Chapter 15



Chapter 15

ENTREPRENEURSHIP,

SOLE PROPRIETORSHIPS,

AND PARTNERSHIPS

What type of business should I choose?

I. Overview

An important objective of this chapter is to introduce students to the law of business entity choices. One of the key roles of attorneys engaged in the practice of modern business law is advising their clients on the selection of the best venue for doing business. What seems like a relatively limited set of options is, in fact, quite extensive. These choices can run the gamut from the simplest lemonade stand set up for a youngster to a multinational publicly-traded corporation.

With each choice, the law provides a list of pros and cons. For example, if a person seeks maximum privacy in his or her financial affairs, a private form of sole proprietorship may be best. Compare, however, the business person who wants to leverage the maximum utilization of other people's money while limiting her personal financial exposure. That person may find the corporate form best suited for her needs.

The law literally has something for everyone. The real issue is first finding out what options are legally available and then choosing the best fit. That fit should be tailored by sound advice from a number of quarters including law, accounting, finance, and business management strategy. It is this constant interdependent equation that makes the practice of business law so difficult yet so interesting. The vast majority of the users of this book may never go to law school. Yet that same majority will be influenced every working day by the business entity law choices made in whatever business pursuits they chose. Many of these choices, like partnerships and corporations, will be explained in the next few chapters.

Take, for example, sole proprietorships, covered in this chapter. It remains the most widely used form of business entity even though it may no longer be the most important in sheer economic terms. With the advent of the so-called "information highway" and more emphasis on entrepreneurial niche marketing of goods and services, this form of business may enjoy a renaissance in the Twenty-First century. As we will see this business choice is easy to form and easy to operate but with several liability disadvantages. See outline below.

One of the key distinctions between the partnership form of doing business and the corporate format is the corporation's ability to have an indefinite or perpetual existence. Under state laws of incorporation, a corporation is allowed to continue its juristic existence in spite of the death of its key players. This is not true with partnerships. A partnership is intrinsically tied to the continuing existence of the partners. Partnerships are literally more personal. When the partner is gone, so too is the partnership.

One of the questions students frequently ask is: how is it that multi-national business organizations, such as large accounting or law firms, stay in business as partnerships when they frequently lose partners through death or through changes in partnership associations? The technical answer is that with each of these changes, the partnership is theoretically ended and a new one is created. In fact, a well-crafted partnership agreement should have, as one of its key components, an orderly process of succession in case of death or termination. Where these circumstances are properly planned for, the transition is seamless, and the life of the partnership goes on.

Most partnerships are not, however, large and multi-national in scale. Most are created and operated by individuals who have sought to capitalize on their respective economic or talent contributions by acting together in the legal sense. These business ventures could be set for a short- term, specific goal, such as erecting a building, or extend to a full professional career such as a licensed practitioner of law, medicine, or accounting. Just like a marriage, the best intentions at the legal altar of partnership do not always work, and the rules of partnership should provide a means of graceful dissolution.

Determination of which business form to choose for a specific venture is not an easy decision. As we saw in the previous chapters each business form has advantages and disadvantages. The partnership, whether general or limited, is no different. The major difference between the two is that a limited partner is merely an investor. General partners are the typical partners and usually have all of the following rights: to share proportionately in profits, return of capital and management; to information; and to an accounting. The advantages and disadvantages of a general partnership are similar to those discussed for a sole proprietorship in the previous chapter. They include:

Advantages: 1. ease of formation

2. single taxation

Disadvantages: 1. unlimited liability

2. poor investment liquidity

3. length of life

4. sharing of control

II. Hypothetical Multi-Issue Essay Question:

Mike Memory decides to start a computer hardware business by opening a shop in the Large Mall in Pennsylvania. Mike agrees to pay Large $500 per week rent and 5% of the profits. The only restrictions imposed by Large are the time and days of opening and closing. After being in business for seven months, Mike defaults on a loan to Happy Bank. Happy , noting that Mike is now broke, attempts to collect from Large claiming that a general partnership exists therefore extending liability to Large. Does a partnership exist between Mike and Large?

