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PARTNERSHIP DISPUTES.
Term Paper ID:25838
Essay Subject:
Examines nature & types of business partnerships, disputes & dissolution, selection of partners, agreements, advantages & disadvantages, majority/minority owner rights, inheritance, valuation, court cases.... More...
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Paper Abstract:
Examines nature & types of business partnerships, disputes & dissolution, selection of partners, agreements, advantages & disadvantages, majority/minority owner rights, inheritance, valuation, court cases.
Paper Introduction:
PARTNERSHIP DISPUTES
Part I - Subject
From a legal perspective, there are three common types of business organizational forms: sole proprietorship, partnership and corporation. Each of these organizational forms has different and important implications for liability, taxation, and succession. Further, with respect to both the partnership and corporation business forms, there exist sub-forms of business organization.
With respect to both the partnership and corporate forms of business organization, there exist a number of areas that may lead to disputes among the owners of the business entity. Such disputes can be especially contentious in business entities organized as partnerships, as lower levels of legal formality is required to form and o
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"Review of the Proposals of the National Bankruptcy Review Commission Pertaining to Business Bankruptcies, Part 1." Business Lawyer 53 (August 1998): 1381- 1452.Charles W. T. Similarly, the desire of an aging partner to remain inthe business and draw a full salary, can cause dissension among younger andharder-working partners. d. Difficulty in finding suitable partners. Borrowing start-up capital from relatives and friends also fails toestablish a business credit rating for the enterprise in the way thatsuccessfully repaid bank loans can contribute to the value of one'srecognized credit worthiness. A sub-type ofthe Subchapter S corporation is the Subchapter C Corporation. As opposed to a corporate form of organization, small businessentrepreneurs may organize their enterprises as either sole proprietorshipsor partnerships. This characteristic is known as limitedliability. The Tax Court, therefore, held that the annuity should have been valued using a .65-year, rather than a 15-year, life expectancy (Nager, Abbin, and Carlson 7 4). Wheremajor disagreements occur, however, partnership agreement typically providefor decision-making on the basis of voting rights attributable toproportional ownership shares in the business. In the instance of either sole proprietorships orpartnerships, principals are directly liable for the debts of the businessenterprise, where under a corporate form of organization, personal assetsare shielded from the obligations of the business enterprise. Berg. P. Limitedpartners are not involved in managing the business and cannot be heldfinancially liable for more than the amount of capital they havecontributed to the partnership. The Tax Court held that the annuity was purely a testamentary device unsupported by economic substance. For many small business firms, however, access to both capitalsources and methods by which capital may be obtained from these sources isoften restricted by a variety of diverse factors. Berg" 2949). Butthe earlier you start succession planning, the more time for something togo wrong" (Williams 79).Valuation A Tax Court ruling in 1993 established that amending a partnershipagreement can reduce transfer tax value. L. General partners must be stripped of the power to effectchanges in partnership structures from those described in the offeringprospectus. The United States Department of Commerceclassification is used in this examination for the purpose of defining a"small business." The findings of this examination are presented in two major sectionsfollowing this introduction of the subject. Partners share in the profits according to the termsof the agreement. A formal partnership agreement maystipulate the minimum when a partner either may opt to sell her or hisshare of the business to the other partners or the maximum age when apartner must sell her or his interest in the business to the otherpartners. "Passing the Torch." Financial World 166 (21 January 1997): 78- 8 .Zobrist, D. The parents serve as general partners, making all thebusiness decisions. In one case, the decedent, whohad cancer, held general partnership interests in two family partnerships("Estate of Gordon B. Unlimited liability (does not apply to limitedpartners). The second of these elements concerns the valuation of the business.While partnership law requires the remaining partners to pay the fair valueof a departing partner's share of the business, partnership law does is notspecific on how fair value is determined. Boththe IRS and the courts, however, are applying increasing oversight to theuse of valuation adjustments in determining the fair market value of familylimited partnerships. At times, the Subchapter S Corporation isselected as the business organization form of choice over the partnershipform. Limited partners, however, may not participate inthe active management of the partnership's business. Thisimpact is the result of differences in income tax liabilities for differenttypes of business forms, and differences in the abilities of the differenttypes of business to generate capital (Brigham 94). As