42.5 Summary and Exercises

Summary

Between partnerships and corporations lie a variety of hybrid business forms: limited partnerships, sub-S corporations, limited liability companies, limited liability partnerships, and limited liability limited partnerships. These business forms were invented to achieve, as much as possible, the corporate benefits of limited liability, centralized control, and easy transfer of ownership interest with the tax treatment of a partnership.

Limited partnerships were recognized in the early twentieth century and today are governed mostly by the Uniform Limited Partnership Act (ULPA-1985 or ULPA-2001). These entities, not subject to double taxation, are composed of one or more general partners and one or more limited partners. The general partner controls the firm and is liable like a partner in a general partnership (except under ULPA-2001 liability is limited); the limited partners are investors and have little say in the daily operations of the firm. If they get too involved, they lose their status as limited partners (except this is not so under ULPA-2001). The general partner, though, can be a corporation, which finesses the liability problem. A limited partnership comes into existence only when a certificate of limited partnership is filed with the state.

In the mid-twentieth century, Congress was importuned to allow small corporations the benefit of pass-through taxation. It created the sub-S corporation (referring to a section of the IRS code). It affords the benefits of taxation like a partnership and limited liability for its members, but there are several inconvenient limitations on how sub-S corporations can be set up and operate.

The 1990s saw the limited liability company become the entity of choice for many businesspeople. It deftly combines limited liability for all owners—managers and nonmanagers—with pass-through taxation and has none of the restrictions perceived to hobble the sub-S corporate form. Careful crafting of the firm’s bylaws and operating certificate allow it to combine the best of all possible business forms. There remained, though, one fly in the ointment: most states did not allow professionals to form limited liability companies (LLCs).

This last barrier was hurtled with the development of the limited liability partnership. This form, though mostly governed by partnership law, eschews the vicarious liability of nonacting partners for another’s torts, malpractice, or partnership breaches of contract. The extent to which such exoneration from liability presents a moral hazard—allowing bad actors to escape their just liability—is a matter of concern.

Having polished off liability for all owners with the LLC and the LLP, the next logical step occurred when eyes returned to the venerable limited partnership. The invention of the limited liability limited partnership in ULPA-2001 not only abolished the “control test” that made limited partners liable if they got too involved in the firm’s operations but also eliminated the general partner’s liability.

Table 42.1 Comparison of Business Organization Forms

Type of Business Form Formation and Ownership Rules Funding Management Liability Taxes Dissolution
Limited partnership Formal filing of articles of partnership; unlimited number of general and limited partners General and limited partners contribute capital General partner General partner personally liable; limited partners to extent of contributionUnder ULPA-2001, the general partner has limited liability. Flow-through as in partnership Death or termination of general partner, unless otherwise agreed
S corporation Formal filing of articles of incorporation; up to 100 shareholders allowed but only one class of stock Equity (sell stock) or debt funding (issue bonds); members share profits and losses Board of directors, officers Owners not personally liable absent piercing corporate veil (see Chapter 43 "Corporation: General Characteristics and Formation") Flow-through as in partnership Only if limited duration or shareholders vote to dissolve
Limited liability company Formal filing of articles of organization; unlimited “members” Members make capital contributions, share profits and losses Member managed or manager managed Limited liability Flow-through as in partnership. Upon death or bankruptcy, unless otherwise agreed
Limited liability partnership (LLP) Formal filing of articles of LLP Members make capital contributions, share profits and losses All partners or delegated to managing partner Varies, but liability is generally on partnership; nonacting partners have limited liability Flow-through as in partnership Upon death or bankruptcy, unless otherwise agreed
Limited liability limited partnership (LLLP) Formal filing of articles of LLP; choosing LLLP form Same as above Same as above Liability on general partner abolished: all members have limited liability Flow-through as in partnership Same as above

