden by law. The Uniform Partnership Act (UPA) prohibits several activities by partners:

• Engaging in certain activities that include unreasonably restricting the right of partners to access partnership books and records;

• Eliminating the duty of loyalty (though partners may define what types of activities are not considered a violation of the duty of loyalty, as long as these are reasonable);

• Eliminating the duty of care or the obligation of good faith owed by each partner to the partnership;

• Restricting the rights of third parties under the act; and • Unilaterally binding the partnership to a contract that assigns the partnership

property for the benefit of creditors, disposes of the partnership’s goodwill, or confesses a judgment.

Each of these is discussed in more detail below.

Limitations of Partners’ Ability to Bind the Partnership

Because they are agents, partners can individually bind the partnership to contracts entered into on its behalf during the regular course of business. The same rules of agency apply: there must be express, implied, or apparent authority. Therefore, if the partner is authorized, and he or she orders office equipment from a store in the name of the part- nership, the partnership is legally obligated to pay the bill. There are certain acts, how- ever, for which the unanimous consent of all partners is required. The reason for this is that these acts are so dangerous for the partnership that every single partner’s consent is needed. These acts include assigning partnership property for the benefit of creditors, disposing of the partnership’s goodwill, and confessing a judgment (Uniform Partner- ship Act § 9(3)(a–e)).

Assigning Partnership Property for the Benefit of Creditors Generally, assigning partnership property means that to resolve a debt with a creditor, the partnership transfers its interest in specific partnership property. In such a secured trans- action, if the partnership does not pay the debt, the creditor may keep the property. The UPA prohibits one partner from assigning partnership property to a third party without the permission of all the other partners. This rule makes sense because, as a partner, you would not want one of the other partners assigning property interests without your per- mission; otherwise, the property of the partnership could be pledged to another without your knowledge.

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Disposing of the Partnership’s Goodwill Goodwill is the intangible “name recognition” of a business that has meaning to custom- ers, and in some cases, may be worth a great deal of money. In this case, the partnership would be selling its name or goodwill to a third party. The UPA prohibits one partner from selling the goodwill of the business without the permission of the other partners. Again, this is an essential asset of the business: that all partners should have a say in assigning property to someone outside of the business.

Confessing a Judgment A judgment occurs at the conclusion of a civil trial, when the jury or judge pronounces a “winner.” In the case of confessing a judgment, however, the debtor is agreeing that he or she owes the creditor money without going to court. For a partnership to confess a debt, all the partners must be in agreement; one partner cannot sign a “confession” that binds the other partners.

Acts That Interfere With the Partnership’s Business Submitting a partnership claim to arbitration or doing any other act that would make it impossible to carry out the ordinary business of the partnership is likewise prohibited by the UPA.

Limitation on Partners’ Right of Compensation

Students are often surprised to learn that partners do not automatically, or even customar- ily, receive a salary. In fact, partners serve without compensation for their services unless the partnership agreement provides otherwise. Instead, partners are paid their respec- tive share of the profits by taking a draw, meaning that they take from the partnership’s account their share of the profits. According to the Revised Uniform Partnership Act (RUPA), a partner is also entitled to reasonable compensation for winding up the busi- ness after the dissolution of the partnership (RUPA (1997) § 401(h)).

Partners’ Capital Contributions

In the event that a partner dies or withdraws from the partnership, that person is entitled to the repayment of his or her capital contribution. Recall that this was the seed money each partner contributed to fund the start of the partnership. Additionally, suppose that a partner made a loan to the partnership or paid a partnership bill out of personal funds. If so, payments or advances to the partnership by any partner above and beyond the agreed- upon initial capital contribution will earn interest for the partner as of the date it is made.

Admission of New Partners

Admission of new partners into an existing partnership agreement can be made only with the unanimous consent of all partners (RUPA (1997) § 401(i)).

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Section 28.2 Partnerships CHAPTER 28

Partners’ Right to Inspect Partnership’s Books

Every partner has the right to inspect the partnership books at any time. The books must be kept at the principal office of the partnership and made available to every partner, at all times, for inspection and copying. RUPA also gives the right to inspect to other inter- ested parties: a partner’s agents and attorneys as well as former partners, their agents, and attorneys, pertaining to the period during which they were partners (RUPA (1997) § 403(b)). While this might not seem like an important right, being able to send an assis- tant (agent) to photocopy hundreds of pages of information can be a significant time- saver for an attorney or partner facing litigation.