anexample, the buying and selling of the organization's equities can bechanneled through a brokerage in which the general partner holds an equityinterest. al. C., and Bahls, J. The earlieryou start succession planning, the more likely it will go smoothly. Buy-sell agreements are used by partners to assure continuity in aclosely held business. Decision-making process. Clauses in a formal partnership agreementcovering each of these eventualities can avoid such disputes. Journal of Political Economy 1 (April 1992): 8 1-877.Nager, R. "Double Trouble." Entrepreneur Magazine 24 (November 1996): 88-9 .Barnard Mendelbaum, et. As a separate entity, the partnership does notpay income tax. The limited partnership became a highly popular investment vehicle inthe 197 s. In the typical two-partner, equal ownership partnership business,decision-making deadlocks not only are a possibility, they occurfrequently. Limited regulation in relation to other businessorganization forms. E., and Conn, R. 4. Payment from capital is feasible when awithdrawal occurs in a planned fashion. By transferring ownershipinterests as gifts to the children over time, they are removed from theparents' taxable estate. A limited partnership differs from a generalpartnership in that only the general partner or partners have unlimitedliability. Therefore, the use of the concept must beconsidered within the context of federal income tax laws. Start-up capital obtained from relatives and friends typically isless dependent upon one's credit rating than are bank loans, and is, thus,typically more easily obtained. c. Divided managerial authority (does not apply to limitedpartners). In any event, it isnecessary to review and update such provisions as the partnership matures. K. Unless stated otherwise in the partnershipagreement, each partner has the same rights, obligations, and authority asevery other member of the partnership. Further,in the absence of the amendments, the decedent was afraid that hisdaughters would seek dissolution" (Nager, Abbin, and Carlson 7 3). On a broadlevel, the Subchapter S Corporation is limited to 1 shareholders, while arequirement for the Subchapter C Corporation is that at least 5 percent ofthe stock must be held by no more than five shareholders. b. The first of these elementsconcerns a partner's right to leave the business. Regardless of the underlying asset base in a tax shelter, the limitedpartnership structure is an effective means of establishing an investmentvehicle which will permit the direct flow of both tax benefits and cashgeneration to the investors. The attraction of the Subchapter S Corporation lies in potentialfederal income tax benefits. Assets of the business are transferredinto a partnership with both general and limited partners. One partner may want to sell out when the other does not havethe money to buy. The basis for marketability adjustments forfamily limited partnership interests stems from a variety of factors, whichinclude the following: 1. General partners must be prohibited from conducting thebusiness of the limited partnership investment organization where conflictsof interest are present. Further, with respect to both thepartnership and corporation business forms, there exist sub-forms ofbusiness organization. Low start-up costs. The Subchapter S corporate form of organization remainspreferable for many small business entrepreneurs, however, because of theability to elect how federal tax liability will apply-as an individual, asa partnership, or as a corporation. Ownership interests are passed to the children, whoare the limited partners. "Significant Recent Developments in Estate Planning, Part 2." Tax Adviser 25 (November 1994): 698-7 9.Nappi, A. d. H. You may thinkany problems can be resolved amicably as they arise. Essentials of Managerial Finance: Principles and Practice 4th ed. It is alsounpredictable because most judges have little experience in determining thevalue of a partnership interest" (Bahls and Bahls 89). Tax Court Memo 1994-539.Estate of Woodbury G. g. 5. Problems leading to partnership disputes may be anticipated andlargely avoided through the preparation of formal partnership agreements.Typically, the process of negotiating the terms of a partnership agreementleads to a greater understanding between or among partners understand andto the structure of a partnership agreement that is acceptable to allconcerned to the extent that any disputes that do arise may be settledamong the partners without resort to legal action. Ward. "In family businesses, for example, where decisions are oftenmade informally, it is hard to imagine the tensions that plague thousandsof other family businesses could ever crop up in yours. Ease of business formation. What must occur, however, is the unambiguousstatement of ownership shares in the formal partnership agreement. Tax Court Memo 1995-255.Bolten, S. The State of Small Business: A Report to the President. M., and Carlson, D. Such disputes can be especiallycontentious in business entities organized as partnerships, as lower levelsof legal formality is required to form and operate such business entitiesthan is true for corporate businesses. Further, most tax shelters are structured in the form ofa limited partnership. One useful aspect of this definition is itsrecognition of the fact that numbers of employees and gross revenues areonly loosely correlated. A wide variety of partnerships exist, and this examination is notconcerned with all of these partnership