Exercises

  1. Yolanda and Zachary decided to restructure their small bookstore as a limited partnership, called “Y to Z’s Books, LP.” Under their new arrangement, Yolanda contributed a new infusion of $300; she was named the general partner. Zachary contributed $300 also, and he was named the limited partner: Yolanda was to manage the store on Monday, Wednesday, and Friday, and Zachary to manage it on Tuesday, Thursday, and Saturday. Y to Z Books, LP failed to pay $800 owing to Vendor. Moreover, within a few weeks, Y to Z’s Books became insolvent. Who is liable for the damages to Vendor?
  2. What result would be obtained in Exercise 1 if Yolanda and Zachary had formed a limited liability company?
  3. Suppose Yolanda and Zachary had formed a limited liability partnership. What result would be obtained then?
  4. Jacobsen and Kelly agreed to form an LLC. They filled out the appropriate paperwork and mailed it with their check to the secretary of state’s office. However, they made a mistake: instead of sending it to “Boston, MA”—Boston, Massachusetts—they sent it to “Boston, WA”—Boston, Washington. There is a town in Washington State called “Little Boston” that is part of an isolated Indian reservation. The paperwork got to Little Boston but then was much delayed. After two weeks, Jacobsen and Kelly figured the secretary of state in Boston, MA, was simply slow to respond. They began to use their checks, business cards, and invoices labeled “Jacobsen and Kelly, LLC.” They made a contract to construct a wind turbine for Pablo; Kelly did the work but used guy wires that were too small to support the turbine. During a modest wind a week after the turbine’s erection, it crashed into Pablo’s house. The total damages exceeded $35,000. Pablo discovered Jacobsen and Kelly’s LLC was defectively created and sought judgment against them personally. May Pablo proceed against them both personally?
  5. Holden was the manager of and a member of Frost LLLP, an investment firm. In that capacity, he embezzled $30,000 from one of the firm’s clients, Backus. Backus sued the firm and Holden personally, but the latter claimed he was shielded from liability by the firm. Is Holden correct?
  6. Bellamy, Carlisle, and Davidson formed a limited partnership. Bellamy and Carlisle were the general partners and Davidson the limited partner. They contributed capital in the amounts of $100,000, $100,000, and $200,000, respectively, but then could not agree on a profit-sharing formula. At the end of the first year, how should they divide their profits?

Self-Test Questions

  1. Peron and Quinn formed P and Q Limited Partnership. Peron made a capital contribution of $20,000 and became a general partner. Quinn made a capital contribution of $10,000 and became a limited partner. At the end of the first year of operation, a third party sued the partnership and both partners in a tort action. What is the potential liability of Peron and Quinn, respectively?

    1. $20,000 and $10,000
    2. $20,000 and $0
    3. unlimited and $0
    4. unlimited and $10,000
    5. unlimited and unlimited

  2. A limited partnership

    1. comes into existence when a certificate of partnership is filed
    2. always provides limited liability to an investor
    3. gives limited partners a say in the daily operation of the firm
    4. is not likely to be the business form of choice if a limited liability limited partnership option is available
    5. two of these (specify)

  3. Puentes is a limited partner of ABC, LP. He paid $30,000 for his interest and he also loaned the firm $20,000. The firm failed. Upon dissolution and liquidation,

    1. Puentes will get his loan repaid pro rata along with other creditors.
    2. Puentes will get repaid, along with other limited partners, in respect to his capital and loan after all other creditors have been paid.
    3. if any assets remain, the last to be distributed will be the general partners’ profits.
    4. if Puentes holds partnership property as collateral, he can resort to it to satisfy his claim if partnership assets are insufficient to meet creditors’ claims.

  4. Reference to “moral hazard” in conjunction with hybrid business forms gets to what concern?

    1. that general partners in a limited partnership will run the firm for their benefit, not the limited partners’ benefit
    2. that the members of a limited liability company or limited liability partnership will engage in activities that expose themselves to potential liability
    3. that the trend toward limited liability gives bad actors little incentive to behave ethically because the losses caused by their behavior are mostly not borne by them
    4. that too few modern professional partnerships will see any need for malpractice insurance

  5. One of the advantages to the LLC form over the sub-S form is

    1. in the sub-S form, corporate profits are effectively taxed twice.
    2. the sub-S form does not provide “full-shield” insulation of liability for its members.
    3. the LLC cannot have a “manager-manager” form of control, whereas that is common for sub-S corporations.
    4. the LLC form requires fewer formalities in its operation (minutes, annual meetings, etc.).

Self-Test Answers

  1. d
  2. e (that is, a and d)
  3. d (Choice a is wrong because as a secured creditor Puentes can realize on the collateral without regard to other creditors’ payment.)
  4. c
  5. d