Alternatives to Incorporation for Persons in Quest of Profit: The Limited Partnership with a Corporate General Partner
Bachelor Thesis 2006 26 Pages
Table of Contents
II. The Limited Partnership
A. Description of the Limited Partnership
B. Historic Development
C. Taxation of the Limited Partnership
III. The Limited Partnership with a Corporate General Partner
A. Development of the Corporate General Partners
B. Control Liability of the Limited Partners – the Main Cases
1. Delaney v. Fidelity Lease
2. Frigidaire Sales Corp. v. Union Properties
IV. Reasons for the Unpopularity of the Limited Partnership with a Corporate General Partner
A. Uncertain Legality
B. Uncertain Law Pertaining to Liability of Limited Partners
C. Diminishing Taxation Advantages
D. New and Better Alternatives
1. The Limited Liability Company
2. The Limited Liability Limited Partnership
American company law traditionally offered a group of businessmen in quest of profit only two choices of business associations: a corporation or a partnership. Both forms have their advantages and disadvantages that depend upon various factors: the size of the envisaged business, its riskiness, capital requirements, need for a separation of ownership and management, liability, desired life of the venture, and transferability of share interests. The partnership has generally been used for smaller enterprises associated with less risk and capital requirements. The corporate form gives businessmen the opportunity to conduct risky business affairs with respect to potential tort liability as well as default risk without being exposed to unlimited personal liability because only the assets of the corporation can be used to satisfy claims. The benefit of limited liability came at the price of disadvantageous double taxation because, unlike a partnership, a corporation has been viewed as an independent entity and its income has consequently been taxed on the corporation’s as well as the shareholders’ level. This has driven smart entrepreneurs to conduct their business affairs in form of a hybrid entity, a combination of a partnership and a corporation, the limited partnership with a corporate general partner. In that form a corporation is the (sole) general partner of a limited partnership which results in limited liability for the owners and managers of this hybrid entity and the advantage of the preferential tax treatment of a partnership. Thus, this entity allows combining the benefits of a corporation and a partnership while reducing their shortcomings. In the beginning the legality of this new form was disputed among academics and courts alike. However, over the course of the past four decades new laws have been enacted that explicitly allow this hybrid form and gradually more limited partnerships have been created with a corporation as their sole limited partner. After the legality of the hybrid form was resolved, the liability of limited partners who started to take part in the control of the limited partnership was the main issue which was later on also decided favorably for the limited partners/investors. Surprisingly however, contrary to other countries where similar forms were legally allowed, the limited partnership with a corporate general partner has not significantly influenced the corporate world in the United States and its utilization has largely been confined to certain industry sectors. Instead, new forms of business associations with similar characteristics (among them most importantly limited liability and preferential tax treatment) have evolved and gained importance.
The goal of this paper is to illustrate the development of the limited partnership with a corporate general partner in the United States over the past four decades and to analyze its advantages and disadvantages. The paper centers on the two main factors that have shaped this form – the recognition of limited liability for its managers and the tax treatment of the limited partnership. For this purpose, the law of the limited partnership will first be described in order to put the reader in the position to evaluate the characteristics of the limited partnership with a corporate general partner more clearly as most of the law, which governs the hybrid entity, stems from the limited partnership. Although this paper is not concerned with details of taxation, I will show the development of the tax treatment of the limited partnership in this chapter as well because tax law has been a major influential factor. Secondly, the development of the hybrid form will be illustrated by means of the pertinent cases and statutory provisions. In this chapter I will focus on the most controversial issue about the hybrid form, the control rule: Do limited partners incur personal liability upon participating in the management of the corporate general partner? In the last chapter, I will elaborate on factors that have contributed to the relative unpopularity of the hybrid form in the United States.
It is important to keep in mind that all law on partnerships in the United States is determined by the individual states and there is no federal regulation as long as antitrust issues and security regulations do not come into play. Most of the law on partnerships is unified through the adoption of uniform acts by each state. In the analysis I will not focus on the various adaptations of the uniform acts but on the rules in the acts themselves. This confinement is helpful and necessary in order to illustrate the prevailing themes of the time and to prevent digressing from the main objectives.
