Do the reading assignment and then look up KRS 275.520 and read its text.Then answer the questions below. Fully explain your answers:

1.What is the taxation advantage of a LLC as opposed to a corporation?

2.What must you do to form a LLC? (Hint: Search KY Secretaryof State and Explore the site.)

3.You are forming a LLC with a business associate that will engage in retail sales. You agree to run the business day to day operations. Your associate will do the accounting and take care of the LLC's finances. In what document would you address these roles?

4.Can a non-profit LLC pay a member profits or give a member an income distribution? Can a LLC pay a member/manager a salary?

5.A nonprofit LLC that has revenues of $100,000 per year pays a manager/ member a salary $99,000 per year. Do you think this would be found by a court to comply with the KY statute described in the article? Why or why not?

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Sole Proprietorships

The simplest form of business organization is asole proprietorship. In this form, the owner is the business. Thus, anyone who does business without creating a separate business organization has a sole proprietorship. More than two-thirds of all U.S. businesses are sole proprietorships. They are usually small enterprisesabout 99 percent of the sole proprietorships in the United States have revenues of less than $1 million per year. A sole proprietorship can be any type ofbusiness, ranging from an informal home-office or Internet undertaking to a large restaurant or construction firm.

See this chapter'sAdapting the Law to the Online Environmentfeature that follows for a discussion of a sole proprietor who tried to change his name to match his business's Web site.

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Advantages of the Sole Proprietorship

A major advantage of the sole proprietorship is that the proprietor owns the entire business and has a right to receive all of the profits (because he or she assumes all of the risk). In addition, it is often easier and less costly to start a sole proprietorship than to start any other kind of business, as few legal formalities are involved. No documents need to be filed with the government to start a sole proprietorship (though a state business license may be required to operate certain types of businesses).

Flexibility

A sole proprietorship also offers more flexibility than does a partnership or a corporation. The sole proprietor is free to make any decision she or he wishes concerning the businessincluding whom to hire, when to take a vacation, and what kind of business to pursue. In addition, the proprietor can sell or transfer all or part of the business to another party at any time without seeking approval from anyone else. In contrast, approval is typically required from partners in a partnership and from shareholders in a corporation.

Taxes

A sole proprietor pays only personal income taxes (including Social Security and Medicare taxes) on the business's profits, which are reported as personal income on the proprietor's personal income tax return. Sole proprietors arealso allowed to establish retirement accounts that are tax-exempt until the funds are withdrawn.

Disadvantages of the Sole Proprietorship

The major disadvantage of the sole proprietorship is that the proprietor alone bears the burden of any losses or liabilities incurred by the business enterprise. In other words, the sole proprietor has unlimited liability, or legal responsibility, for all obligations incurred in doing business. Any lawsuit against the business or its employees can lead to unlimited personal liability for the owner of a sole proprietorship.

The personal liability of the owner of a sole proprietorship was at issue in the following case.

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Partnerships

Apartnershiparises from an agreement, express or implied, between two or more persons to carry on a business for profit. Partners are co-owners of a business and have joint control over its operation and the right to share in its profits.

Partnerships are governed both by common law conceptsin particular, those relating to agencyand by statutory law. The National Conference of Commissioners on Uniform State Laws has drafted the Uniform Partnership Act (UPA), which governs the operation of partnershipsin the absence of express agreementand has done much to reduce controversies in the law relating to partnerships. In other words, the partners are free to establish rules for their partnership that differ from those stated in the UPA.

The UPA has undergone several major revisions since it was first issued in 1914. Except for Louisiana, every state has adopted the UPA. The majority of states have adopted the most recent version of the UPA, which was issued in 1994 and amended in 1997 to provide limited liability for partners in a limited liability partnership. We therefore base our discussion of the UPA in this chapter on the 1997 version of the act.

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Agency Concepts and Partnership Law

When two or more persons agree to do business as partners, they enter into a special relationship with one another. To an extent, their relationship is similar to an agency relationship because each partner is deemed to be the agent of the other partners and of the partnership. Thus, the common law agency concepts outlined inChapter 21applyspecifically, the imputation of knowledge of, and responsibility for, acts done within the scope of the partnership relationship. In their relationships with one another, partners, like agents, are bound by fiduciary ties.

In one important way, however, partnership law is distinct from agency law. A partnership is based on a voluntary contract between two or more competent persons who agree to commit financial capital, labor, and skill to a business with the understanding that profits and losses will be shared. In a nonpartnership agency relationship, the agent usually does not have an ownership interest in the business, and he or she is not obliged to bear a portion of the ordinary business losses.

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When Does a Partnership Exist?

Parties sometimes find themselves in conflict over whether their business enterprise is a legal partnership, especially when there is no formal, written partnership agreement. In determining whether a partnership exists, courts usually look for the following three essential elements, which are implicit in the UPA's definition of a general partnership:

1. A sharing of profits and losses.
2. A joint ownership of the business.
3. An equal right to be involved in the management of the business.

If the evidence in a particular case is insufficient to establish all three factors, the UPA provides a set of guidelines to be used.

Joint ownership of property does not in and of itself create a partnership. In fact, the sharing of gross revenues and even profits from such ownership "does not by itself establish a partnership" [UPA 202(c)(1), (2)].

