978-0077733711 Chapter 37 Lecture Note

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Chapter 37 – Introduction to Forms of Business and Formation of Partnerships

CHAPTER 37

INTRODUCTION TO FORMS OF BUSINESS AND FORMATION

OF PARTNERSHIPS

I. OBJECTIVES

This chapter serves the function of introducing a student to the forms of business

organization and the creation of partnerships and limited liability partnerships (LLPs).

Students should master at least the following subjects covered by this chapter:

A. The differences between the various forms of business.

B. The advantages and disadvantages of the various forms of business.

C. When a partnership is created.

D. When a person becomes a purported partner of another person.

E. The distinction between partnership property and partner’s property.

F. The effects created by a transfer of a partner’s transferable interest and an issuance of

a charging order against a partner’s transferable interest.

II. ANSWER TO INTRODUCTORY PROBLEM

A. Although virtually any business form may be adapted to the needs of this new

business, the forms that are the best fits are the LLC and LLLP. Both forms will

allow the owners to deduct the business’s losses in its first two years on their

individual federal income tax returns if partnership tax status is elected. Each form

will also easily allow you to assume all management of the business.

B. If an LLC is chosen, you will want to designate that the LLC is member-managed

with you as the manager. It is important that the operating agreement state that you

may not be removed except with your consent. While the limited partnership will

also work, the LLLP is better, because it grants limited liability to the general partner

(you), if that form is chosen. As the only general manager in an LLLP, you will

control the business. An LLP could also be used, with all partners agreeing that you

are the only managing partner. An S Corporation could also work if the number of

shareholders is limited to 100 and you are elected as the sole director of the

corporation each year. To elect yourself as the only director, you will need to

maintain majority ownership of the shares or create different classes of shares, with

only your shares being able to elect the directors. This is beyond the scope of this

chapter. See Chapters 43 and 44 regarding how to adapt the corporation to your

needs. While the Internal Revenue Code requires an S Corporation to have only one

class of shares, IRS regulations indicate that a difference in voting rights by itself

does not create two classes of shares for Subchapter S purposes.

III. SUGGESTIONS FOR LECTURE PREPARATION:

A. Choosing a Form of Business

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Chapter 37 – Introduction to Forms of Business and Formation of Partnerships

1. Begin your lecture by listing the eight business forms summarized in Figure 1

(page 995) briefly distinguishing them, and explaining that choosing a business

form is important for many reasons, especially liability and tax reasons.

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Chapter 37 – Introduction to Forms of Business and Formation of Partnerships

Note the three most recently created business forms: the limited liability company,

the limited liability partnership, and the limited liability limited partnership. Note

that the LLP was created in reaction to the enormous amount of liability imposed

on professionals due to the savings and loan associations debacle of the early

1990s. The Revised Uniform Partnership Acts gives limited liability for all

obligations to a partner of an LLP, except for wrongful acts committed by the

partner.

2. It may be instructive to reproduce Figure 1 on the chalkboard or overhead screen.

Start by listing the forms of business across the top of the chalkboard and listing

the characteristics as students answer your questions. Elaborate on students

answers to clear up any ambiguities.

3. Students may struggle with the confusingly similar names and acronyms for the

various business forms. You can eliminate this confusion by organizing the forms

by type and by pronouncing the names of the forms in a way that reinforces what

they are. For example, the partnership and LLP are essentially the same form.

The LLP is a limited liability [pause] partnership, that is, a partnership for which

the partners have chosen limited liability.

The limited partnership and the LLLP are essentially the same form. The LLLP is

a limited liability [pause] limited partnership, that is, a limited partnership whose

partners have chosen limited liability for the general partner.

Some students will want to conclude that an LLP has limited partners. Correct

that misimpression by stating that only the limited partnership and LLLP have

two classes of partners by default. The default rule in a partnership or LLP is that

there is only one class of partners. If partners in a partnership or LLP do create

more than one class of partners, they will not use the terms limited partners and

general partner. Partners who manage the business will be called managing

partners, and non-managing partners will be called partners.