II. The Limited Partnership
A. Description of the Limited Partnership
In the following I will describe the limited partnership by illustrating its features and comparing them to the two main forms, the general partnership and the corporation. The concept of the limited partnership borrows from both forms but also adds unique elements. A partnership is an association of two or more persons who bind themselves together to pursue a joint economic purpose. With respect to partnership law, a “person” may be an individual as well as a legal entity, and the definition explicitly includes corporations. In a general partnership both partners assume joint and several liability for the partnership debts and both are obliged to carry out the business activities. The relationship among the partners is characterized as legal, financial, business, and personal. Limited partnerships resemble general partnerships in many ways. They also involve at least two persons, a general partner and a unique type, a limited partner. Under the Revised Uniform Limited Partnership Act of 1985 (RULPA (1985)), the most widely adopted limited partnership act, natural persons as well as legal entities such as corporations can assume the role of a general or limited partner. The most important distinction between the general and the limited partners is that in contrast to a general partner, who is fully liable for the partnership obligations, the limited partner’s liability for partnership obligations is limited to his agreed upon capital contribution. The purpose of the limited partnership is to give passive investors (the limited partners) the chance to contribute capital to a business and to benefit from its profitability without requiring them to actively engage in the management and fearing joint and several liability for all debts. This rather straightforward separation of a general partner and a limited partner becomes blurred when a general partner also holds an interest in the partnership as a limited partner which is permissible under RULPA (1985) and the Uniform Limited Partnership Act of 1916 (ULPA (1916)). As the limited partners are passive and often numerous, mostly only a financial and no personal relationship exists between them and the general partners. This makes them similar to preferred shareholders of a corporation as both have priority regarding distribution of the business’s profits. Additionally, a limited partnership, in contrast to a general partnership, calls for greater formality and publicity. General partnerships can be created simply by conduct, whereas a limited partnership needs to be registered with its “home state” and every state, where it wishes to do business in, in order to have its limited liability recognized. Partnership interests are, in addition to limited partnership law, also governed by securities law which imposes disclosure requirements and other regulations on limited partnerships. They are also much more rigid in structure as the distribution of profits and required capital contributions are highly regulated in the partnership certificate to prevent moral hazards. Besides, the limited partnership is much less easily resolved, the limited partners have little ability to do so and the general partners’ ability is often restricted in the partnership agreement. For taxation purposes, limited partnerships and general partnerships are treated equally today because they both qualify for the preferential pass through income taxation which means that the partnership income (profit and loss) is not taxed on the entity level but is instead directly attributed (added or deducted) to the taxable income of each general and limited partner and then taxed at his personal tax rate.
When comparing the features of a limited partnership to a corporation, one sees striking differences. One significant distinction between a corporation and a partnership lies in the tax treatment. Corporations under Subchapter C of the Internal Revenue Code pay taxes on their profits and cannot deduct dividend payments from their taxable income. Upon disgorgement of these profits to the shareholders, the dividends are taxed again by the shareholder at his personal income tax rate which effectively leads to a double taxation of the profits. A structural difference is that the hierarchy is not so pronounced in a limited partnership (lack of board of directors and officers), as there is only one level of management, the general partners. They enjoy a much higher degree of independency than the board and the officers. They are required to manage the partnership, their withdrawal can cause its dissolution, and they are not elected for a specified term but serve as long as they maintain their status as general partners. To account for that powerful position of the general partners, limited partners also enjoy better protection than shareholders. Similar to directors, general partners also owe fiduciary duties to the partnership and the limited partners. Depending on the partnership agreement, limited partners may also bring derivative suits on behalf of the partnership against errant management and they may have a right to access important information concerning the partnership. Some partnership agreements also allow limited partners to vote on important business matters such as the sale of substantially all assets, or give limited partners the right to exclude inapt general partners. Most importantly and distinctively, however, limited partners are effectively protected from exploitation by an alignment of interest. As general partners are personally liable, they have a strong incentive to conduct transactions only if they are beneficial for the partnership. Contrary to officers, their personal wealth is at stake in a case of malperformance.
B. Historic Development
As I have shown above, the limited partnership combines various elements of the general partnership and the corporation. The modern form of a limited partnership has evolved as a result of an interesting development which began in the middle ages. At that time, just as today, businesses have required capital and decent management to succeed. A person who was a good manager might not have been equipped with enough capital to run the business so that he had to find others willing to contribute to his business. Traditionally, contributions could only be made as loans with a fixed interest rate. Because usury laws restricted the interest rate some lenders yearned for more flexibility concerning their rate of return. That need gave rise to the modern corporation in the 19th century but much earlier, in the middle ages, also to the commenda, the early form of the limited partnership. Experiencing a similar need of investors, New York was the first state to adopt a limited partnership statute based on the French Code de Commerce in 1822. Many states followed New York subsequently and adopted similar statutes. It was expected that the chance to form a limited partnership encouraged investment because people seeking to invest their funds were not deterred by potential personal liability. At this time, the general partnership was known to the common law (referred to as “ordinary partnership”) but the limited partnership was solely a creation of the legislation. This lead to a very narrow interpretation of the statutes, which, moreover, also contained several harsh restrictions. Consequently, the law was very unpredictable and the limited partnership formed under the New York Act of 1822 (and its progeny) very unattractive and unpopular.