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Entity versus Aggregate Theory of Partnerships

At common law, a partnership was treated only as an aggregate of individuals and never as a separate legal entity. Thus, at common law a lawsuit could never be brought by or against the firm in its own name. Each individual partner had to sue or be sued.

Today, in contrast, a majority of the states follow the UPA and treat a partnership as an entity for most purposes. For example, a partnership usually can sue or be sued, collect judgments, and have all accounting procedures in the nameof the partnership entity [UPA 201, 307(a)]. As an entity, a partnership may hold the title to real or personal property in its name rather than in the names of the individual partners. Additionally, federal procedural laws permit the partnership to be treated as an entity in suits in federal courts and bankruptcy proceedings.

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Tax Treatment of Partnerships

Modern law does treat a partnership as an aggregate of the individual partners rather than as a separate legal entity in one situationfor federal income tax purposes. The partnership is a pass-through entity and not a taxpaying entity. Apass-through entityis a business entity that has no tax liabilitythe entity's income is passed through to the owners of the entity, who pay income taxes on it.

Thus, the income or losses the partnership incurs are "passed through" the entity framework and attributed to the partners on their individual tax returns. The partnership itself has no tax liability and is responsible only for filing aninformation returnwith the Internal Revenue Service. A partner's profit from the partnership (whether distributed or not) is taxed as individual income to the individual partner. Similarly, partners can deduct a share of the partnership's losses on their individual tax returns (in proportion to their partnership interests).

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Partnership Formation

As a general rule, agreements to form a partnership can beoral, written, orimplied by conduct. Some partnership agreements, however, must be in writing (or an electronic record) to be legally enforceable under the Statute of Frauds (seeChapter 11for details).

A partnership agreement, calledarticles of partnership, can include any terms that the parties wish, unless they are illegal or contrary to public policy or statute

Duration of the Partnership

The partnership agreement can specify the duration of the partnership by stating that it will continue until a certain date or the completion of a particular project. A partnership that is specifically limited in duration is called apartnership for a term.

Generally, withdrawing prematurely (before the expiration date) from a partnership for a term constitutes a breach of the agreement, and the responsible partner can be held liable for any resulting losses [UPA 602(b)(2)]. If no fixed duration is specified, the partnership is apartnership at will.

Partnership by Estoppel

Occasionally, persons who are not partners may nevertheless hold themselves out as partners and make representations that third parties rely on in dealing with them. In such a situation, a court may conclude that apartnership by estoppelexists. The law does not confer any partnership rights on these persons, but it may impose liability on them. This is also true when a partner represents, expressly or impliedly, that a nonpartner is a member of the firm. Whenever a third person has reasonably and detrimentally relied on the representation that a nonpartner was part of the partnership, a partnership by estoppel is deemed to exist. When this occurs, the nonpartner isregarded as an agent whose acts are binding on the partnership [UPA 308].

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Rights of Partners

The rights of partners in a partnership relate to the following areas: management, interest in the partnership, compensation, inspection of books, accounting, and property.

Management Rights

In a general partnership, all partners have equal rights in managing the partnership [UPA 401(f)]. Unless the partners agree otherwise, each partner has one vote in management mattersregardless of the proportional size of his or her interest in the firm. Often, in a large partnership, partners will agree to delegate daily management responsibilities to a management committee made up of one or more of the partners.

The majority rule controls decisions in ordinary matters connected with partnership business, unless otherwise specified in the agreement. Decisions that significantly affect the nature of the partnership or that are not apparently for carrying on the ordinary course of the partnership business, or business of the partnership's kind, however, require theunanimousconsent of the partners [UPA 301(2), 401(i), (j)].

Unanimous consent is likely to be required for such decisions as whether to admit new partners, amend the articles of partnership, enage in new business, or undertake any act that would make further conduct of the partnership impossible.

Interest in the Partnership

Each partner is entitled to the proportion of business profits and losses designated in the partnership agreement. If the agreement does not apportion profits (indicate how the profits will be shared), the UPA provides that profits will be shared equally. If the agreement does not apportion losses, losses will be shared in the same ratio as profits [UPA 401(b)].

Compensation

Devoting time, skill, and energy to partnership business is a partner's duty and generally is not a compensable service. Rather, as mentioned, a partner's income from the partnership takes the form of a distribution of profits according to the partner's share in the business. Partners can, of course, agree otherwise. For instance, the managing partner of a law firm often receives a salaryin addition to her or his share of profitsfor performing special administrative or managerial duties.

Inspection of Books

Partnership books and records must be accessible to all partners. Each partner has the right to receive (and the corresponding duty to produce) full and complete information concerning the conduct of all aspects of partnership business [UPA 403]. Each firm keeps books for recording and preserving such information. Partners contribute the information, and a bookkeeper or an accountant typically has the duty to preserve it. The books must be kept at the firm's principal business office and cannot be removed without the consent of all of the partners.

Accounting of Partnership Assets or Profits

An accounting of partnership assets or profits is required to determine the value of each partner's share in the partnership. An accounting can be performed voluntarily, or it can be compelled by court order. Under UPA 405(b), a partner has the right to bring an action for an accounting during the term of the partnership, as well as on the partnership'sdissolutionandwinding up.