4. Log On (p. 994): This website has a practical guide to starting a business,

including getting the necessary tax forms.

5. Example: Problem Cases ## 1, 2, and 3.

6. Additional Example: Chapter Introductory Problem (p. 990)

7. The Global Business Environment (p. 994): Note that while the names may be

different, business forms are generally similar worldwide. The United States has

taken the lead in recent years in creating new business forms, and it is expectable

that other nations will follow suit and create similar forms, like the LLLP and

LLP.

8. Ethics in Action (p. 996):

a. You can examine the first question from each of the ethical perspectives

presented in Chapter 4. Here are some suggestions. A profit maximizer

would find it ethical to comply with the law and to select limited liability

status when the law permits, unless creditors were unwilling to transact with a

business whose owners have no personal liability. For example, a bank may

be willing to lend money to an LLP only if the partners agree to be personally

liable on the loan agreement. A profit maximizer would find it necessary to

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Chapter 37 – Introduction to Forms of Business and Formation of Partnerships

accept that liability when the loan is expected to contribute to the LLP’s

profitability.

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Chapter 37 – Introduction to Forms of Business and Formation of Partnerships

A utilitarian would consider the impact of limited liability on society as a

whole, finding that society benefits when business people protected by limited

liability engage in a valuable business that they otherwise would not

undertake, but also finding that limited liability may encourage unduly risky

business ventures that harm society when they fail. Another cost is that

creditors who are not paid by failed a business may leave the credit field or

increase the cost of credit for all businesses having owners with limited

liability.

A rights theorist, especially someone who believes in Kant’s categorical

imperative, would consider the effect of a rule that allows a business person to

escape liability for the contracts and other liabilities of his business. He might

conclude that taking advantage of limited liability will cause credit to dry up

for all businesses including his own, and therefore accepting limited liability

is not a rule that he would impose on others. However, he might conclude that

knowledgeable creditors will protect themselves by insisting that business

owners agree to assume personal liability before the creditors extend credit to

the business.

A believer in justice theory will respond to that last argument by agreeing that

contract creditors have the ability to make contracts with the owners to protect

the contract creditors. Yet tort creditors (that is, victims of torts) often do not

have the ability to contract with a business or its owners prior to the

commission of a tort. Tort creditors are, therefore, disadvantaged and deserve

to be compensated by someone for the harm they have suffered. That is one

of the reasons, by the way, why individuals who commit torts have personal

liability for torts they commit, despite otherwise having limited liability.

b. An analysis of the ethics of tax treatment is similar to the analysis of the ethics

of limited liability. See Chapter 4 for additional guidance.

B. Introduction to Partnership

1. History of Partnerships. We tend to allow students to cover this in their reading,

except to point out that the partnership is not some recent creation, but has existed

for thousands of years.

2. The RUPA is the dominant partnership law in the United States. Note the number

of states that have adopted the RUPA and whether your state has adopted the

RUPA by going online at www.nccusl.org.

3. Characteristics of Partnerships. When beginning your lecture on partnerships,

write on the chalkboard the most important characteristics of partnerships under

the RUPA, especially that a partnership can be created with no formalities, its

partners are managers, partners are fiduciaries, partners have unlimited liability,

and partners share profits and losses. You may wish to refer merely to Figure 2 on

page 997.

C. Creation of Partnership

1. Consequence of Being a Partner.

a. Begin with a summary of the consequences of being held to be another’s

partner and give several examples. The consequences are listed in Figure 3 on

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Chapter 37 – Introduction to Forms of Business and Formation of Partnerships

page 999. There is significant shock value to the students here, as they learn

of the severe consequences of having to share profits with someone, or being

held liable for another’s contracts or torts. This impresses them with the

relevancy of knowing when a partnership is created.

