Partnerships and limited liability companies

• Pages: 51-105
• Author: William A. Klein,John C. Coffee Jr.,Frank Partnoy

51

Chapter 2

PARTNERSHIPS AND LIMITED

LIABILITY COMPANIES

I. INTRODUCTION

A. JOINT OWNERSHIP

We have seen in Chapter 1 that there are business firms that

normally are, and sensibly may be, thought of as ‘‘owned’’ by a single

individual, the sole proprietor. As we examine such firms more closely,

however, we may find a complex set of relationships between and among

that owner and other contributors of economic inputs such as suppliers,

lenders, and managerial and other employees. We then can see that the

nonowner contributors to the economic venture may to various degrees

share in ownership attributes such as risk of loss, an interest in profits,

and control. Certain of the significant attributes of ownership may also

be shared by customers—particularly those who buy much of what they

need from the firm and have few, if any, alternative sources of supply.

Thus, we can see that since the concept of ownership is not as simple

and clearcut as one might have thought, neither are the distinctions

among various forms of organization. Indeed, one important objective of

this book is to encourage a perspective that emphasizes the functional

elements, such as risk and control, that are the common threads in the

various forms of business organization that our legal system has devel-

oped, and, by the same token, to restrain a natural tendency to think of

categories such as proprietorship, partnership, and corporation as air-

tight compartments.

In recent years the Limited Liability Company (LLC) has become

the dominant form of legal organization for small businesses. For the

present, however, the basic attributes of LLCs can best be understood by

beginning with the more widely understood and more analytically devel-

oped legal and economic attributes of partnerships. The legal attributes

of LLCs are described in Section X(B) of this Chapter.

Still, even in the most smoothly continuous spectrum, lines can

usefully be drawn. Accordingly, at this point in our examination of

business organization, while recognizing that the basic elements of one

form of organization can gradually be modified to the point where it

fades into the next, we can observe that as we turn from proprietorship

to partnership we enter the realm of economic arrangements exhibiting

clearly the characteristic of straightforward joint ownership. As we

examine the law and custom of partnership organization, we will try to

give definition to the notion of joint ownership of a firm and try to gain

52 PARTNERSHIPS & LIMITED LIABILITY COMPANIES Ch. 2

an appreciation of both the problems encountered in such a relationship

and the solutions that may be available for coping with those problems.

B. RULES DESIGNED FOR SMALL FIRMS

As we proceed from proprietorship to partnership, we move from

firms that tend to be very small, to somewhat larger ones. As one might

logically expect, when firm size increases joint ownership becomes more

common. Even so, partnerships1 themselves ordinarily are engaged in

economic ventures of relatively small scope.2 This means that partner-

ships are encountered most frequently in those sectors of the economy

(such as legal services and retailing) where the optimal firm size is

relatively small. By the same token, partnerships are not found in those

sectors (such as automobile manufacture) where the optimal firm size is

large. This observation is consistent with the observation that the law

of partnership, whose major function is to prescribe the economic rela-

tionship among the partners, is geared to the needs and circumstances of

small firms. Partnership law is addressed primarily to the firm with a

few partners, all of whom are involved in the operation of the business

and all of whom look to their share of the profits of the business as the

return for their contributions of capital or services or both. While the

basic law leaves ample leeway for express agreements designed to alter

the rules that it supplies for this kind of firm, one begins, at least, with

rules designed for people who have decided that they want to enter

actively into business with other people whom they know and with

whom they think they can work. The personal relationship typically is

an essential element of the bargain that is manifested in the formation

of a partnership. This is not to say that partners usually like each

other—only that ordinarily they know each other, that each has sized up

the others, and that they have relied on their judgments about the

people with whom they have embarked on the enterprise. It is likely,

moreover, that the partners will, at least to some significant extent, trust

one another. Not always, but usually. In fact, it is a commonplace

among people who have been in business that one is ill-advised to enter

into business ventures with others unless one can trust and rely on

them. The attribute of reliance on the personal characteristics of one’s

partners seems to be present even in firms with a large number of

partners, as, for example, in law and accounting.

1 The term ‘‘partnership’’ is used here to

refer to what lawyers sometimes call a

‘‘general partnership,’’ the word ‘‘general’’

being attached to distinguish what may be

thought of as the normal partnership from

special forms such as the limited partner-

ship (described in Sec. X(A) of this Chap-

ter).

2 The partnership form has, however,

been used for some large firms, such as the

major national and international account-

ing firms and law firms. In such firms, the

basic partnership model tends to be modi-

fied by, for example, delegation of control to

an executive committee and the use of vari-

ous levels of partnership status, including

‘‘non-equity’’ partners.

53REASONS FOR JOINT OWNERSHIPCh. 2

One should not infer from these observations that basic partnership

law is in all respects ideally suited to the needs and circumstances of all,

or even most, small firms. We will see that the basic partnership rules

concerning the power of partners to bind the partnership (Sec. VIII(C)),

personal liability (Sec. VII (D)), and duration and continuity (Sec. IX), do

create problems for at least some small firms. What is suggested,

rather, is that partnership rules can best be understood if it is recog-

nized that they seem to have been developed with small firms in mind.

The reader should also be warned that many small firms (sole

proprietorships as well as partnerships) are organized as corporations or

as limited liability companies (which are a recent development and

reflect something of a hybrid of partnership and corporate law). In this

Chapter and in Chapter 3 we will see some of the organizational

considerations that might be thought to argue for use of the corporate

form for a small firm. In recent years, however, the choice of form has

been affected most significantly by tax considerations. We live in an

Alice-in-Wonderland world in which, for example, an entertainer can

achieve certain tax benefits only by engaging in the economically mean-

ingless process of forming a fictional entity (a corporation) of which he or

she becomes the sole owner (shareholder) and at the same time the sole

‘‘employee’’ (as well as Chair of the Board of Directors, President, etc.).

It is also worth noting that while partnership law is generally

associated with small ventures, some large ventures may use the part-

nership form. For example, two or more large corporations may engage

in a joint venture to manufacture and sell a new automobile or airplane.

They might decide to set up a new corporation, in which they share

ownership, to carry on the joint activity. It is also conceivable, however,

that they might operate simply as a ‘‘joint venture’’ (which is a type of

partnership). In such situations, the parties are likely to adopt a detailed

agreement concerning their relationship with one another. To the extent

they do so, the general rules of partnership law, which are mostly

‘‘default’’ rules (that is, rules that apply in default of express agree-

ment), decline in importance. There will, however, inevitably be gaps in

the express agreement. If these gaps become significant, they will be

filled from the rules of partnership law.

II. REASONS FOR JOINT OWNERSHIP

A. JOINT OWNERSHIP VERSUS PURCHASED INPUTS

Much of the material in this chapter discusses problems that arise

from division among two or more people of the ownership of a business

enterprise—problems that are largely avoided when the entire ownership

interest is held by one person. To some extent these are problems of

specifying with some precision (but not too much) the rights and

obligations of joint owners. But those problems are manifestations of