Property Rights

Property acquiredbya partnership is the property of the partnership and not of the partners individually [UPA 203]. Partnership property includes all property that was originally contributed to the partnership and anything later purchased by the partnership or in the partnership's name (except in rare circumstances) [UPA 204].

A partner may use or possess partnership property only on behalf of the partnership [UPA 401(g)]. A partner isnota co-owner of partnership property and has no right to sell, mortgage, or transfer partnership property.

In other words, partnership property is owned by the partnership as an entity and not by the individual partners. Thus, partnership property cannot be used to satisfy the personal debt of an individual partner. That partner's creditor, however, can petition a court for acharging orderto attach the partner'sinterestin the partnership (her or his proportionate share of the profits and losses and right to receive distributions) to satisfy the partner's obligation. (A partner can also assign her or his right to a share of the partnership profits to another to satisfy a debt.)

Duties and Liabilities of Partners

The duties and liabilities of partners are basically derived from agency law. Each partner is an agent of every other partner and acts as both a principal and an agent in any business transaction within the scope of the partnership agreement.

Each partner is also a general agent of the partnership in carrying out the usual business of the firm "or business of the kind carried on by the partnership" [UPA 301(1)]. Thus, every act of a partner concerning partnership business, or "business of the kind," and every contract signed in the partnership's name bind the firm.

Fiduciary Duties

The fiduciary duties a partner owes to the partnership and to the other partners are theduty of careand theduty of loyalty[UPA 404(a)]. Under the UPA, a partner's duty of care involves refraining from "grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law" [UPA 404(c)]. A partner is not liable to the partnership for simple negligence or honest errors in judgment in conducting partnership business, though.

The duty of loyalty requires a partner to account to the partnership for "any property, profit, or benefit" derived by the partner from the partnership's business or the use of its property [UPA 404(b)]. A partner must also refrain from competing with the partnership in business or dealing with the firm as an adverse party.

The duty of loyalty can be breached by self-dealing, misusing partnership property, disclosing trade secrets, or usurping a partnership business opportunity, as the followingClassic Caseillustrates.

Authority of Partners

The UPA affirms general principles of agency law that pertain to the authority of a partner to bind a partnership in contract. A partner may also subject the partnership to tort liability under agency principles. When a partner is carrying on partnership business with third parties in the usual way, both the partner and the firm share liability.

If a partner acts within the scope of her or his authority, the partnership is legally bound to honor the partner's commitments to third parties. The partnership will not be liable, however, if the third parties know that the partner had no authority to commit the partnership. A partnership may limit the capacity of a partner to act as the firm's agent or transfer property on its behalf by filing a "statement of partnership authority" in a designated state office [UPA 105, 303]. Agency concepts that we explored inChapter 21relating to actual (express and implied) authority, apparent authority, and ratification also apply to partnerships.The extent of implied authority is generally broader for partners than for ordinary agents, though.

Liability of Partners

One significant disadvantage associated with a traditional partnership is that partners arepersonallyliable for the debts of the partnership. In most states, the liability is essentially unlimited because the acts of one partner in the ordinary course of business subject the other partners to personal liability [UPA 305].

Joint Liability

Each partner in a partnership is jointly liable for the partnership's obligations.Joint liabilitymeans that a third party must sue all of the partners as a group, but each partner can be held liable for the full amount. (Under the prior version of the UPA, which is still in effect in a few states, partners were subject to joint liability on partnership debts and contracts, but not on partnership debts arising from torts.)

If, for instance, a third party sues one individual partner on a partnership contract, that partner has the right to demand that the other partners be sued with her or him. In fact, if the third party does not name all of the partners in the lawsuit, the assets of the partnership cannot be used to satisfy the judgment. With joint liability, the partnership's assets must be exhausted before creditors can reach the partners' individual assets.

Joint and Several Liability

In the majority of the states, under UPA 306(a), partners are jointly and severally (separately or individually) liable for all partnership obligations, including contracts, torts, and breaches of trust.

Joint and several liabilitymeans that a third party has the option of suing all of the partners together (jointly) or one or more of the partners separately (severally). All partners in a partnership can be held liable regardless of whether a particular partner participated in, knew about, or ratified the conduct that gave rise to the lawsuit. Normally, though, the partnership's assets must be exhausted before a creditor can enforce a judgment against a partner's personal assets [UPA 307(d)].

A judgment against one partner severally (separately) does not extinguish the others' liability. (Similarly, a release of one partner does not discharge the partners' several liability.) Those not sued in the first action may be sued subsequently, unless the court in the first action held that the partnership was not liable. If a plaintiff is successful in a suit against a partner or partners, he or she may collect on the judgment only against the assets of those partners named as defendants. A partner who commits a tort may be required to indemnify (reimburse) the partnership for any damages it paysunless the tort was committed in the ordinary course of the partnership's business.

Liability of an Incoming Partner

A partner newly admitted to an existing partnership is not personally liable for any partnership obligations incurred before the person became a partner [UPA 306(b)]. The new partner's liability to existing creditors of the partnership is limited to her or his capital contribution to the firm.

