Chapter 38 Limited Liability Companies and Limited Partnerships

Introduction Limited liability companies are relatively new creatures of state statute. An LLC is a hybrid entity that combines the limited liability of a corporation and the tax advantages of a partnership. LLC’s are increasingly become the entity of choice for businesses.

§ 1: LLC’s 1997 IRS rules provide that any unincorporated business (including LLC’s) will automatically be taxed as a partnership unless otherwise indicated on the tax return. LLC’s are attractive in today’s global business environment because they allow foreign investors to own interests.

LLC Formation Like corporations, LLC’s are creatures of state law. The owners are called “members” (not shareholders) and their ownership is called an “interest” (not shares). LLC’s are formed by filing articles of organization with the Secretary of State. (see LLC rules at Texas Secretary of State).Texas Secretary of State

LLC Formation [2] Articles of Organization require: Name of Business. Principal Address. Name and Address of Registered Agent. Names of the Owners; and How the LLC will be managed. Business name must include LLC or Limited Liability Company.

LLC Citizenship An LLC is a legal entity separate from its owners. For federal jurisdiction based on diversity, an LLC may be treated differently than a corporation. For diversity purposes the citizenship of an LLC is the citizenship of its members, which may live in multiple jurisdictions.

LLC Advantages & Disadvantages AdvantagesDisadvantages Member liability is limited to amount of investment. State statutes are not uniform. Can be treated as a “pass through” entity for tax purposes. Not all states recognize LLC’s. Profits can be distributed to members without the double taxation of a corporation. Members pay personal income tax on received dividends.

LLC Operating Agreement Operating agreement is analogous to corporation’s bylaws. Operating agreements may be oral and contain provisions relating to management, dividends, meetings, transfer of membership interests, and other significant issues. Generally, if the operating agreement is silent, courts will apply partnership principles.

LLC Management There are two options for management, generally set forth in the articles of organization: Member-Managed: all of the members participate in management, like a partnership. Manager-Managed: members are elected to manage the LLC. If the articles are silent, statutes provide either that each member has one vote or votes are made based on percentage of ownership.

§ 2: LLP’s Creature of state statute, similar to an LLC except that an LLP is designed for professionals who normally do business as a partnership (lawyers and accountants). LLP allows partnership to limit personal liability of the partners but allows “pass through” tax advantages.

LLP Liability Recall that partnership law makes all partners jointly and severally for another partner’s tort, including personal assets. The LLP allows professionals to avoid personal liability for the malpractice of other partners. Supervising Partner is also liable for acts of subordinate.

Family Limited Liability Partnerships FLLP is a limited liability partnership in which the majority of the partners are related to each other. Used frequently for agriculture.

§ 3: Limited Partnerships Entity that limits the liability of some of its owners (the limited partners). Creature of state statute. Filing a certificate with the Secretary of State is required.Filing a certificate with the Secretary of State is required. Agreement of two or more persons to carry on a business for profit with at least one general partner and one limited partner.

Limited Partnerships The General partner assumes all management and personal liability. Limited Partner contributes cash but has no management rights. Liability is limited to the amount of investment. A limited partner can forfeit this “veil” of immunity by taking part in the management of the LP.

Rights and Liabilities of LP General partners are personally liable to 3 rd parties for breach of contract and tort liability. However, a corporation (or an LLC) can be a general partner and have limited liability. Limited partners have the right to inspect the LP’s books and be informed of the LP’s business.

Rights and Duties of the LP [2] On dissolution, the limited partner is entitled to return of capital contributions. LP interests are considered securities and regulated by both federal and state securities laws. Limited partners’ liability is limited to the capital investment.

LP Management Only General Partners can manage but they have a fiduciary obligation to LP’s. LP’s enjoy limited liability as long as they do not engage in management functions. An LP will be liable to a 3 rd party if the 3 rd party believes, based on conduct, that the LP is a general partner.

Dissolution of the LP Dissolved in much the same way as a general partnership (Chapter 33). Retirement, withdrawal, death bankruptcy or mental incompetence of a general partner will trigger dissolution unless the remaining GP’s consent to continue. Creditors are paid first then partners.

§ 4: LLLP’s Limited Liability Limited Partnership is a type of limited partnership. Difference between LP and LLLP is that the general partner has limited liability, like a limited partner, up to the amount of investment. Most states do not allow for LLLP’s.