types. The IRS contended that a gift tax deficiency of $31,142,5 7, plusinterest and penalties, existed, arguing that the private annuitytransaction was really a part gift/part sale. The Tax Court is becoming increasinglysensitive to a failure of appraisers for both the government and thetaxpayers to adequately support their opinions of valuation adjustments("Estate of William Luton" 539; "Barnard Mendelbaum, et al. In the absence of effective regulation covering limited partnershipinvestments, however, general partner's are in a position to permitmanipulation of the activities of a limited partnership investmentorganization in such a way that the unlimited risk of the general partneris reduced, while, at the same time, the limited risk of the limitedpartners is increased. The typical decision-makingprocess in partnerships is based on a consensus among the partners. These issues include the following (Bahls and Bahls 89: 1. W., Abbin, B. These broad advantages and disadvantages are asfollows: 1. Information disclosure is required in limited partnership investmentswith respect to both financial data, and identification of limited partnersto other limited partners. H., and Bradford, S. These proportions indicate that small-business plays an importantrole in the American economy, but not the dominant role often attributed toit. Bank loans, however, are a good source of capital for the smallbusiness entrepreneur with a strong credit rating and a sound businessplan. The decedent died in September 1986 (Nager, Abbin, and Carlson 7 2). By permitting the flow through of tax benefitsdirectly to investors, limited partnerships permit investors to avoid thedouble taxation, which is characteristic of corporate dividends (Haight11). (1994, November). ... The court also noted that, other than the $25 , , no annual annuity payment was set out in the agreement. First, it noted that the general partnership interests were undervalued by almost $5 million for annuity calculation purposes. As an example, in Estate of Woodbury Andrews v.Commissioner, the Tax Court held that adjustments for lack of controlapplied even when the decedent and his siblings owned all of the stock ofthe corporations in question. Frequently, formal partnership agreements are not prepared. Among the partnership typesnot included in this examination are (1) public-private partnerships, whichinvolve public sector organizations and private business entities, (2)limited liability companies, which are treated by some analysts aspartnerships, (3) Subchapter S corporations, which provide owners with theoption of being taxed as partnerships, (4) business-to-businesspartnerships, which may involve either cooperative endeavors or more formaljoint venture agreements, and (5) business entities that are classified asother than "small businesses." The 198 White House Conference on Small Business defined a small-business as one with 5 or fewer employees (United States Small BusinessAdministration, "The State of Small Business 198 " 3). Peer pressure and partnership. The organizational form of business organization has a direct impacton the financial structure and financial performance of a firm. Typically, each general partner is actively engaged in the conductof the partnership business. f. These major sections are"Discussion" and "Analysis." The final section of the examination is the"Conclusion." Part II - Discussion Five issue areas are addressed in this discussion. In setting the annuity, it was assumed that the decedent's remaining life expectancy under Regulation Sec. Such agreements also can be used to resolvesuccession issues in partnerships (Williams 79). Limited partners provide most of the capital for an investment in thebusiness of the partnership, and they are not authorized any role in themanagement of the partnership. E., Jr., Sigal, M., and Schorling, W. 349 (1986).Roy O. Limited partnerships are structured with two types of partners-thegeneral partner and the limited partner. 87 T.C. Part IV - Conclusion With respect to limited partnerships, the principal areas which mustbe addressed with respect to the protection of limited partners in limitedpartnership investments involve (1) the regulation of the activities ofgeneral partners and (2) disclosure of relevant information to investorsand potential investors in limited partnership investments. For such persons, the partnership organizational formoffers an added capital source while retaining some of the characteristicsof a sole proprietorship. Subchapter Scorporations are permitted to make an election whereby shareholders will betaxed (for federal income tax purposes) as individuals, as opposed totaxing the business organization as a corporation, and then taxingindividual shareholders on income derived from the corporation. Limited Partnerships. Valuation. Partnership law is generally standard throughout the United States,however, because most states have adopted both the Uniform Partnership Actand the Uniform Limited Partnership Act. C. Works CitedBahls, S. The deficiency was based onthe stipulated partnership liquidation value, less the value of theretained life estate (which the IRS calculated based on an estimated lifeexpectancy of .65 years) and the $25 , payment (Nager, Abbin, andCarlson 7 2). In the event of the unexpecteddeath of a partner, however, a business is better served through theinclusion in the formal partnership agreement of a requirement for thebusiness to carry life insurance on all partners. This definitioncovers almost all business enterprises in the United States-99.7 percent-in1998 (United States Small Business Administration, "The State of SmallBusiness 1998" 19). Neither financial position or decision-making authority in a partnership are required to be equal among thepartners. 