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Partner's Dissociation

Dissociationoccurs when a partner ceases to be associated in the carrying on of the partnership business. Although a partner always has thepowerto dissociate from the firm, he or she may not have therightto do so. Dissociation terminates the partner's actual authority to act for the partnership and to participate with the partners in running the business. Otherwise, the partnership continues to do business without the dissociating partner.

Events That Cause Dissociation

Under UPA 601, a partner can be dissociated from a partnership in any of the following ways:

1. By the partner's voluntarily giving notice of an "express will to withdraw."
2. By the occurrence of an event agreed to in the partnership agreement.
3. By a unanimous vote of the other partners under certain circumstances, such as when a partner transfers substantially all of her or his interest in the partnership, or when it becomes unlawful to carry on partnership business with that partner.
4. By order of a court or arbitrator if the partner has engaged in wrongful conduct that affects the partnership business, breached the partnership agreement or violated a duty owed to the partnership or to the other partners, or engaged in conduct that makes it "not reasonably practicable to carry on the business in partnership with the partner" [UPA 601(5)].
5. By the partner's declaring bankruptcy, assigning his or her interest in the partnership for the benefit of creditors, or becoming physically or mentally incapacitated, or by the partner's death. Note that although the bankruptcy or death of a partner results in that partner's "dissociation" from the partnership, it is not anautomaticground for the partnership's dissolution (dissolutionwill be discussed shortly).

Wrongful Dissociation

As mentioned, a partner has the power to dissociate from a partnership at any time, but if she or he lacks the right to dissociate, then the dissociation is considered wrongful under the law [UPA 602]. When a partner's dissociation is in breach of the partnership agreement, for instance, it is wrongful.

Similarly, if a partner refuses to perform duties required by the partnership agreementsuch as accounting for profits earned from the use of partnership propertythis breach can be treated as a wrongful dissociation. A partner who wrongfully dissociates is liable to the partnership and to the other partners for damages caused by the dissociation.

Effects of Dissociation

Dissociation (rightful or wrongful) terminates some of the rights of the dissociated partner, requires that the partnership purchase his or her interest, and alters the liability of the parties to third parties.

Rights and Duties

On a partner's dissociation, his or her right to participate in the management and conduct of the partnership business terminates [UPA 603]. The partner's duty of loyalty also ends. A partner's duty of care continues only with respect to events that occurred before dissociation, unless the partner participates inwinding upthe partnership's business (to be discussed shortly).

Buyouts

After a partner's dissociation, the partnership must purchase his or her partnership interest according to the rules in UPA 701. Thebuyout priceis based on the amount that would have been distributed to the partner if the partnership had been wound up on the date of dissociation. Offset against the price are any amounts owed by the partner to the partnership, including any damages to the firm for the partner's wrongful dissociation.

Liability to Third Parties

For two years after a partner dissociates from a continuing partnership, the partnership may be bound by the acts of the dissociated partner based on apparent authority [UPA 702]. In other words, the partnership may be liable to a third party with whom a dissociated partner enters into a transaction if the third party reasonably believed that the dissociated partner was still a partner. Similarly, a dissociated partner may be liable for partnership obligations entered into during a two-year period following dissociation [UPA 703].

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Partnership Termination

The same events that cause dissociation can result in the end of the partnership if the remaining partners no longer wish to (or are unable to) continue the partnership business. Only certain departures of a partner will end the partnership, though, and generally the partnership can continue if the remaining partners consent [UPA 801].

The termination of a partnership is referred to asdissolution, which essentially means the commencement of the winding up process.Winding upis the actual process of collecting, liquidating, and distributing the partnership assets.

Dissolution

Dissolution of a partnership generally can be brought about by the following:

1. Acts of the partners or, in a corporation, acts of the shareholders and board of directors.
2. The subsequent illegality of the firm's business.
3. The expiration of a time period stated in a partnership agreement or a certificate of incorporation.
4. Judicial decree.

Additionally, if the partnership agreement states that it will dissolve on a certain event, such as a partner's death or bankruptcy, then the occurrence of that event will dissolve the partnership. A partnership for a fixed term or a particular undertaking is dissolved by operation of law at the expiration of the term or on the completion of the undertaking.

Good Faith

Each partner must exercise good faith when dissolving a partnership. Some state statutes allow partners injured by another partner's bad faith to file a tort claim for wrongful dissolution of a partnership.

Impracticality

Under the UPA, a court may order dissolution when it becomes obviously impractical for the firm to continuefor instance, if the business can only be operated at a loss [UPA 801(5)]. Even when one partner has brought a court action seeking to dissolve a partnership, the partnership continues to exist until it is legally dissolved by the court or by the parties' agreement.

Winding Up

After dissolution, the partnership continues for the limited purpose of the winding up process. The partners cannot create new obligations on behalf of the partnership. They have authority only to complete transactions begun but not finished at the time of dissolution and to wind up the business of the partnership [UPA 803, 804(1)].

Winding upincludes collecting and preserving partnership assets, discharging liabilities (paying debts), and accounting to each partner for the value of her or his interest in the partnership. Partners continue to have fiduciary duties to one another and to the firm during this process. UPA 401(h) provides that a partner is entitled to compensation for services in winding up partnership affairs (and reimbursement forexpenses incurred in the process) above and apart from his or her share in the partnership profits.