Partners’ Liability for Partnership Debt

Partners are jointly and severally liable for all partnership debts. This means that part- ners can be sued individually or together by any person to whom the partnership owes a debt. These include debts that arise from contracts, tort liability, or liability to the state and federal governments for taxes or fees connected with running the business. Thus, each partner is subject to unlimited personal liability for partnership debts. If a single partner is sued by a creditor, the partner must fully discharge the debt out of his or her personal assets and would then be able to seek reimbursement from the other partners for their individual share of the liability. If the other partners are insolvent, however, the solvent partner could be left with no recourse.

New partners admitted to an existing partnership are liable only for partnership debts incurred after they join the partnership, and partners who dissociate themselves from the partnership are liable only for debts incurred up to the time of their dissociation, but not after.

Partners’ Property Rights

Because a partnership is an entity distinct from its partners, the partnership holds title to the partnership property. Property that is acquired by or in the name of the partnership is the property of the partnership and does not belong to any individual partner (RUPA § 203). The partnership can hold and dispose of property in the same way in which a corporation or an LLC can hold and dispose of property—in the “name of the partner- ship,” not in the name of individual partners. This brings the partnership form of business organization in line with other forms of business organization that are creatures of statute, such as the limited partnership, corporation, and LLC.

Purported Partners

In our discussion of agency by estoppel in Chapter 27, we saw that if a principal misleads a third party into believing that a person who is not an agent is in fact the principal’s agent, the principal will be unable to disavow acts of the purported agent. After all, the third party relied on the purported agent’s misrepresentations and may have suffered some tangible loss as a consequence. The principal is thereby prevented from denying the existence of the agency or the lack of authority of the purported agent when he or she is sued by an innocent third party, who justifiably relied on the existence of the agency because of the misrepresentation.

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Section 28.3 Partnership Dissociation CHAPTER 28

The same common law tenet applies to partnerships. Partners can be prevented from deny- ing a purported partner’s partnership status if the partners allow an innocent third party to mistakenly and justifiably believe that a nonpartner is a partner. In such cases, a part- nership by estoppel exists. This means that the partners are prevented (estopped) from denying the nonpartner’s partnership status with regard to any innocent third person:

If a person, by words or conduct, purports to be a partner, or consents to being represented by another as a partner . . . the purported partner is liable to a person to whom the representation is made, if that person, relying on the rep- resentation, enters into a transaction with the actual or purported partnership. (RUPA § 308(a) (1997))

Partners are also liable for the purported agent’s actions as though the person were in fact a partner. Under the common law, UPA, and RUPA, if all partners in the partnership consent to the misrepresentation, all partners are bound by it. However, if fewer than all the partners consent to the misrepresentation, only those partners who consented to the misrepresentation are jointly and severally liable to any innocent third parties who relied on the misrepresentation in dealing with the purported partner (RUPA § 308(b) (1997)). The following examples will illustrate:

• Adam tells Betty that he is a partner of Charlene and David. Betty believes him and enters into a contract with Adam to sell the partnership of Adam, Charlene, and David $1,000,000 worth of office supplies and equipment. The contract will not bind Charlene or David, as the statements by Adam were not made in their presence or with their acquiescence. Only Adam is liable under this contract.

• Adam tells Betty that he is a partner of Charlene and David in Charlene’s pres- ence, and Charlene does not dispute the statement. Betty later enters into a con- tract with Adam to sell the partnership of Adam, Charlene, and David $1,000,000 worth of office supplies and equipment. The contract will bind Charlene but not David, as the statements by Adam were not made in David’s presence or with his acquiescence. Only Adam and Charlene are liable under this contract.

• Adam tells Betty that he is a partner of Charlene and David in the presence of both Charlene and David, who do not dispute the statement. Betty later enters into a contract with Adam to sell the partnership of Adam, Charlene, and David $1,000,000 worth of office supplies and equipment. The contract will bind Char- lene and David (as well as Adam) because the misrepresentation was made in their presence and was not objected to by either of them.

28.3 Partnership Dissociation

Even if the partners formed their business with the idea that they would continue for many years, it is not uncommon for people to have a falling out. At that juncture, the partners then wonder how to end the partnership that they formed. The name given

to ending a partnership is dissociation. There are a number of voluntary and involuntary ways in which a partner may be dissociated from the partnership.

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Section 28.3 Partnership Dissociation CHAPTER 28

If the partnership is one “at will,” then by definition, it has no ending date. Any partner can leave the partnership at any time without incurring further liability. Sometimes the partnership agreement states that it will end upon the happening of an event. For exam- ple, the partnership agreement might say:

TERM OF THE PARTNERSHIP This partnership will end when the house at 124 Elm Street is purchased, the renova- tions complete, and the house is sold to a third-party purchaser.

