A Partnership is an association of two or more persons or entities in a joint venture, business, or trade, which are governed by state statutes. Most states have adopted the Uniform Partnership Act (U.P.A.). This act, like other uniform acts, was drafted by legal scholars to serve as a "model act" for states to follow. The U.P.A. defines a partnership as "an association of two or more persons to carry on as co-owners for profit." The U.P.A. further defines "person" to include "individuals, partnerships, corporations, and other associations". According to the U.P.A., a partnership has the following characteristics:

(1) Assets, liabilities, and business transactions of the firm are treated as those of a business unit, and are considered separate and distinct from the individuals assets, liabilities, and non-partnership business transactions of its members. U.P.A. Section 25.

(2) In the marshaling of assets, the assets and liabilities of the firm and those of the respective individual members are considered separate and distinct. Partnership creditors of the individual members have a priority right, respectively, to the separate assets of their individual debtors. U.P.A. Section 40(h).

(3) Title to real estate may be acquired by a partnership in the partnership name and, if so acquired, can be conveyed only in the partnership name. U.P.A. Section 8(3).

(4) Every partner is considered an agent of the partnership. U.P.A. Section 9(1).

(5) In certain states and in federal courts, a partnership may sue and be sued in the partnership name.

(6) A partnership is defined as a person in such statutes as the Uniform Commercial Code and the Bankruptcy Reform Act.

Because a partnership is an aggregate of its individual members, the individuals are generally ultimately liable for the partnership's debts. Further, any one partner may be held liable for the entire indebtedness of the partnership. This is called joint and several liability. This is particularly worrisome since every partner is considered an agent of the partnership.

An agent is a person who can represent another person, and since a partner is an agent of the partnership, he can act on behalf of the partnership, i.e., he can legally enter the partnership into a binding contract. Since all partners are jointly and severally liable on all partnership obligations, in essence, one partner can bind all other partners.

EXAMPLE: A client, a real estate developer by profession, formed a general partnership with three other individuals to develop a new real estate community. The developer's net worth was close to $12,000,000. The other three partners had considerably less net worth. Then it happened--a financial crunch--and the partnership suddenly found itself with over $18,000,000 in indebtedness and suits. Can creditors prevail in this particular situation, the answer is yes! Joint and several liability in this case is a simple way of saying, any one of the partners can be held legally liable for the full debts of the partnership.

What was this man's mistake? His error was twofold: (1) not operating as a limited partnership and (2) not selecting more financially suitable persons as partners. Tragically, bankruptcy was the final course of action. As this illustrates, liability assumption is frequently the result of operating as a general partnership. We do not say you should never form a general partnership or be involved in one, what we say is, review the possible liability exposure with an attorney prior to entering into a general partnership. We have seen some general partnerships try to cover this liability exposure by using insurance and subordination agreements, sometimes this works and sometimes it does not.

The reason why so many people unwisely use a general partnership is that it is quite simple to form. Persons become partners by associating themselves in business together as co-owners, with an agreement to associate as partners as explicit or implicit. While most partnerships have articles of partnership that clearly spell-out the partnership relations, this is not needed to establish a general partnership. Consequently, absent any formal writing, a court may find that a general partnership exists--even if the "partners" do not consider themselves to be partners.

All partners in a general partnership have a fiduciary relationship with the other partners and the partnership. A fiduciary duty is a duty of trust, meaning that a general partner cannot place his own interests above those of the partnership, he cannot profit at the expense of the partnership.

Because a partner's liability exposure is so great in a General Partnership, another form of partnership has evolved that reduces the liability exposure of some partners. Such a partnership is called a Limited Partnership. A limited partnership is a partnership composed of one or more general partners and one or more limited partners. It differs from a general partnership in several ways. However, there are three basic differences.

First, there must be a state statute that provides for the formation of a limited partnership. A limited partnership is purely a statutory creation. Without a statute to create it, it cannot exist. This differs from a general partnership in that, although governed by statute, may exist without an explicit statute authorizing its existence.

Second, the limited partnership must fully comply with the requirements of the statute. If it does not comply completely with the statute, then it will not be regarded as a limited partnership. Instead it will be treated as a general partnership making all the limited partners really general partners, who can be jointly and severally liable for all partnership debts.