Both creditors of the partnership and creditors of the individual partners can make claims on the partnership's assets. In general, partnership creditors and the partners' personal creditors share proportionately in the partners' assets, which include their interests in the partnership. A partnership's assets are distributed according to the following priorities [UPA 807]:

1. Payment of debts, including those owed to partner and nonpartner creditors.
2. Return of capital contributions and distribution of profits to partners.

If the partnership's liabilities are greater than its assets, the partners bear the lossesin the absence of a contrary agreementin the same proportion in which they shared the profits (rather than, for example, in proportion to their contributions to the partnership's capital).

Limited Liability Partnerships

Thelimited liability partnership (LLP)is a hybrid form of business designed mostly for professionals who normally do business as partners in a partnership. The major advantage of the LLP is that it allows a partnership to continue as apass-throughentity for tax purposes but limits the personal liability of the partners. The LLP is especially attractive for two categories of businesses: professional service firms and family businesses.

Formation of an LLP

LLPs must be formed and operated in compliance with state statutes, which may include provisions of the UPA. The appropriate form must be filed with a central state agency, usually the secretary of state's office, and the business's name must include either "Limited Liability Partnership" or "LLP" [UPA 1001, 1002]. In addition, an LLP must file an annual report with the state to remain qualified as an LLP in that state [UPA 1003].

In most states, it is relatively easy to convert a traditional partnership into an LLP because the firm's basic organizational structure remains the same. Additionally, all of the statutory and common law rules governing partnerships still apply (apart from those modified by the LLP statute). Normally, LLP statutes are simply amendments to a state's already existing partnership law.

Liability in an LLP

An LLP allows professionals, such as attorneys and accountants, to avoid personal liability for the malpractice of other partners. A partner in an LLP is still liable for her or his own wrongful acts, such as negligence, however. Also liable is the partner who supervised the individual who committed a wrongful act. (This supervisory liability generally applies to all types of partners and partnerships, not just LLPs.)

Although LLP statutes vary from state to state, generally each state statute limits the liability of partners in some way. For instance, Delaware law protects each innocent partner from the "debts and obligations of the partnership arising from negligence, wrongful acts, or misconduct." The UPA more broadly exempts partners from personal liability for any partnership obligation, "whether arising in contract, tort, or otherwise" [UPA 306(c)].

Limited Partnerships

We now look at a business organizational form that limits the liability ofsomeof its ownersthelimited partnership (LP). Limited partnerships originated in medieval Europe and have been in existence in the United States since the early 1800s. Limited partnerships differ from general partnerships in several ways.

A limited partnership consists of at least one general partner and one or more limited partners. Ageneral partnerassumes management responsibility for the partnership and so has full responsibility for the partnership and for all of its debts. Alimited partnercontributes cash or other property and owns an interest in the firm but does not undertake any management responsibilities and is not personally liable for partnership debts beyond the amount of his or her investment. A limited partner can forfeit limited liability by taking part in the management of the business.

Most states and the District of Columbia have adopted the Revised Uniform Limited Partnership Act (RULPA), which we refer to in the following discussion of limited partnerships.

Formation of an LP

In contrast to the informal, private, and voluntary agreement that usually suffices for a general partnership, theformation of a limited partnership is a public and formal proceeding that must follow statutory requirements. Not only must a limited partnership have at least one general partner and one limited partner, but the partners must also sign acertificate of limited partnership. This certificate must include certain information such as the name, mailing address, and capital contribution of each general and limited partner. The certificate must be filed with the designated state officialusually, the secretary of state.

Liabilities of Partners in an LP

General partners, unlike limited partners, are personally liable to the partnership's creditors. Thus, at least one general partner is necessary in a limited partnership so that someone has personal liability. This policy can be circumvented in states that allow a corporation to be the general partner in a partnership. Because the corporation has limited liability by virtue of corporate laws, if a corporation is the general partner, no one in the limited partnership has personal liability.

In contrast to the personal liability of general partners, the liability of a limited partner is limited to the capital that she or he contributes or agrees to contribute to the partnership [RULPA 502]. Limited partners enjoy this limited liability only so long as they do not participate in management. A limited partner who participates in management will be just as liable as a general partner to any creditor who transacts business with the limited partnership and believes, based on the limited partner's conduct, that the limited partner is a general partner [RULPA 303]. The extent of review and advisement a limited partner can engage in before being exposed to liability remains rather vague, though.

Dissociation and Dissolution of an LP

A general partner has the power to voluntarily dissociate, or withdraw, from a limited partnership unless the partnership agreement specifies otherwise. A limited partner can withdraw from the partnership by giving six months' noticeunlessthe partnership agreement specifies a term, which most do. Also, some states have passed laws prohibiting the withdrawal of limited partners.

Events That Cause Dissociation

In a limited partnership, a general partner's voluntary dissociation from the firm normally will lead to dissolutionunlessall partners agree to continue the business. Similarly, the bankruptcy, retirement, death, or mental incompetence of a general partner will cause the dissociation of that partner and the dissolution of the limited partnership unless the other members agree to continue the firm [RULPA 801].