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Chapter 37 – Introduction to Forms of Business and Formation of Partnerships

b. Example: Two students agree to buy basketball tickets, to resell them

(scalping), and to share the profits. They may not intend to create a

partnership, but they have. As a result, if one of the students has a bad night

and loses money on his sales, the other student must assume a share of the

loss. In addition, neither student should be selling tickets for his personal

profit when he has partnership tickets to sell, or else he breaches the fiduciary

duty of competing with the partnership. They also share the power to decide

what tickets to buy.

2. Definition of Partnership.

a. List the four elements on the chalkboard and explain them briefly before

covering each in detail.

b. Association of Two or More Persons

Note that no person may be forced to be a partner of another person.

c. Co-ownership

1) Students have the most problems with the co-ownership element. Stress

that sharing profits is prima facie proof of a partnership, because usually

only owners of a business share profits. Point out that sharing profits is

the most important factor establishing a partnership, and that sharing

management is the second most important. Together, the two almost

always ensure that a partnership results.

a) Example: Problem Cases ## 4, 6, 7, and 8.

b) Additional Example: Two business consultants share the revenues of a

business and the expenses of the business. Are they partners? Yes.

Since revenues minus expenses are profits, the consultants are sharing

profits and, therefore, presumed to be partners. This is similar to

Problem Case # 5.

2) The RUPA exceptions to the rule that sharing profits presumptively proves

partnership create problems for students, especially with regard to

creditors who exercise management powers. Stress that the exceptions

exist to allow people to share profits not because they co-own a business,

but because it is convenient for an obligation, such as wages, rent, or other

debt, to be paid out of profits.

Example: Joe loans $50,000 to Karen’s business. Joe has the right to

approve any additional borrowing by Karen and to veto her decision to

expand her business. Joe has the right to receive, as interest on the loan,

the greater of $5,000 per year or 25% of Karen’s profits. Karen must

repay the principal amount of the loan in 10 years. Joe is not a partner,

because the loan has a maturity date, principal amount, and interest

obligation. If the loan had no repayment date, the loan would be similar to

a capital contribution, because repayment would appear to be subject to

the risk of the success of the business. His status would be more nearly

that of a partner than of a creditor, and he will be held to be a partner.

Stress here the importance of a creditor documenting his creditor status by

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Chapter 37 – Introduction to Forms of Business and Formation of Partnerships

having a written promissory note with a principal amount, interest rate,

and maturity date.

Additional Example: Problem Cases # 5. Sharing profits as compensation

to an employee creates no presumption of partnership.

3. Intent of the Parties

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Chapter 37 – Introduction to Forms of Business and Formation of Partnerships

Students are surprised to learn that they can be partners even if they tell each

other that they are not partners. Stress that it is their intent as evidenced by their

relationship with others–not their stated intent–that determines whether a

partnership has been created. That is, actions speak louder than words.

Rasmussen v. Jackson (p. 999): The Iowa court of appeals held that Rasmussen

and Jackson were not partners because there was no co-ownership of the business.

Points for Discussion: Ask the students to list the three rules that the court used to

show there was no partnership. First, there was no joint ownership of property

used in the business. Second, the two parties did not agree to share gross receipts

from the business. Third, the two partners did not share profits.

Be careful to point out that the first two reasons, even if the facts proved the

opposite, would not presumptively create a partnership. The rationale behind the

third reason, sharing profits, is the most important basis for finding a partnership.

Note also that the court did not consider two other very important factors, the

sharing of control and making contributions to the business. Magee and

Rasmussen shared some control over the maintenance of the herd: Magee helped

maintain the herd and the land, and Rasmussen maintained the land. Each also

contributed some property: Magee contributed bison and equipment and

Rasmussen contributed land.

Why was the court not convinced that the two parties jointly owned the property

of the business? Rasmussen owned the land where Jackson grazed the bison, and

Rasmussen never had title to any of the bison. Moreover, new equipment that

maintained the bison was titled only in Rasmussen’s name. You may want to

point out here–and the court acknowledged–that joint ownership of property is

not sufficient to a finding of partnership. It is also not necessary, provided the

parties co-own the business. Its absence is some weight, however, tending to

prove a lack of partnership.

