Chapter 13 Choice of Business Entity, Sole Proprietorship, and Partnerships McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Overview The factors to be considered in determining what business form fits which types of business. Fundamental principles of the law governing sole proprietorships. Legal regulation for formation and governance of partnerships including personal liability of partnerships for business debts and other liabilities. Rules governing the separation of partners from the partnership and procedures for dissolving a partnership.

CHOOSING A BUSINESS ENTITY Formation Liability Capitalization Taxation Management Operation Succession

Sole Proprietorships Ease of formation and maintenance makes this entity a popular choice. Sole proprietorships are typically capitalized using a proprietor’s personal resources or through a private or commercial loan that is secured by the proprietor’s personal assets.

Sole Proprietorships A sole proprietorship business is not subject to corporate income taxation and no tax return is filed on behalf of the business. The chief drawback to this form of entity is a complete lack of protection of the principal’s personal assets for unpaid debts and liabilities of the business.

Partnerships An entity with more than one principal has a number of additional choices. The simplest multiple-person business entity is a partnership.

General Partnerships Unlike most business entities, general partnerships are not created by filing a form with a government agency. Instead, the law recognizes two or more principals as being a general partnership if they have demonstrated an intent to carry on as co-owners of a business for profit.

Formation of a GP Fundamentally, a general partnership is: (1) an association of two or more people/entities, (2) who are co-owners/co-managers, and (3) share in the profits of an ongoing business operation. These partnerships typically use the designation GP at the end of their business name to signify the general partnership as their form of entity.

Liability of the Partners General partners have no protection of their personal assets for unpaid debts and liabilities of the partnership. The RUPA imposes additional liability on general partners who are jointly and severally liable. This means that general partners’ personal assets are at risk both together (jointly) and separately (severally) for all debts and liabilities of the partnership regardless of the source of the debt or liability.

Capitalization General partnerships are generally funded through debt (borrowing money), or Selling of equity (selling a percentage of ownership rights in the partnership). Partnerships may not, however, sell ownership rights (stock) through the public markets .

Taxation of Partnership and Principals Just as in the case of a sole proprietorship, a partnership is a pass-through entity. This means that the partnership entity pays no level of corporate tax. Rather, profits are taxed after they pass through the business and are distributed to the individual partners.

Operation and Management of the Partnership Absent an agreement by the parties, the RUPA governs certain internal operations of the general partnership. For example, unless the parties agree otherwise: each partner receives an equal share of the partnership profit payments regardless of the partner’s involvement in the success of the business, the same rule applies to losses, general partners have the general power to bind the partnership to a contractual obligation.

Fiduciary Obligations RUPA sets out these duties as threefold: (1) loyalty, (2) care, and (3) good faith.

Limited Partnerships An entity that exists by a state statute that recognizes one or more principals as general partners managing the business enterprise with unlimited liability. Limited partners normally participate only in terms of contributing capital or property, and have limited liability.

Formation of LP A limited partnership is formed by the general partner filing a certificate of limited partnership with the state government authority (usually in the secretary of state’s office).

Personal Liability of Principals Each general partner in a limited partnership is personally liable for all of the partnership’s debts and liabilities. Limited partners do not have the same automatic personal liability of a general partner, it is limited to whatever the limited partner contributed to the partnership.

Capitalization Limited partnerships are generally funded through either debt (borrowing money), or Selling of equity (selling a percentage of ownership rights in the partnership and any profits of the business).

Taxation of Partners Limited partnerships are pass-through entities just like general partnerships. The same rules apply for taxation as in a general partnership.

Management and Operation Under the RULPA, limited partners may engage in consulting and contribute expertise, but may not engage in management activities such as supervision of employees.

Clancy v. King, 936 A.2d 852 (Md. 2008) Duty of good faith and fair dealing underlie the actions of the partners. The court defined an act of bad faith as an act where a primary motivator of the partner’s conduct is to injure either the firm’s value or other partners. Under the doctrine of good faith, a partner impliedly promises to refrain from conduct that will harm the partnership and other partners.

Family Limited Partnerships A family limited partnership is partnership that is used for estate planning for families of considerable wealth. The legal procedures governing family limited partnership transactions are a very complex area of tax and estate law.

Partner Dissociation and Dissolution of the Partnership When a partner no longer wishes to be a principal in the partnership, she may choose to leave the partnership. The RUPA uses the term dissociation to describe this act of separation while the RULPA uses the term withdrawal.

Dissociation under the RUPA Three events trigger dissociation: (1) voluntary separation from the partnership; (2) expulsion by vote of the other partners; (3) partner can no longer carry out her duties to the partnership or no longer has an economic stake in the business.

Withdrawal under RULPA RULPA sets down default rules for withdrawal of partners if no written agreement. A general partner may withdraw provided that the partnership still has at least one remaining general partner, and the partners (both general and limited) agree in writing to continue. Limited partners are subject to restrictions on withdrawal.

Other Events of Dissolution Once a partnership has reached its agreed upon term (a certain date set out in the filings and/or partnership agreement), or By court order, or In the case of a general partnership, by unanimous consent of the partners.

learning outcomes checklist 13 - 1 Articulate the factors that business owners should consider when selecting a business entity. 13- 2 List the elements required to form a general partnership and the statutory requirements for forming a limited partnership.

learning outcomes checklist 13- 3 Recognize the effect and role of the RUPA for general partnerships and the RULPA for limited partnerships. 13- 4 Identify methods through which sole proprietorships and partnerships may be capitalized (funded).

learning outcomes checklist 13- 5 Distinguish between personal liability for general partners and limited partners. 13- 6 Explain the concept of pass-through taxation. 13- 7 Articulate the consequences of partner separation and dissolution.