Bankruptcy of a limited partner, however, does not dissolve the partnership unless it causes the bankruptcy of the firm. Death or an assignment of the interest of a limited partner does not dissolve a limited partnership [RULPA 702, 704, 705]. A limited partnership can be dissolved by court decree [RULPA 802].

Distribution of Assets

On dissolution, creditors' claims, including those of partners who are creditors, take first priority. After that, partners and former partners receive unpaid distributions of partnership assets and, except as otherwise agreed, amounts representing returns of their capital contributions and proportionate distributions of profits [RULPA 804]. Partners can agree ahead of time how the assets will be valued and divided if the partnership dissolves. Buy-sell agreements can help the partners avoid disputes. Nonetheless, buy-sell agreements do not eliminate all potential for litigation, especially if the terms are subject to more than one interpretation.

Limited Liability Companies

For many entrepreneurs and investors, the ideal business form would combine the tax advantages of the partnership form of business with the limited liability of the corporate enterprise. Although the limited partnership partially addresses these needs, the limited liability of limited partners is conditional: limited liability exists only so long as the limited partner doesnotparticipate in management.

This is one reason that every state has adopted legislation authorizing a form of business organization called thelimited liability company (LLC). The LLC is a hybrid form of business enterprise that offers the limited liability of thecorporation but the tax advantages of a partnership. Today, LLCs are a common form of business.

Like an LLP or LP, an LLC must be formed and operated in compliance with state law. LLC statutes vary from state to state and are not uniform. In fact, less than one-fifth of the states have adopted the Uniform Limited Liability Company Act (ULLCA). About one-fourth of the states specifically require LLCs to have at least two owners, calledmembers. In the rest of the states, although some LLC statutes are silent on this issue, one-member LLCs are usually permitted.

Formation of an LLC

To form an LLC,articles of organizationmust be filed with a central state agencyusually the secretary of state's office [ULLCA 202]. Typically, the articles are required to include such information as the name of the business, its principal address, the name and address of a registered agent, the names of the members, and information on how the LLC will be managed. The business's name must include the wordsLimited Liability Companyor the initialsLLC. In addition to requiring the filing of articles of organization, a few states require that a notice of the intention to form an LLC be published in a local newspaper.

Sometimes, the future members of an LLC may enter into contracts on the entity's behalf before the LLC is formally formed. As you will read inChapter 24, persons forming a corporation may enter into contracts during the process of incorporation but before the corporation becomes a legal entity. These contracts are referred to as preincorporation contracts. Once the corporation is formed and adopts the preincorporation contract, it can then enforce the contract terms.

Jurisdictional Requirements

One of the significant differences between LLCs and corporations involves federal jurisdictional requirements. Under federal law, a corporation is deemed to be a citizen of the state where it is incorporated and maintains its principal place of business.The statute does not mention the citizenship of partnerships, LLCs, and other unincorporated associations, but the courts have tended to regard these entities as citizens of every state of which their members are citizens.

The state citizenship of LLCs may come into play when a party sues an LLC based on diversity of citizenship. When parties to a lawsuit are from different states, a federal court can exercise diversity jurisdiction if the amount in controversy exceeds $75,000.Totaldiversity of citizenship must exist, however.

Advantages of the LLC

The LLC offers many advantages, which is why this form of business organization has become increasingly popular.

Limited Liability

A key advantage of the LLC is that the liability of members is limited to the amount of their investments. Although the LLC as an entity can be held liable for any loss or injury caused by the wrongful acts or omissions of its members, the members themselves generally are not personally liable.

Taxation

Another advantage is the flexibility of the LLC in regard to taxation. An LLC that hastwo or more memberscan choose to be taxed either as a partnership or as a corporation. A corporate entity must pay income taxes on its profits, and the shareholders then pay personal income taxes on profits distributed as dividends. An LLC that wants to distribute profits to its members may prefer to be taxed as a partnership to avoid the "double taxation" that is characteristic of the corporate entity.

Unless an LLC indicates that it wishes to be taxed as a corporation, the IRS automatically taxes it as a partnership. This means that the LLC as an entity pays no taxes. Rather, as in a partnership, profits are "passed through" the LLC to the members who then personally pay taxes on the profits. If an LLC's members want to reinvest the profits in the business, however, rather than distribute the profits to members, they may prefer that the LLC be taxed as a corporation. Corporate income tax rates may be lower than personal tax rates. For federal income tax purposes, one-member LLCs are automatically taxed as sole proprietorships unless they indicate that they wish to be taxed as corporations. With respect to state taxes, most states follow the IRS rules.

Management and Foreign Investors

Still another advantage of the LLC for businesspersons is the flexibility it offers in terms of business operations and management. Finally, because foreign investors can participate in an LLC, the LLC is attractive as a way to encourage investment.

Disadvantages of the LLC

The main disadvantage of the LLC is that state LLC statutes are not uniform. Therefore, businesses that operate in more than one state may be treated differently in different states.

Generally, most states apply to a foreign LLC (an LLC formed in another state) the law of the state where the LLC was formed. Difficulties can arise, though, when one state's court must interpret and apply another state's laws.