III. Outline

Entrepreneurship – forming and operating a new business

Forms of Conducting Domestic Business

Sole proprietorship—single owner

General partnership—two or more owners carry on a business for profit

Limited partnership—general and limited partners (investors)

Limited liability partnership (LLP)—all partners are limited partners

Limited liability company (LLC)—owned by members-hybrid

Corporation-separate legal entity owned by stockholders

Advantages of Sole Proprietorship

Owner is the business; no separate legal entity—can operate under trade name by filing a fictitious business name statement

Easy and inexpensive to form

Owner has right to make all management decisions concerning the business

Sole proprietor owns all of the business and has the right to receive all of the business’s profits

Sole proprietorship can be easily transferred and sold at owner’s discretion

Sole proprietor only subject to personal tax on income

Disadvantages of Sole Proprietorship

Sole proprietor bears the entire risk of loss of the business

He or she will lose his or her entire capital contribution if the business fails

Sole proprietor has unlimited personal liability

Creditors may recover claims against the business from the sole proprietor’s personal assets

Law for Business Organizations

Type of Organization Common Law Statutory Law

Partnership Contracts and Agency Uniform Partnership Act (UPA)

Corporation Contracts and Agency Model Business Corp. Act

(MBCA)

Definition of a General Partnership

A voluntary association of two or more persons created for carrying on a business as co-owners for profit

Tests for Existence of a Partnership:

1. sharing of profits ( prima facie evidence

2. voice in management

community of interests

Duration of Partnership

Partnership for a term

A partnership with a fixed duration

Partnership at will

A partnership with no fixed duration

Partnership Agreements—even though contract (refer to chapter on Contract Law) law does not always require a writing, there should always be a written agreement

A written partnership agreement should contain:

The firm name

The names and addresses of the partners

The principal office of the partnership

The nature and scope of the partnership business

The duration of the partnership

The capital contributions of each partner

The manner for division of profits and losses among the partners

The salaries, if any, to be paid to the partners

The duties of the partners regarding management of the partnership

Limitations, if any, on the authority of partners to bind the partnership

Provision for admission and withdrawal of partners from the firm

Provisions for continuing partnership upon withdrawal of a partner, death of a partner, or other dissolution of the partnership

Any other provisions deemed relevant by the partners

Terms of Interest in Partnership Law:

1. partner’s capital ( contributions from partners for permanent use

2. partnership property ( (1) plus property purchased plus profits retained

partner’s interest ( right to share in profits, right to share in return of capital and voice in management

Property Rights of the Partnership and the Partners (tenants in partnership)

Partnership property

Property that is originally brought into the partnership on account of the partnership and property that is subsequently acquired by purchase or otherwise on account of the partnership or with partnership funds. It is owned by the partnership with partners having the right to use but not separately transfer.

Right of survivorship

A deceased partner’s right in specific partnership property vests with the remaining partners upon his or her death.

Partner’s interest

A partner’s share of profits (usually equal unless noted – applies to losses unless noted) and surplus of the partnership and voice in management

All of these rights except for voice in management can be assigned

Normal Rights of Partners

Right to participate in management—usually equally with ordinary matters requiring a majority

Right to share in profits—usually equally with losses the same

Right to an accounting—court review

Right to return of capital—based on what was contributed

Right to information—see the books

Contract Liability to Third Parties (joint liability)

A partnership acts through its agents, i.e., partners

If partners have express, implied, or apparent authority, contracts are binding

Tort Liability to Third Parties (joint and several liability)

The partnership is liable if the tortious act of a partner or employee or agent of the partnership is committed while the person is acting within the ordinary course of partnership business or with the authority of his or her copartners

Liability of Incoming Partners

A new partner who is admitted to the partnership is liable for the existing debts and obligations of the partnership only to the extent of his or her capital contribution

The new partner is personally liable for debts and obligations incurred by the partnership after becoming a partner

Note, if a partner withdraws from the partnership, there is only liability for existing debts

Dissolution – change in relationship of partners. Does not always result in

termination.

Causes of Dissolution

Time

Task accomplished

Withdraw of partner either in compliance with or violation of

agreement

Operation of the Law

Illegal operations

Bankruptcy

Death of partner

Court Decree ( e.g. partner’s incapacity

If partnership terminates, there is a winding up period during which the

partnership affairs are settled. Pool for the distribution of assets are set

by way of the doctrine referred to as marshalling of assets.

Distribution of Assets

After the winding-up of a dissolved partnership, the assets of the partnership are distributed in the following order

Creditors (except partners who are creditors)

Creditor-partners

Capital contributions

Profits

Limited Partnerships – has both general and limited partners

Limited partners are investors with no voice in management and no unlimited personal liability.

They are formed under state statute similar to RULPA by execution of a certificate of limited partnership. Note, MLP’s interests are traded on securities exchanges.