Case 38.1: Skywizard.com, LLC v. Computer Personalities, Inc. (LLC Formation) FACTS: Skywizard.com, an ISP, entered into an agreement with Computer Personalities Systems, Inc. (CPSI), a computer retailer. CPSI agreed that beginning September 1, it would run, a “special promotion,” one weekend per month so that a a customer who bought a specified computer would receive a year’s free Internet service through Skywizard. For each computer sold under this promotion, CPSI agreed to pay Skywizard $79.

FACTS (cont’d) By March 2000, most of the ISP’s subscribers were people who had bought computers through CPSI, including about a third of those who bought the “special promotion” computers. CPSI failed to run the promotion on September 1, and Skywizard sued for breach of contract. HELD: FOR SKYWIZARD. $ However, damages could not be determined due to the newness of the business. The court held that CPSI breached the contract but that damages could not be determined. Case 38.1: Skywizard.com, LLC v. Computer Personalities, Inc. (LLC Formation)

Case 38.2: Hurwitz v. Padden (LLC Operating Agreement) FACTS: Hurwitz and Padden formed a law firm as a partnership without a written agreement. They shared all proceeds on a fifty ‑ fifty basis and reported all income as partnership income. Later, Hurwitz filed articles with the state to establish the firm as an LLC. More than three years later, Padden told Hurwitz that he wanted to dissolve their professional relationship. They failed to resolve a division of fees from several of the firm’s cases. Hurwitz sued, seeking a distribution of the fees on a fifty-fifty basis.

HELD: FOR HURWITZ. The court applied partnership law and entered a judgment in favor of Hurwitz. The state LLC act specifically incorporated the definition and use of the term “dissolution” from the Uniform Partnership Act (UPA). The firm had no written agreement regarding the division of receipts before or on dissolution, the disputed fees related to work acquired before the dissolution, and before the dissolution, the firm divided receipts equally between the parties. Case 38.2: Hurwitz v. Padden (LLC Operating Agreement)

Case 38.3: Miller v. Dept. of Revenue (Formation of Limited Partnership) FACTS: Loverin and Miller formed an LP and bought a low- income housing project and retained Rockwood Development Corporation to manage it. Loverin and Miller were the general partners and Rockwood the only limited partner/ The certificate allocated 2 percent of the profits/losses to Loverin and Miller and 98 percent to the limited partners. Eventually 21 other limited partners invested, but none signed the articles or the certificate.

FACTS (cont’d): American Properties Corporation (APC) replaced Rockwood, and Loverin, Miller, and the president of APC signed a document that purported to amend the articles. The document provided that the partners could reallocate profits and losses as they “may agree.” On their income tax returns, Loverin and Miller allocated 99.9 percent of the losses to themselves. Oregon Department of Revenue reallocated the losses according to the provisions in the original articles—2 percent to general partners and 98 percent to limited partners. Miller sued. Case 38.3: Miller v. Dept. of Revenue (Formation of Limited Partnership)

HELD: AGAINST MILLER. “There is no evidence in this record that the amended articles were signed by the 21 limited partners” other than APC. Without those signatures, the amended articles were not effective, and Loverin and Miller could not rely on them to allocate profits and losses. Case 38.3: Miller v. Dept. of Revenue (Formation of Limited Partnership)

Case 38.4: BT-I v. Equitable Life Insurance (Limited Partners and Management) FACTS: BT ‑ I and Equitable entered into a limited partnership to develop and operate an office building and retail complex. BT-I was the limited partner, and Equitable was the general partner with the sole right to manage the firm. Banque Paribas lent the firm $62.5 million and Equitable bought it for $38.5 million. On the due date, Equitable demanded full payment from the partnership, but none was made and foreclosure resulted. BT-I sued Equitable claiming breach of fiduciary duty.

HELD: FOR BT-I. A general partner of a limited partnership is subject to the same restrictions, and has the same liabilities to the partnership and other partners, as in a general partnership. Equitable’s conduct in buying and foreclosing the loans went far beyond whatever safe harbor might be found in the partnership agreement. Equitable was still a fiduciary, and its conduct must be measured by fiduciary standards. Case 38.4: BT-I v. Equitable Life Insurance (Limited Partners and Management)