Note that while the agreement with the previous land owner, Magee, provided for

the sharing of the proceeds (revenue) from the sale of the bison and the expenses

of maintaining the herd, Rasmussen stated he did not want such a relationship.

Had he agreed to that relationship, he would have been agreeing to share profits,

as revenue minus expenses is profits. That would have been strong proof of

partnership.

The court probably was greatly persuaded by a clause in Rasmussen and

Jackson’s agreement that there is no partnership between them. Such statements

are not always followed by a court when objective evidence shows intent to form

a partnership. Yet when the evidence of partnership is scant, as here, such a

statement helps a court reach a conclusion that there is no partnership.

D. Purported Partners

1. Essence. This concept is nearly the same as the old UPA’s concept of partnership

by estoppel. Stress that since purported partner status is an estoppel concept, it is

based upon reasonable reliance. It is reasonable for me to rely upon your

representations that you are a partner of another person. If I transact with another

person because you have misled me, you will be liable on contracts and torts

arising from that transaction.

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Chapter 37 – Introduction to Forms of Business and Formation of Partnerships

2. Consequences. Students have trouble distinguishing the consequences of being

an actual partner from the consequences of being a purported partner. They seem

to confuse purported partnership with creation of partnership. Start your lecture

by listing the consequences and non-consequences of being a purported partner.

The purported partner does not co-own a business, does not share profits or

management, does not owe fiduciary duties, and does not have unlimited liability.

He is liable only on contracts that a person entered in reliance upon the

appearance of partnership and torts that arose in the course of the performance of

those contracts.

3. Purporting to be a Partner. Use a demonstration to define purporting to be a

partner. Hold out your hand and say that by calling someone your partner you are

figuratively purporting or representing this person to be your partner or making it

appear this person is your partner by holding this person on your hand and saying,

“Look. This person is my partner. I am holding him out to you as my partner. I

am representing that he is my partner. I am purporting that we are partners. I am

making it appear that this person is my partner.”

4. Consent to Being Represented as a Partner. Note that a person is not liable for

someone else representing or holding her out as a partner unless she consents–by

her words or her actions–to the holding out.

Example: Helen retires from her partnership, but frequently visits the office to

pass the time. Her former partners introduce her to customers as “my partner,

Helen.” If Helen does not deny that she is a partner, she may be found to be a

partner by estoppel. Her silence is consent to her being held out as a partner.

5. Reliance Resulting in a Transaction with the Partnership. Most courts have little

difficulty finding that a person has relied on the appearance of partnership. Often

it is inferred merely from the person having knowledge of the representation of

partnership and transacting with a purported partner.

Example: Problem Cases ## 8 and 9.

McGregor v. Crumley (p. 1002). The court concluded that Clint and Paige were

neither partners in fact nor purported partners. Therefore, Paige was not liable on

the contract to purchase cattle.

Points for Discussion: For what reasons did the court conclude that Paige was not

Clint’s partner? McGregor presented no evidence that Paige shared in the title to

the farm they operated, that she shared any gross returns of the business, that she

shared its profits, and even that she was compensated at all. The court especially

criticized McGregor for presuming that a husband and wife in business together

were partners.

Additional Point for Discussion: For what reasons did the court refuse to find that

Paige was Clint’s purported partner? Again, McGregor presented no evidence

that Paige caused him to believe that she was Clint’s partner. Paige’s giving

McGregor a check of the business is not a holding out that she is a partner,

because an employee can do that very act. Moreover, her refusal to discuss the

bill for the second shipment of cattle is good evidence she is not a partner, who

ordinarily would hold and exercise authority to discuss bills.

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Chapter 37 – Introduction to Forms of Business and Formation of Partnerships

6. Ethics in Action (p. 1004): The doctrine of purported partnership can be justified

by Kant’s categorical imperative because it reflects a rule that that you would

want others to live by. It recognizes that people should be allowed to rely on

representations. If there was no rule of purported partnership, people may decide

not to do business with those who claim to be partners for fear that those persons

are not partners and not liable for each other’s actions.

