Questions & Answers Series

Business Associations Topics: Choice of Corporate Entity and Formation; Limited Partnerships; Partnerships vs. Joint Ventures

Choice of Corporate Entity and Formation

Question:

Reed Bailey practices law with six partners in a boutique litigation firm. Last year Reed got hit with a malpractice claim in which the settlement exceeded the group's malpractice policy limits. Each partner had to chip in $40,000. They do not wish to see that happen again.

What alternatives do they have?

(A) Remain a partnership because the bar association rules require it.

(B) Form a corporation and elect subchapter S.

(C) Form a professional service corporation.

(D) Form a limited partnership with Reed as the general partner.

Answer:

Answer (C) is the best answer. Beginning in the 1960s, most states adopted professional service corporation acts. Generally, anyone required to be licensed (physician, lawyer, accountant, cosmetologist, dentist, veterinarian, etc.) incorporates under that act rather than under the general business corporation law. All shareholders and directors must be members in good standing of the same profession (except architects and structural engineers). Two disparate professions (surgeon and undertaker) cannot combine. The active business of the corporation must be limited to the carrying on of the profession. Passive business investments (e.g., owing real estate or stocks and bonds) are permitted. The incorporated professional or professionals must place a special appellation ("PS" or "PC" are common) after the corporate name.

The acts dealt with the malpractice liability issue in one of two ways. Some acts provided that with regard to rendition of the professional service there would be no limited liability. Other acts remained silent on the theory that if professionals abused the privilege of incorporation, say, by practicing without malpractice insurance, courts would pierce the corporate veil to hold the professionals personally liable as the owners of the enterprise.

Answer (A) is incorrect. Partners are liable for the acts of every other partner for carrying on in the usual way the business of the partnership. Bar Associations used to require complete financial responsibility for each and every lawyer in a group practice. Lawyers did that by practicing law together in a partnership. Today, while lawyers may have to be financially responsible for one another, they may accomplish that in ways other than remaining in a general partnership and being personally liable.

Answers (B) and (D) are not the best answers for the reasons stated above.

Limited Partnerships

Question:

Your friend Evelyn is a law librarian who, over the years, has been a persistent real estate investor. She does not own real estate directly. Rather she has purchased units of participation in limited partnerships that, in turn, purchased a number of commercial and multi-family real estate developments.

Evelyn has decided to take early retirement. She intends to move to Sun Valley, Idaho, and become a professional snowboarder. She wishes to cash in her units of participation to raise cash to purchase a Hummer and a condominium at Elkhorn, near Sun Valley.

She seeks your advice. What do you tell her?

Answer:

One difficulty is that limited partnership interests are extremely illiquid. There are firms that stand willing to purchase some limited partnership interests, but at a deep discount from probable market value. Usually, there is no market in which to sell your interest to another investor. Illiquidity makes partners' dissolution rights doubly important. RULPA [Revised Uniform Limited Partnership Act] § 603 provides that a limited partner may withdraw on six months' notice to the general partner, absent a contrary agreement. Under RULPA § 604, the withdrawing partner must be paid any distributions to which she is entitled and, if not otherwise provided in the agreement, the fair value of her interest in the partnership. Those are the default rules. Usually (but not always - so it is worth checking each of Evelyn's agreements), the limited partnership agreement "provides otherwise." The agreement may provide for sale of the real estate after a holding of so many years, e.g., ten years, followed by a distribution. There may also be provision for dissolution by a vote of a majority, or a super majority, of the units of participation. If the partnership is a smaller, local "deal," perhaps Evelyn can procure the requisite vote. Overall, however, I am afraid that, after examining the agreements, I will have to tell her that it is a patchwork. She will obtain liquidity only over time. 

Partnerships vs. Joint Ventures

Question:

Liam and Clare each own an Irish pub in City X. To cash in on the microbrew craze, Liam and Clare wish to go together to establish a small microbrewery that will supply two or three locally brewed beers to each pub. The brewery will be located off site, in the industrial section of City X. The premises will be leased.

If Liam and Clare do nothing more than jointly sign the lease, hire the brewmeister, and purchase supplies and equipment, their new enterprise will be:

(A) A partnership.

(B) A joint venture.

(C) A limited liability company.

(D) Both (A) and (B).

Answer:

Answer (D) is the best answer. A joint venture is the association of two or more persons or entities in business for a limited purpose and normally involves a less than total merging of the business interests and assets of the venturers. That has happened here, so Answer (B) is a correct answer, though not the best answer. Strictly, speaking, however, a joint venture is not a form of business organization itself. It must assume a form. For example, if two large forest products companies jointly build, say, a paper mill costing hundreds of millions of dollars, they may form a corporation, with joint control of the board of directors, or, today, a limited liability company (LLC). The corporation or LLC would hold title to and operate the paper mill.

If, however, the co-venturers (Liam and Clare) take no affirmative steps to form a business organization such as a corporation or an LLC, their joint venture will be a partnership at will ("an association of two or more persons to carry on as co-owners a business for profit," UPA [Uniform Partnership Act] § 6(1); RUPA [Revised Uniform Partnership Act] § 202(a)). Thus, Answer (A) is a correct answer. But, the best answer is Answer (D) (both Answers (A) and (B)). 

The scope of each co-venturer's authority to bind the enterprise will be limited by the scope of the venture. In Matanuska Valley Bank v. Arnold, 223 F.2d 778 (9th Cir. 1955), Arnold supplied money, borrowed from the bank, and Davis acted as contractor in building a house. Unbeknownst to Arnold, Davis went to the bank, borrowing more money, ostensibly to build another house, but using the money for personal purposes. When the bank sought to hold Ms. Arnold liable, the court refused to hold Ms. Arnold responsible, even though under general partnership law "[e]very partner is the agent of the partnership for the purpose of its business, and the act of every partner .… for apparently carrying on in the usual way the business of the partnership of which he is a member binds the partnership ...." UPA § 9(1)…." RUPA § 301(1) is similar: "Every partner is the agent of the partnership for the purpose of its business."

Davis, as a joint venturer, did not have the general implied authority of a partner in an ordinary trading or commercial partnership. His authority was limited to the scope of the venture, that is, building one house. Answer (C) is incorrect, as Liam and Clare have taken none of the formal steps, such as filing with a state official, to form a limited liability company.