The LLC Operating Agreement

The members of an LLC can decide how to operate the various aspects of the business by forming anoperating agreement[ULLCA 103(a)]. Operating agreements typically contain provisions relating to management, how profits will be divided, the transfer of membership interests, whether the LLC will be dissolved on the death or departure of a member, and other important issues.

A Writing Is Preferred

In many states, an operating agreement is not required for an LLC to exist, and if there is one, it need not be in writing. Generally, though, LLC members should protect their interests by creating a written operating agreement. As in any business, disputes may arise over any number of issues. If there is no agreement covering the topic under dispute, such as how profits will be divided, the state LLC statute will govern the outcome. For example, most LLC statutes provide that if the members have not specified how profits will be divided, they will be divided equally among the members.

Partnership Law May Apply

When an issue, such as the authority of individual members, is not covered by an operating agreement or by an LLC statute, the courts often apply principles of partnership law. These principles can give the members of an LLC broad authority to bind the LLC.

Of course, the members of an LLC are bound to the operating agreement that they make. The agreement's provisions may become especially important in determining the relative rights of the parties when a dispute arises among the members, as the following case illustrates.

Management of an LLC

Basically, the members of an LLC have two options for managing the firm. It can be either a "member-managed" LLC or a "manager-managed" LLC. Most LLC statutes and the ULLCA provide that unless the articles of organization specify otherwise, an LLC is assumed to be member managed [ULLCA 203(a)(6)].

In amember-managedLLC, all of the members participate in management, and decisions are made by majority vote [ULLCA 404(a)]. In amanager-managedLLC, the members designate a group of persons to manage the firm. The management group may consist of only members, both members and nonmembers, or only nonmembers.

Fiduciary Duties

Under the ULLCA, managers in a manager-managed LLC owe fiduciary duties (the duty of loyalty and the duty of care) to the LLC and to its members, just as corporate directors and officers owe fiduciary duties to the corporation and to its shareholders [ULLCA 409(a), (h)]. Because not all states have adopted the ULLCA, though, some state statutes provide that managers owe fiduciary duties only to the LLC and not to its members.

Although to whom the duty is owed may seem insignificant at first glance, it can have a dramatic effect on the outcome of litigation. In North Carolina and Virginia, for instance, the LLC statutes do not explicitly create fiduciary duties for managers to members. Because the statutes are silent on a manager's duty to members, courts in some states provide that a manager-member owes fiduciary duties only to the LLC and not to the individual members.

Decision-Making Procedures

The members of an LLC can also include provisions governing decision-making procedures in their operating agreement. For instance, the agreement can include procedures for choosing or removing managers. Although most LLC statutes are silent on this issue, the ULLCA provides that members may choose and remove managers by majority vote [ULLCA 404(b)(3)].

The members are also free to include provisions designating when and for what purposes they will hold formal members' meetings. Members may also specify in their agreement how voting rights will be apportioned. If they do not, LLC statutes in most states provide that voting rights are apportioned according to the members' capital contributions. Some states provide that, in the absence of an agreement to the contrary, each member has one vote.

Dissociation and Dissolution of an LLC

Recall in the context of partnerships,dissociationoccurs when a partner ceases to be associated in the carrying on of the business. The same concept applies to LLCs. A member of an LLC has thepowerto dissociate from the LLC at any time, but she or he may not have therightto dissociate.

Under the ULLCA, the events that trigger a member's dissociation from an LLC are similar to the events causing a partner to be dissociated under the Uniform Partnership Act (UPA). These include voluntary withdrawal, expulsion by other members or by court order, bankruptcy, incompetence, and death. Generally, if a member dies or otherwise dissociates from an LLC, the other members may continue to carry on the LLC's business, unless the operating agreement provides otherwise.

Dissociation

When a member dissociates from an LLC, he or she loses the right to participate in management and the right to act as an agent for the LLC. The member's duty of loyalty to the LLC also terminates, and the duty of care continues only with respect to events that occurred before dissociation. Generally, the dissociated member also has a right to have his or her interest in the LLC bought out by the other members. The LLC's operating agreement may contain provisions establishing a buyout price, but if it does not, the member's interest is usually purchased at a fair value. In states that have adopted the ULLCA, the LLC must purchase the interest at "fair" value within 120 days after the dissociation.

If the member's dissociation violates the LLC's operating agreement, it is considered legally wrongful, and the dissociated member can be held liable for damages caused by the dissociation.

Dissolution

Regardless of whether a member's dissociation was wrongful or rightful, normally the dissociated member has no right to force the LLC to dissolve. The remaining members can opt to either continue or dissolve the business. Members can also stipulate in their operating agreement that certain events will cause dissolution, or they can agree that they have the power to dissolve the LLC by vote. As with partnerships, a court can order an LLC to be dissolved in certain circumstances, such as when the members have engaged in illegal or oppressive conduct, or when it is no longer feasible to carry on the business.

Winding Up

When an LLC is dissolved, any members who did not wrongfully dissociate may participate in the winding up process. To wind up the business, members must collect, liquidate, and distribute the LLC's assets.

Members may preserve the assets for a reasonable time to optimize their return, and they continue to have the authority to perform reasonable acts in conjunction with winding up. In other words, the LLC will be bound by the reasonable acts of its members during the winding up process.