The third basic difference is that the liability of a limited partner for partnership debts or obligations is limited to the extent of the capital that he has contributed or agreed to contribute. A standard limited partnership agreement specifies the contribution each limited partner will make. This contribution is the maximum amount that a limited partner will be liable for the debts of the limited partnership. For instance, if you were to contribute $100 to a limited partnership and the partnership became solvent, the partnership's creditors will try to recover any unpaid amounts from the partners. While all general partners will be jointly and severally liable for the debt, you, as a limited partner, will not lose any more that the $100 that you have already contributed.

As you might guess, the rights of a general partner in a limited partnership differ from those of a limited partner. These rights are usually set forth in the articles of a limited partnership. In addition to the rights set out in the articles of a limited partnership, a general partner has all the rights and powers of a partner in a general partnership. Further, the general partners' right of control and management in a limited partnership is almost exclusive. A limited partner cannot share in the management or control of the limited partnership. If he does participate, he will forfeit his limited liability.

The duties of a general partner also differ from those of a limited partner. A general partner is subject to all the duties and restrictions of a partner in a general partnership. That is, a general partner has a fiduciary relationship with both the limited partnership and the limited partners. However, a limited partner generally does not have a fiduciary relation with the general partners of the limited partnership. Table 2-1 summarizes the differences between a general partner and a limited partner in a limited partnership.

Table 2-1: Comparison of General and Limited Partners

The IRS views partnerships as an aggregate of individuals, that is, it does not require a partnership to file a federal income-tax return. Rather the partnership must file an information return listing the name of each partner and the amount of income generated by the partnership. The individual partners must claim on their personal income-tax return 1040 their share (K-1 Distribution) of the partnership income. A partner is taxed on their share (the amount Distributed on K-1 Form) of the partnership income, regardless of whether he received the actual income or just the liability.

Under the Uniform Limited Partnership Act, the general partners who conduct the limited partnership are personally liable to creditors of the partnership. By definition, a limited partnership is a partnership having one or more general partners and one or more limited partners. The necessity for at least one general partner reflects a policy that someone have personal liability. However, it is often circumvented in states where corporations (with limited liability by virtue of corporate laws) can be the general partner.

Under the Model Corporation Act as originally proposed, each corporation was anticipated to have powers that included a power to be a partner or manager of any partnership. Common law courts denied that a corporation had implied power to become a partner; therefore, the Model Code expressly provided for that power.

Most states have modified the model act provisions and have deleted any reference of a corporation's ability to act as a partner. Many states are silent on the matter of allowing a corporation to serve as a general partner in a limited partnership and, because the relationship was discouraged at common law, corporate counsels have been reluctant to advise it. However, most of the states are silent, as far as expressly providing for a power in corporations to serve as a general partner in limited partnerships, do provide or do have case law to the effect that corporations may be general partners of limited partnerships if it is so specified in the corporation's Articles of Incorporation.

Corporations are free to serve as general partners under such express powers where it is not prohibited by statute or modified, such as in California, where a corporate general partner must be capitalized to the extent of $200,000 or it is prohibited from so serving.

Due to the public policy considerations suggesting some equitable remedy for an inadequately capitalized corporation serving as general partner of a limited partnership, and the pitfalls associated with attempting to collect a judgment from a corporate shell, much has recently been written regarding possible solutions to the undercapitalized corporation/general partner problem. See Ratigan, Piercing the Veil of the Corporate General Partner in the Hybrid Limited Partnership: A Suggested Remedy for Inequitable Conduct by Limited Partners, 17 Suffolk U.L. Rev 949 (1983).

A limited partner is personally liable for any losses of the partnership to the extent of his investment in the assets of the business. But a limited partner is not liable as a general partner unless, in addition to the exercise of his rights and powers as a limited partner, he takes part in the control of the business. In other words, to be free from personal liability, a limited partner may not in any matter interfere with the conduct or control of the partnership business.

As a rule, there must be active participation of domination by a limited partner to constitute control, but the fact that a limited partner acts as a manager or a foreman has been held not to constitute the requisite control that would make him liable as a general partner. The Uniform Limited Partners Act, Sec. 303(a) (1976) describes the kind of conduct that may be construed to be control on t he part of the limited partners.

The real power of the limited partnership is in its power to thwart lawsuits and judgments. If a partner is sued, the judgment creditor cannot take action against the assets owned by the limited partnership for satisfaction. Nor can they attach those assets or force the general partner to make distribution of profits to himself or the limited partners. What the creditor is entitled to is what is known as a "charging order".