IV. Objective Questions

Terms:

1. A business entity that is noncorporate in nature, and that is not considered a separate taxpaying entity for income tax purposes is known as a _______________ ________________.

2. If a sole proprietorship fails in business, the owner is subject to _______________ _________________ liability for claims against the business.

3. A ____________________ is a person who forms and operates a new business.

4. When the relation of the partners changes because a partner ceases to be associated in the carrying on of the business of the partnership, a _______________ occurs.

5. _____________ _____________ equals a partner’s permanent contribution to a partnership.

6. A _______________ partner is only an investor.

7. A doctrine dictating that partnership creditors may not seek satisfaction from the separate assets of individual partners until such time as the debts owed to individual creditors of such individual partners have been satisfied is called _______________ _______________ _______________.

8. _________________ happens when a partnership ends.

9. The process of preserving and selling the assets of the LLC and distributing the money and property to creditors and members after dissolution is known ______________ ______________.

True/False:

1. ____ The general partners of a limited partnership have limited personal liability for the debts and obligations of the limited partnership.

2. ____ The personal liability of a sole proprietor is limited to the extent of her capital contribution to the business.

3. ____ Sole proprietorships are prohibited by law from operating under a fictitious name.

4. ____ A sole proprietorship is owned by its stockholders.

5. _____ A partnership that is formed for a specific time or purpose dissolves upon the affirmative vote of a majority of the existing partners following the expiration of the time or accomplishment of the objective.

6. ____ A partnership dissolves automatically by operation of law upon the death of a partner.

7. ____ A partnership will be dissolved by judicial decree of dissolution following an event that

makes it unlawful for the business of the partnership to be carried on or for the partners to

carry it on.

8. ____ Assignment of one's partnership interest will cause the dissolution of a partnership.

9. ____ Generally, the dissolution of the partnership terminates the partners' actual authority to enter into contracts or otherwise act on behalf of the partnership.

Multiple Choice:

1. There are several advantages to the sole proprietorship form of operating a business. Which of the following is not one of its advantages?

A. Formation is simple and low in cost.

B. The sole proprietor retains the right to make all management decisions concerning the business.

C. The sole proprietor is legally responsible for the debts and obligations of the business only to the extent of his capital contribution.

D. A sole proprietorship can be transferred or sold quite easily.

2. Which of the following organizations is a separate taxpaying entity for federal income tax purposes?

A. Corporation.

B. General partnership.

C. Limited partnership.

D. Sole proprietorship.

3. One of the most glaring disadvantages to the sole proprietorship form of business is:

A. Sole proprietorships are taxed like corporations.

B. Owner’s have complete control of the business.

C. Sole proprietors are unlimitedly liable for the debts of the business.

D. None of the above.

D. None of the above.

4. Ted and Fred entered into a written partnership agreement to operate a retail clothing store. Their agreement was silent as to the duration of the partnership. Ted wishes to dissolve the partnership. Which of the following statements is correct?

A. Ted may dissolve the partnership at any time.

B. Ted may dissolve the partnership only after notice of the proposed dissolution is given to all partnership creditors.

C. Ted may not dissolve the partnership unless Fred consents.

D. Ted must apply to a court and obtain a decree unless Fred consents.

5. Abe, George, and Thomas are partners in a bookstore specializing in books relating to history. George has loaned the partnership a significant amount of money, and the partnership has since begun the process of termination. If partnership funds are insufficient to repay the amounts owed to George, which of the following statements is correct?

A. George will not be repaid.

B. Abe and Thomas must contribute their proportionate share towards repayment of the loan from George.

C. George will receive only the interest accrued on the unpaid amount.

D. None of the above.

6. Assume the same facts as in question 5. Which of the following statements is correct?

A. The partners will be paid their capital contributions after creditors of the partnership have been

repaid.

B. The loan made by George will be repaid before other creditors of the partnership are paid.

C. George is not entitled to receive interest on the money advanced if not repaid when due.

D. None of the above.

7. The partnership agreement of one of your clients provides that upon death or withdrawal, a partner shall be entitled to the book value of his or her partnership interest as of the close of the year preceding such death or withdrawal and nothing more. It also provides that the partnership shall continue. Regarding this partnership provision, which of the following is a correct statement?

A. It is unconscionable on its face.

B. It has the legal effect of preventing a dissolution upon the death or withdrawal of a partner.

C. It effectively eliminates the legal necessity of a winding up of the partnership upon the death or

withdrawal of a partner.