The abovementioned disadvantages of the New York Act of 1822 led the way to ULPA (1916) which was drafted to improve the attractiveness of the limited partnership. The drafters explained their intentions by stating their assumptions: “No public policy justifies imposing personal liability on a person with little control over the business and without creditors believing that the person is liable.” Businesses should also be able to obtain financing from others in exchange for an ownership right if the contributors do not compete with creditors for the assets of the business. In accordance with these principles ULPA (1916) restricted possible personal liability for a limited partner by making substantial compliance with formation formalities sufficient, required reliance on the part of the creditors on false statements in the partnership certificate in order to find a limited partner personally liable, and rejected the proposition that all rules that do not originate from the common law ought to be narrowly interpreted. Further features of the 1916 Act gave flexibility by allowing cash or property contributions and permitting structural changes. But one important restriction remained: a limited partner must not participate in the control of the business or else he will be treated as a general partner and become fully liable. That issue became important when the first limited partnerships with corporate general partners as their sole general partners were created, as ULPA (1916) was the law that was adopted by most states at the time the limited partnership with a corporate general partner was born.
ULPA (1916) was soon widely adopted among all states with minor modifications and, therefore, largely succeeded in creating a unified law governing the limited partnership. ULPA (1916) was modified and replaced by the Revised Uniform Limited Partnership Act in 1976 (RULPA 1976) and 1985 and the Revision of Uniform Limited Partnership Act of 2001 (ULPA (2001)). Unlike the intention of the drafters of ULPA (1916) to make the limited partnership more attractive, the main purpose of RULPA (1976) was to render it less attractive because of its widespread use as a tax shelter device. Limited partnerships were used in the oil & gas, real estate, and shipping businesses with thousands of limited partners. Interests of partnerships were sold on markets just like shares but with the additional benefit of tax deductibility of the partnership losses. Furthermore, RULPA (1976) also limited the liability of a limited partner who participates in the management of the partnership by requiring a higher level of participation and by listing activities that a limited partner may do without taking part in control. Moreover, the Act also required that the person, with whom the limited partner transacted, had actual knowledge of the limited partner’s participation in control. However, that knowledge was not necessary in order to find a limited partner liable for the partnership obligation “if the limited partner’s participation in control of the business is … substantially the same as the exercise of the powers of a general partner.” This language is ambiguous and vague and, therefore, complicated the interpretation of that provision.
RULPA (1985) further increased the safe harbor list and abolished the vague language of its predecessor. Under RULPA (1985) a limited partner could be found liable only if he participated in the control of the business and if the other person, who transacts with the partnership, could “reasonably believe, based upon the limited partner’s conduct, that the limited partner is a general partner”. Among many other activities the safe harbor list was most importantly expanded to include “being an officer, director, or shareholder of a general partner that is a corporation”. This is a direct response from the legislator to the conflicting decisions of the Supreme Court of Texas and the Supreme Court of Washington, effectively following the Supreme Court of Washington. Therefore, RULPA (1985) makes it very clear that a limited partnership with a corporate general partner does not impose personal liability on the directors and officers of the corporate general partner even if they are also limited partners. These changes were triggered by the perception of the legislator that “it is not sound public policy to hold a limited partner […] liable for the obligations of the partnership except to persons who have done business with the limited partnership reasonably believing, based on the limited partner’s conduct, that he is a general partner.” The newest act, ULPA (2001), totally disposed of the limited partners’ control liability. Thus far, ULPA (2001) has only been adopted by two states (Missouri and Georgia) and their versions have in fact eliminated the control rule for limited partners. That means that limited partners of limited partnerships formed under this law do not become liable even if they exercise control over the enterprise.
 See William T. Allen & Reinier Kraakman, Commentaries and Cases on the Law of Business Organizations 81 (2003) for a good introduction to the corporation.
 See Peter Hay, Law of the United States 228-30 (2002) for a concise introduction to US partnership law.
 This general rule holds in the absence of special circumstances that give rise to the possibility of piercing the corporate veil to satisfy creditors and tort victims. Special circumstances arise when the corporate form was used to perpetuate fraud. There are no strict guidelines when the corporate veil may be pierced, for a collection of important cases on veil-piercing, see Allen & Kraakman, supra note 1, at 147-61.
 The main exception to this is Louisiana, the only state with a civil law system and its own form of the limited partnership, the partnership in commendam. The peculiarities of this exception are too large to be covered in this essay; therefore, I will confine my analysis to the common law form of the limited partnership.
 Unif. Partnership Act of 1914 (UPA) § 6(1); Revised Unif. Partnership Act of 1996 (RUPA) § 202(a).
 UPA § 2 (1914), RUPA § 101(10) (1996).
 UPA § 15(a) (1914).
 See UPA § 8 (1914) in connection with §35.
 See Alan R. Bromberg & Larry E. Ribstein, Bromberg and Ribstein on Partnership 11:4 (2005 ed.).