A charging order gives the judgment creditor the right to receive any income that is distributed to the debtor/partner. In a properly drafted partnership agreement the general partner is given the power to withhold distribution of Income to meet the needs of the partnership. Unless income is distributed to the partners, the creditor cannot collect on his charging order.

Even though the judgment creditor receives no payment on his charging order, the I.R.S. has ruled that he is liable for tax on the 25 percent share of the partnership's income that he was otherwise entitled to receive! Revenue Ruling 77-137 states:

"A", a limited partner in a limited partnership formed under the Uniform Limited Partnership Act of a state, assigned the limited partnership interest to "B". The agreement of the partnership provides, in part, that assignees of limited partners may not become substituted limited partners in the partnership without the written consent of the general partners. However, it also provides that a limited partner may, without the consent of the general partners, assign irrevocably to another the right to share in the profits and losses of the partnership and to receive all distributions, including liquidating distributions, to which the limited partner would have been entitled had the assignment not been made. Under the terms of the assignment "A", who was the nominal limited partner under local law, agreed to exercise any residual powers remaining in A solely in favor of and in the interest of "B".

"It was also held, even though the general partners did not have their consent to the assignment, since "B", the assignee, acquired substantially all of the dominion and control over the limited partnership interest, for Federal income tax purposes "B" is treated as a substituted limited partner. Therefore, "B" must report the distributive share of partnership items of income, gain, loss, deduction, and credit attributable to the assigned interest on "B's" federal income tax return in the same manner and in the same amounts that would be required if "B" was substituted limited partner."

The judgment creditor, as irrevocable assignee and substitute limited partner according to Rev. Rule 77-137, receives a K-1 form showing he must report $25,000 of income he never received. The other partners receive similar K-1 forms and no distribution of funds in like manner, which may create tax problems for them. However, any general partner can receive compensation for their services as general partners. The charging order system puts the limited partner, from a liability posture, in a better position than a shareholder of a corporation. Therefore, it is usually under attack by creditors and their attorneys on these grounds. These facts should be considered in long-range planning.

In California, this statutory scheme received its first comprehensive judicial analysis in 1989 when the First District Court of Appeal held in Centurion Corp. that a limited partnership interest may be sold on foreclosure of a charging order lien, at the request of a limited partner's judgment creditor. The court held that a court may authorize the foreclosure and sale when three conditions are met:

1. The judgment creditor obtains a charging order against the partnership interest.

2. The judgment remains unsatisfied.

3. All partners other than the debtor consent to the sale of the interest.

In 1991, the California Third District Court of Appeal held in Hellman that a judgment creditor may foreclose on a debtor's general partnership interest, without the consent of the other partners, as long as the foreclosure does not unduly interfere with the partnership's business. This case dealt with the foreclosure sale of an 80% general partnership interest in a land development venture by a judgment creditor holding an unsatisfied judgment and a charging order. In reaching its conclusion, the court agreed with the First District Court of Appeals, holding in Centurion Corp. that a partnership interest can be subject to foreclosure of the charging order lien, but disagreed with its conclusion that all the other partners must consent.

Conclusion. Under Centurion, foreclosure and sale of the partnership interest of a judgment debtor whose interest is subject to a charging order may be frustrated by a veto from any partner other than the debtor. Under Hellman, the court may order sale without consent of all the others; it is prevented from doing so only on a showing of disruption to partnership interests.

With the continuing power to vote after a foreclosure sale, the debtor-partner may still place settlement pressure on the foreclosing judgment creditor. This may be brought about by causing distributions to be withheld while imposing pro-rata tax liability for partnership earnings on the creditor as assignee.

Ordinarily, one would await a future case in which the California Supreme Court resolves the differences between the First and Third District Courts of Appeal on these issues. The resolution, however, comes from another source: The National Conference of Commissioners on Uniform State laws. The current draft of its Revised Uniform Partnership Act provides at Section 504(b) as follows:

"The court may order a foreclosure of the charging order at any time and under such conditions as it considers appropriate. The purchaser at the foreclosure sale has the rights of an assignee."

The name of the game in asset protection is "anticipate and change your protecting system before it is too painful".

JURISDICTIONS THAT HAVE ADOPTED THE U.P.A.