D. It is not binding upon the spouse of a deceased partner if the book value figure is less than the fair

market value figure.

8. Sandy Shorterm, who has been a partner of Shorterm, Attention, & Span for years, decides to withdraw from the partnership despite the fact that the partnership agreement prohibits such withdrawal. Which of the following is correct?

A. Sandy's withdrawal will cause the dissolution of the partnership by operation of law.

B. Because the withdrawal is wrongful, it will have no impact upon the partnership or the continuing partners.

C. Sandy's withdrawal will cause the dissolution of the partnership if a court decree is sought.

D. None of the above.

9. A limited partner:

A. May have a voice in management.

B. Has unlimited liability.

C. All of the above.

D. None of the above.

10. The law dealing with business organizations can include:

A. Agency law.

B. Contract law.

C. Statutory law.

D. All of the above.

11. The most important factor in determining the existence of a partnership is:

A. The sharing of profits.

B. A voice in management.

C. A community of interests.

D. None of the above.

V. Answers to Objective Questions

Terms:

1. Sole proprietorship. Under the tax laws, business income and losses are reported on the individual tax returns of the sole proprietor. Although this has many disadvantages, one major benefit is that the problem of corporate double taxation is avoided.

2. Unlimited personal. Because there is no legal distinction between the sole proprietor and his or her business, the liabilities of the business and the proprietor are considered one and the same.

3. Entrepreneur. This business may be started alone or with others.

4. Dissolution. Per section 29 of the Uniform Partnership Act, a dissolution is defined as “the change in the relationship of the partners caused by any partner ceasing to be associated in the carrying on as distinguished from the winding up of the business.”

5. Partnership Capital. This becomes part of partnership property

6. Limited. They also have no voice in management and no unlimited liability.

7. Marshaling of assets. This is an equitable doctrine requiring an arrangement or ranking of assets in a certain order towards the payment of debt.

8. Termination. Not all dissolutions end in termination.

9. Winding Up. This happens if the business is not continued after a legal dissolution.

True/False:

1. False. A corporation is a separate taxpaying entity for federal income tax purposes. Thus, corporations are said to be subject to double taxation.

2. False. A sole proprietor bears the entire risk of loss of such a business and has unlimited personal liability.

3. False. A sole proprietorship can operate under the name of the sole proprietor or a trade name. If a trade name is used, a fictitious business name statement will probably have to be filed.

4. False. Stockholders own a corporation. The owner of the sole proprietorship is the business.

5. False. Such a partnership dissolves automatically upon the expiration of the time or accomplishment of the objective.

6. True. Death of a partner acts as an operation of law dissolution of the partnership.

7. False. A partnership will be dissolved by operation of law following an event that makes it unlawful for the business of the partnership to be carried on or for the partners to carry it on.

8. False. Under the UPA, a partner may assign her interest without causing the dissolution of the partnership.

9. True. The partnership has technically ended.

Multiple Choice:

1. C. A sole proprietor has unlimited personal liability with respect to the debts and obligations of the business.

2. A. All of the others are considered conduits for tax purposes, and the taxes are attributable to the partner or proprietor.

3. C. “A” is not a characteristic of a sole proprietorship and “B” is probably not a disadvantage.

4. A. Because the partnership agreement does not state a duration, Ted may dissolve the partnership at any time without liability.

5. B. A partner who makes a loan to the partnership becomes a creditor of the partnership. Partners are personally liable for the partnership's debts and obligations.

6. A. Capital contributions are repaid only after creditors have been paid, but before profits are paid out.

7. C. Such an agreement does not prevent dissolution; it merely eliminates the necessity of the next step of winding up.

8. D. Sandy's actions will cause an automatic dissolution of the partnership, not a dissolution by operation of law or by court decree.

9. D. A limited partner may not have a voice in management and has limited liability.

10. D. These all apply in some fashion to the formation and operation of business organizations.

11. A. This is prima facie evidence of the existence of a partnership.

VI. Answers to Essay Question

The tests for existence of a partnership include the prima facie criteria of sharing profits, the voices in management of the partners and a community of interests. While the use of the mall may be very loosely considered a voice in management and a community of interests (although probably not so), the fact that the sharing of profits is part of the rental agreement would rebut the presumption of the existence of a partnership. There is probably no partnership here and Happy will have to pursue remedies against Mike.

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