In such a case, the partnership ends upon the happening of an event that all the partners agreed to upon partnership formation.

Sometimes the actions of a partner are so egregious that the other partners do not want that person associated with the partnership anymore. When this occurs, the partners may expel the partner from the partnership if they have a partnership agreement that provides for such a scenario. Without an agreement, a partner can still be expelled from a partner- ship, but it must be by unanimous vote of the partners and only for reasons such as “It is unlawful to carry on the partnership business with that partner.” If the partnership cannot agree to expel a partner, then the partnership can go to court and seek a judicial determi- nation for a reason such as the partner engaging in wrongful conduct that “adversely and materially affected the partnership business.” Both UPA and RUPA have lists of reasons to terminate a partnership. Examples of reasons to terminate a partnership vary from state to state, depending on how that state adopted the UPA. For examples of what two states have adopted as reasons for termination, see http://delcode.delaware.gov/title6/c015/index .shtml (Delaware) and http://www.leg.state.nv.us/NRS/NRS-087.html#NRS087Sec4343 (Nevada).

Winding Up

After dissociation, a partnership enters the winding-up period. During this time, the part- ners may continue to carry out business that is reasonably necessary to complete contracts in progress and to otherwise bring the business affairs to an orderly close. Upon disso- ciation, partners lose the authority to bind the partnership to new contracts. If a partner enters into new contracts on behalf of the partnership during the winding-up period, the partnership and other partners will not be bound by such contracts; rather, the partner acting without express authority will be personally liable on these contracts in the same way as any agent who exceeds his or her actual authority (see Chapter 27, Section 27.2).

Even after dissociation and winding up, partners retain unlimited personal liability for partnership debts. If the assets of a dissolved partnership are insufficient to cover part- nership debts, creditors of the partnership can sue partners individually or jointly for any shortfall.

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Key Terms CHAPTER 28

Notice to Third Parties Upon Dissolution

Because partners are agents of the partnership, when a partnership is dissolved other than by operation of law (such as by the death or bankruptcy of a partner), partners still have apparent authority to bind the partnership with respect to persons who had previously extended credit to the partnership or known of its existence. For this reason, it is essential that notice be given to such persons that the partnership has been dissolved. Until such notice is received, persons who knew of the partnership’s existence or who had extended credit to the partnership in the past may still enter into binding contracts with the part- nership through any of its partners. Several methods are available for effectively revoking partners’ apparent authority to bind the partnership to new contracts:

• Persons who have previously extended credit to the partnership must be person- ally notified of the partnership’s dissolution by any reasonable means (e.g., by letter, telephone, telegraph, or in person). If such notification is mailed, it is effec- tive when it is received, even if it is never read.

• Notification to persons who might have known of the existence of the partner- ship but had not extended credit to it previously is sufficient if it is published in a newspaper of general circulation in the area or areas where the partnership did business.

Key Terms

assigning partnership property for the benefit of creditors To resolve a debt with a creditor, the partnership transfers its interest in specific partnership property to a creditor..

assumed name (D.B.A.) A name for a business, other than the owner’s real name. Also known as doing business as, or D.B.A.

capital contribution The initial amount of money each partner contributes to begin the business; “seed money.”

confessing a judgment A legally binding agreement in which a party admits that he or she owes another money; thus, the creditor does not have to sue the debtor in court but can use the confession to collect the money from the debtor.

corporation A business entity that is separate and distinct from its owners, the shareholders. The law grants a corporation status as an artificial being, much like a person, in that it has the right to enter into contracts, loan and borrow money, sue and be sued, hire employees, own assets, and pay taxes.

dissociation When a partner leaves a partnership either voluntarily, because of the partnership agreement terms, or owing to egregious conduct. Upon dissociation, partners lose the authority to bind the partnership to new contracts.

draw A partner’s share of the profits, withdrawn on a regular basis from the partnership’s account.

federal tax identification number (TIN) The number the government assigns to a business entity (e.g., a sole proprietorship) in the form of a nine-digit number; used for filing tax returns.