E. Partnership Property and Partners’ Property Rights

1. Distinguishing Partnership Property from Partners’ Property.

a. Students have the greatest difficulty in sifting through the conflicting evidence

of ownership. List the common indicia of ownership in the order of their

importance:

1) what is the partners’ intent;

2) who paid for the property;

3) whether title was taken in the name of the partnership;

4) whether title was transferred to a partner acting as a partner;

5) who pays taxes;

6) who pays insurance premiums; and

7) who maintains and repairs the property.

Go through these indicia individually and explain that partners’ intent is

conclusive, that purchasing the property with partnership funds is

presumptive, that holding title is presumptive, and that the other factors can

overcome the presumptions of ownership.

b. Stress the importance of making a distinction between partnership property

and partners’ property. The examples on page 1004 in the text may be used

and expanded. Not only is taxation an issue, but also when property is

partnership property all partners share in the value of the property. If property

is a partner’s property, that partner gets all the value of the property.

McCormack v. Brevig (p. 1005). The court concluded that the cattle remained

partner’s property, that is, Clark’s property, despite evidence that Clark knew

that the cattle was listed on partnership tax returns and that proceeds from the

sale of the cattle’s offspring was placed in partnership accounts.

Points for Discussion: Ask your students which RUPA section led the court to

presume that the cattle belonged to Clark? The court applied RUPA section

204(d), which essentially states that property acquired by a partner with the

partner’s funds in the name of the partner with no indication that the partners

is acting on behalf of the partnership is the partner’s property. That is

completely sensible, and it comports with the facts, which indicate that Clark

and Joan’s mother transferred rights to the cattle to Clark and his sons, not to

Joan or the partnership.

Additional Points for Discussion: Why, then, did Joan contest ownership of

the cattle? Because she believed there was evidence of the partners’

agreement that the cattle would be partnership property. What evidence did

Joan cite? She cited that Clark consented to the cattle being listed on

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Chapter 37 – Introduction to Forms of Business and Formation of Partnerships

partnership tax returns and having proceeds of the sale of their offspring

placed in partnership accounts. Why didn’t the court accept Joan’s

arguments? The court seemed not to think those facts were evidence of the

partners’ agreement, focusing instead only the inability of the partnership to

claim ownership merely because it fed, watered, and pastured them.

Ask whether your students think the court was being evasive. We know that

listing an asset on the partnership books is evidence of the asset belonging to

the partnership. Why shouldn’t that be the case with assets listed on

partnership tax return? Why would an owner of cattle allow their calves to be

sold and then place the proceeds in the partnership account? Aren’t those two

facts strong evidence of partnership property?

Final Point for Discussion: This is a good case to point out what well

planned partnerships should do. The partners should make it clear who owns

the property in written partnership agreements, and should not act, as Clark as

here, in a way inconsistent with that agreement.

Additional Examples: Problem Cases ## 10 and 11.

Additional Example: Frank, Susan, and Ryan create a partnership. Frank and

Susan each contribute $50,000 in cash. Ryan makes no cash contribution, but

he lets the partnership use his land and building, which are worth $50,000.

Ryan retains title to the land and building. The partnership pays no rent to

Ryan. Ryan insures the land and building, but the partnership pays for all

upkeep and repairs. This is probably Ryan’s property, because he has title and

pays for insurance. Should the land and building be considered Ryan’s capital

contribution merely because he has otherwise made no contribution? No.

Ryan’s contribution could be the partnership’s free use of the land and

building. Besides, partners may agree that one partner need make no

contribution. Stress to students that the partners should have stated expressly

in writing who owns this property to avoid disputes.

2. Partners’ Rights in Partnership Property.

Note that the RUPA gives partners no ownership rights in partnership property.