Once all the LLC's assets have been sold, the proceeds are distributed to pay off debts to creditors first (including debts owed to members who are creditors of the LLC). The members' capital contributions are returned next, and any remaining amounts are then distributed to members in equal shares or according to their operating agreement.

Reviewing ... Sole Proprietorships, Partnerships, and Limited Liability Companies

Grace Tarnavsky and her sons, Manny and Jason, bought a ranch known as the Cowboy Palace in March 2009, and the three orally agreed to share the business for five years. Grace contributed 50 percent of the investment, and each son contributed 25 percent. Manny agreed to handle the livestock, and Jason agreed to do the bookkeeping. The Tarnavskys took out joint loans and opened a joint bank account into which they deposited the ranch's proceeds and from which they made payments for property, cattle, equipment, and supplies. In September 2013, Manny severely injured his back while baling hay and became permanently unable to handle livestock. Manny therefore hired additional laborers to tend the livestock, causing the Cowboy Palace to incur significant debt. In September 2014, Al's Feed Barn filed a lawsuit against Jason to collect $12,400 in unpaid debts. Using the information presented in the chapter, answer the following questions.

1. Was this relationship a partnership for a term or a partnership at will?
2. Did Manny have the authority to hire additional laborers to work at the ranch after his injury? Why or why not?
3. Under the UPA, can Al's Feed Barn bring an action against Jason individually for the Cowboy Palace's debt? Why or why not?
4. Suppose that after his back injury in 2013, Manny sent his mother and brother a notice indicating his intent to withdraw from the partnership. Can he still be held liable for the debt to Al's Feed Barn? Why or why not?

Debate This

Because LLCs are essentially just partnerships with limited liability for members, all partnership laws should apply.

Chapter Summary: Sole Proprietorships, Partnerships, and Limited Liability Companies

• Sole Proprietorships
• The simplest form of business organization; used by anyone who does business without creating a separate organization. The owner is the business. The owner pays personal income taxes on all profits and is personally liable for all business debts.
• Partnerships

1. A partnership is created by agreement of the parties.
2. A partnership is treated as an entity except for limited purposes.
3. Each partner pays a proportionate share of income taxes on the net profits of the partnership, whether or not they are distributed. The partnership files only an information return with the Internal Revenue Service.
4. Each partner has an equal voice in management unless the partnership agreement provides otherwise.
5. In the absence of an agreement, partners share profits equally and share losses in the same ratio as they share profits.
6. Partners have unlimited personal liability for partnership debts.
7. A partnership can be terminated by agreement or can be dissolved by action of the partners, operation of law (subsequent illegality), or court decree.

• Limited Liability Partnerships (LLPs)

1. FormationLLPs must be formed in compliance with state statutes. Typically, an LLP is formed by professionals who normally work together as partners in a partnership. Under most state LLP statutes, it is relatively easy to convert a traditional partnership into an LLP.
2. Liability of partnersLLP statutes vary, but under the UPA, professionals generally can avoid personal liability for acts committed by other partners. Partners in an LLP continue to be liable for their own wrongful acts and for the wrongful acts of those whom they supervise.

• Limited Partnerships (LPs)

1. FormationA certificate of limited partnership must be filed with the designated state official. The certificate must include information about the business. The partnership consists of one or more general partners and one or more limited partners.
2. Rights and liabilities of partnersWith some exceptions, the rights of partners are the same as the rights of partners in a general partnership. General partners have unlimited liability for partnership obligations. Limited partners are liable only to the extent of their contributions.
3. Limited partners and managementOnly general partners can participate in management. Limited partners have no voice in management. If they do participate in management activities, they risk having liability as general partners.
4. Dissociation and dissolutionGenerally, a limited partnership can be dissolved in much the same way as an ordinary partnership. A general partner has the power to voluntarily dissociate unless the parties' agreement specifies otherwise.Some states limit the power of limited partners to voluntarily withdraw from the firm. The death or assignment of the interest of a limited partner does not dissolve the partnership. Bankruptcy of a limited partner also will not dissolve the partnership unless it causes the bankruptcy of the firm.

• Limited Liability Companies (LLCs)

1. FormationArticles of organization must be filed with the appropriate state officeusually the office of the secretary of statesetting forth the name of the business, its principal address, the names of the owners (called members), and other relevant information.
2. Advantages and disadvantagesAdvantages of the LLC include limited liability, the option to be taxed as a partnership or as a corporation, and flexibility in deciding how the business will be managed and operated. The main disadvantage is the lack of uniformity in state LLC statutes.
3. Operating agreementWhen an LLC is formed, the members decide, in an operating agreement, how the business will be managed and what rules will apply to the organization.
4. ManagementAn LLC may be managed by members only, by some members and some nonmembers, or by nonmembers only.
5. Dissociation and dissolutionMembers of an LLC have the power to dissociate from the LLC at any time, but they may not have the right to dissociate. Dissociation does not always result in the dissolution of an LLC. The remaining members can choose to continue the business. Dissociated members have a right to have their interest purchased by the other members. If the LLC is dissolved, the business must be wound up and the assets sold. Creditors are paid first, and then members' capital investments are returned. Any remaining proceeds are distributed to members.