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Key Terms CHAPTER 28

general partnership A type of business formed by two or more persons for the purpose of engaging in a business for a profit. Also can exist de jure (by law).

goodwill The intangible “name recogni- tion” of a business that has meaning to customers and, in some cases, may be worth a great deal of money.

joint and several liability The concept that partners can be sued individually or collectively for debts the partnership owes or to pay damages in tort lawsuits.

limited liability company (LLC) A type of business formed by permission of the secretary of state’s office; usually applies to professionals such as doctors or lawyers.

limited partnership A type of partnership in which there are general partners and limited partners who are investors in the general partnership.

partnership A type of business formed by two or more people in which they are engaged in a business as co-owners with the intent to make a profit.

partnership agreement The contract entered into by the partners setting forth their respective rights and duties.

partnership books The records showing the financial transactions of the partner- ship. The books must be kept at the prin- cipal office of the partnership and made available to every partner, at all times, for inspection and copying.

partnership by estoppel When partners are prevented (estopped) from denying the nonpartner’s partnership status with regard to any innocent third person who justifiably relied on the misrepresentation by an apparent partner.

profits and losses Profits refers to the money accrued after paying any debts owed; losses refers to not having any money accrue or having less money after paying debts.

Revised Uniform Partnership Act (RUPA) Approved by the National Con- ference of Commissioner Uniform State Laws (NCCUSL) in 1994 and amended in 1996 to add the Limited Liability Partner- ship (LLP) provisions. Each state adopted the RUPA on a different date.

sole proprietorship A type of business in which the owner personally operates the business and is solely responsible for all aspects of the enterprise.

secretary of state The state official respon- sible for registering business entities.

testamentary gift A gift given through a will.

Uniform Partnership Act (UPA) A set of laws articulating how to create, dissolve, and run a partnership, originally written by the National Conference of Commis- sioner Uniform State Laws (NCCUSL) and adopted by every state except Louisiana. Each state’s adoption of the UPA varies; all states follow the gist of the law, but states may have changed parts of the law in their adoption of it.

unlimited personal liability In a part- nership, once the partnership assets are exhausted, the personal assets of the part- ners are subject to collection by a creditor. For a sole proprietor, all debts incurred by the business are the personal responsibility of the owner.

winding up The period after dissocia- tion, when partners may continue to carry out business that is reasonably necessary to complete contracts in progress and to otherwise bring the partnership’s business affairs to an orderly close.

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Critical Thinking and Discussion Questions CHAPTER 28

Critical Thinking and Discussion Questions

1. What formalities are necessary for the formation of a sole proprietorship? 2. What are the basic benefits of doing business as a sole proprietorship? What are

the drawbacks? 3. What duties do partners owe the partnership? What duties are owed all the part-

ners by the partnership? 4. In the absence of an agreement to the contrary, how are profits in a partnership

shared? What about expenses? 5. Partners may generally unilaterally bind the partnership to contracts they enter

into with third parties on the partnership’s behalf in the regular course of busi- ness. But some types of acts require unanimous assent by all partners in a part- nership. What are they?

6. What types of activities can a partnership engage in during the winding-up period?

7. Robert Nussbaum, a talented college student with a wonderful voice, would like to start his own business selling self-published audiobooks that he will produce himself by reading from works of fiction in the public domain, digitally record- ing these on his computer and burning them on CDs. He intends to sell his custom collections on eBay and will advertise his collections as Robert Nussbaum’s Classic Audiobooks.

a. Will Robert be in violation of the law if he starts doing business without first seeking a permit from the state?

b. Can Robert name his business Classic Audiobook Productions without getting a state permit?

c. If Robert’s state has a sales tax that applies to the sale of audio and music compact discs, can he go into business without informing the state if he believes that most of the sales will come from out of state?

8. Harry and Harriet enter into an agreement to start an antique dealership busi- ness as equal partners. Harry agrees to make a $50,000 capital contribution to the business, and Harriet agrees to provide a commercial building that she has inherited worth $150,000 as her capital contribution. The agreement between the partners specifically states that business profits and losses will be shared equally. After successfully running the business for a number of years, the part- ners decide they would like to hire someone to manage the daily operation of the business for them. They hire Helen as the general manager of the business. Although Helen is not a part owner of the business, her salary will be based on a share of the business profits. And, although all fundamental business decisions are made by Harry and Harriet, they often ask her advice before implementing new policies.

a. Is Helen a partner? Explain fully. b. If the business goes bankrupt and after dissolution its debts exceed its assets

by $200,000, what will the responsibility of Harry, Harriet, and Helen be with regard to the debts?

c. Assume that after dissolution, the debts of the business exceed its assets by 100,000 and that Harry is insolvent, but Harriet has personal assets (including her family home) in excess of $100,000. How much of the debt could creditors ask Harriet to bear? Explain.

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