Partners merely have the right to use partnership property for partnership

purposes.

3. Partner’s Transferable Interest. Students have little trouble understanding that a

partner’s transferable interest is her personal property, like her car or television

set. They also have little difficulty understanding that a transferee or a creditor

with a charging order does not obtain all the rights that a partner had. However,

students have difficulty distinguishing transfers from charging orders. List the

elements and consequences of transfers and charging orders.

a. Transfer of a Partner’s Transferable Interest

1) Voluntary by partner.

2) Transferee receives only the transferring partner’s share of partnership

distributions, such as a share of the profits distributed to partners.

3) Transferee is not a partner and has no right to manage the partnership or

inspect its books and records.

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Chapter 37 – Introduction to Forms of Business and Formation of Partnerships

4) Transferring partner remains a partner with all the rights he had before the

transfer, except the right to receive partnership distributions that he has

transferred.

5) Transferee may seek a judicial dissolution and winding up of a

partnership-at-will.

6) Nontransferring partners may agree unanimously to expel the transferring

partner from the partnership. This is a nonwrongful dissociation of the

expelled partner.

b. Charging Order against Transferable Interest

1) Involuntary. Partner is powerless to stop a court from issuing a valid

charging order to partner’s creditor.

2) Creditor receives only the charged partner’s share of partnership

distributions, such as a share of the profits distributed to partners.

3) Creditor is not a partner and has no right to manage the partnership or

inspect its books and records.

4) Partner who suffers a charging order remains a partner with all the rights

he had before the charging order was issued, except the right to receive

partnership distributions.

5) Creditor with a charging order may foreclose on the charging order and

obtain sale of a partner’s transferable interest. The purchaser of the

transferable interest at a foreclosure sale is treated as a transferee of the

transferable interest and may seek dissolution and winding up of a

partnership-at-will.

6) Partners who have not suffered charging orders may agree unanimously to

expel the partner who suffered the charging order. The expulsion is a

nonwrongful dissociation.

7) Partners who have not suffered charging orders may agree to redeem the

charging order.

c. Explain that a transferee obtains greater rights than a creditor with a charging

order, because a transfer is voluntary: a transferring partner can protect

himself by refusing to assign his interest. Only by seeking foreclosure will a

creditor with a charging order be able to obtain the same rights as a transferee.

Example: Problem Case #12.

Additional Examples:

1) Betty transfers her transferable interest to Henry. Henry tells Betty’s

partners that he is now their partner and that he wants to inspect the

partnership’s books and records. Must Betty’s partners allow this? No.

Henry will be allowed to receive Betty’s distributions, but he is not a

partner and cannot inspect the books.

2) Betty’s partners refuse to allow her to participate in the management of the

partnership after her transfer. This is wrongful, unless Betty’s partners

have voted unanimously to expel her as a partner.

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Chapter 37 – Introduction to Forms of Business and Formation of Partnerships

IV. RECOMMENDED REFERENCES:

A. Gregory, Hornbook on the Law of Agency and Partnership (3rd ed. 2001).

B. Henn, Agency-Partnership and Other Unincorporated Business Enterprises (1972).

Liberally supplied with actual case excerpts and additional examples.

C. Hynes & Loewenstein, Agency, Partnership, and the LLC in a Nutshell (4th ed. 2008).

D. Jamison, Kulsrud, Curry, & Stephenson, 2015 Multistate Tax Guide to Pass-Through

Entities (2015). A new edition is published every year.

E. Kleinberger, Examples & Explanations: Agency, Partnerships, and LLCs (4th ed.

2011).

F. Rothenberg & Melnikova, Comparative Forms of Doing Business in Russia and New

York State—Proprietorships, Partnerships, and Limited Partnerships, 40 AM. BUS. L

J. 563 (2003).

G. Shade, Business Organizations in a Nutshell (3rd ed. 2009).

H. Sullivan & Callison, Partnership Law and Practice: General and Limited

Partnerships (2014-2015). A regularly updated treatise.

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