 See Bromberg & Ribstein, supra note 9, at 11:4.
 It further includes partnerships, limited partnerships, trusts, estates, and associations. See RULPA § 101(11) (1985).
 RULPA § 303(a) (1985).
 See F. Hodge O’Neal, Comments on Recent Developments in Limited Partnership Law, 1978 Wash. U. L.Q. 669, 669 (1978).
 ULPA § 12 (1916) and RULPA § 404 (1985) (stating that a dual limited and general partner has the characteristics of a general partner).
 In 1979, all partnerships had an average of 5.07 members whereas limited partnerships had 17.28 members; in 1987, the spread increased so that the respective figures were 10.42 and 43.98. See Susan Nelson & Tom Petska, Partnerships, Passive Losses, and Tax Reform in Internal Revenue Service, Statistics of Income Division, Statistics of Income and Related Administrative Record Research 1988 – 1989, 251, 252.
 See Peter C. Kostant, Business Organizations 49 (1996).
 See Bromberg & Ribstein, supra note 9, at 11:4–11:5.
 See Mike Allison, The Limited Partnership with a Corporate General Partner – Federal Taxation – Partnership or Association?, 24 Sw. L. J. 285, 286 (1970). Also see discussion infra Part II.C for a more detailed analysis of the partnership taxation.
 I.R.C. § 7704(a) (2006); Treas. Reg. § 301.7701-2(b)(7); Allen & Kraakman, supra note 1, at 73.
 The relatively new Job and Growth Tax Relief Reconciliation Act of 2003 reduced the tax rate on dividends to 15%. See Mark Sargent & Walter Schwidetzky, Limited Liability Company Handbook, Law-Sample Documents-Forms, 2004-2005 12 (2004-2005).
 See RULPA § 801(4) (1985) for a detailed description of the dissolution of a partnership in case of a withdrawal of a general partner.
 See Bromberg & Ribstein, supra note 9, at 11:6.
 The duties originate from RUPA § 404(a) (1996). See Uta Karen Klawitter, Die GmbH & Co. KG im U.S.-amerikanischen Recht: (Limited Partnership with a Corporate General Partner) 94-95 (1997).
 See Bromberg & Ribstein, supra note 9, at 11:6.
 See id.
 See Nathan W. Drage, Are Limited Partnership Interests Securities? A Different Conclusion Under the California Limited Partnership Act, 18 Pac. L. J. 125, 151 (1986-87).
 See Norman Abrams, Imposing Liability for “Control” under Section 7 of the Uniform Limited Partnership Act, 28 Case W. Res. L. Rev. 785, 788 n.10 (1978).
 See Lewis Haney, Business Organization and Combination 58-59 (1928).
 Limited partners had to be wary of being found personally liable by a court for minor violations of the statute, misrepresentations on the partnership certificate, or when becoming active in the management of the partnership. It even sufficed if one limited partner out of many in a partnership misstated the value of his contributions in order to render all limited partners fully liable as general partners. See also Klawitter, supra note 23, at 62.
 See Drage, supra note 26, at 152.
 Official Comment to ULPA § 1, 6 ULA 564 (1969).
 See id.
 ULPA § 2(2) (1916).
 ULPA § 6 (1916).
 ULPA § 28(1) (1916).
 ULPA § 2(1)(a)(VI) (1916).
 ULPA § 24 (1916).
 See discussion infra Part III.A.
 See Larry E. Ribstein, Unincorporated Business Entities 282 (1996).
 See Bromberg & Ribstein, supra note 9, at 11:26. The tax deductibility of partnership losses for partnerships that were publicly traded was severely curtailed with the Tax Reform Act of 1986.
 See RULPA § 303(b) (1976). This list is referred to as a “safe harbor” for limited partners.
 RULPA § 303(a) (1976).
 RULPA § 303(a) (1985).
 RULPA § 303(b) (1985).
 Delaney v. Fidelity Lease, Ltd., 517 S.W.2d 420 (Tex. App. 1974), rev’d in part, 526 S.W.2d 543 (Tex. 1975).
 Frigidaire Sales Corporation v. Union Properties, 88 Wn.2d 400 (1977). See discussion infra Part III.B for a detailed analysis of the two leading cases.
 Comment to RULPA § 303 (1985).
 See ULPA § 303 (2001) (“A limited partner is not personally liable, directly or indirectly, by way of contribution or otherwise, for an obligation of the limited partnership solely by reason of being a limited partner, even if the limited partner participates in the management and control of the limited partnership.”).
 See Ga. Code Ann. § 14-9-303; Mo. Rev. Stat. § 359.201.
 See Alan R. Bromberg & Larry E. Ribstein, Bromberg and Ribstein on Limited Liability Partnerships, The Revised Uniform Partnership Act, and The Uniform Limited Partnership Act (2001) 196 (2005 ed.).