58 Tax Court Memo 1989-1 6.Estate of Gordon B. The limited partnership concept may be, and has, been applied tovirtually all types of investments, from cattle breeding to cabletelevision (Haight 2 2). For many others, however, the greaterflexibility available through the partnership form of businessorganization, together with the fact that lenders likely will demand anacceptance of personal financial liability by the business owners, willlead to the selection of the partnership form of business organization. The generalpartner is fully liable for the debts and obligations of the business, butalso may be entitled to a greater share of the profits earned by thebusiness. Disadvantages: a. No othersingle act on the part of partners can be more effective in precluding thedevelopment of or resolving partnership disputes. Partners can legally bind one another without priorapproval from the other partner or partners (does not apply to limitedpartners). f. General partners must be stripped of the power to shieldthemselves from liability, while passing that liability to the limitedpartners. Partnerships (such as those found in legal or accounting firms) createan environment where all the members share the business risk and also sharethe wealth created by the partnership, which involves profits earned by orlosses incurred by the partnership. McLendon" 459). Some individuals, however, may be reluctantto commit all of their personal savings to a new business venture (Boltenand Conn 118). Regulation of limited partnershipinvestments is required to preclude abuses by general partners.Specifically, the following steps are essential: 1. Several crucial issues should be covered in formal partnershipagreements. As will be revealed insubsequent discussions in this examination, the partnership form ofbusiness organization offers both advantages and disadvantages compared toother business organization forms in relation to financial liability,operational control, and taxation. A formal partnership agreement shouldspecify the source of the funds to be used to pay a withdrawing partner forher or his share of the business. There is no public market for family limited partnershipinterests. In return for assuming these duties and risks,the general partner is compensated out of the funds of the limitedpartnership, in addition to sharing in the organization's earnings on thebasis of equity position. This ruling confirmedcourts rulings. 7. e. A widely applied maneuver in this context is theextraction by a general partner of inordinate fees for services rendered.Extraordinarily large fees for services permit the general partner toprotect her or his investment, while shifting liability for losses to thelimited partners. Such anoutcome may be avoided by anticipating what problems may occur in apartnership and addressing those problems in a partnership agreement (Bahlsand Bahls 88). With respect to financial disclosure, such disclosure is requiredbecause financial statement, and the disclosure of other informationrelevant to these statements are central to the securities investmentprocess. 3. Family limited partnership agreements frequently require theconsent of the other partners before a substitute limited partner may beadmitted. Recent court cases relevant to these issue arereviewed as a part of the examination of the issues. The Tax Court held that the annuity payment was substantially lessthan the value of the remainder interest, resulting in a gift. Andrews. These latter criteriarestrict the small-business classification to those enterprises that haveeither (1) fewer than 1 employees, or (2) less than one-million dollarsin annual receipts. Partners should "expectthe unexpected. The initial annuity payment was $25 , . Part III - Analysis An important business organizational form for small businesses is theSubchapter S Corporation. In this partnership type, each partner isresponsible for, and must assume the consequences of the actions of theother partner or partners. To this point, there is nothing unfair orinequitable about this arrangement. Instead, the court found that the fair market value(FMV) of the partnership interests, rather than the aggregate value of theunderlying assets, was the appropriate measure for transfer tax purposes.The parties stipulated this value to be between approximately one-third andone-half of liquidation value. Family limited partnership agreements frequency placerestrictions on the transfer of partnership interests. Various, and often contradictory, governmental actions in the 198 s,together with dynamic and, in many instances, unforeseen economicdevelopments, created an economic environment in which thousands ofinvestors saw their equities in limited partnerships either disappear orgrow significantly smaller. Broader management base than a sole proprietorship. Rather, the individual partners include in their ownincome tax returns their individual share of the partnership income,deductions, or loss. "Small Business Eligibility: A Definitional Issue." Journal of Small Business Management, (198 ): 23-3 .Northern Trust Co., 87 T.C. Family partnerships are a sub-type of the limited partnership type ofpartnership. McLendon. Payment provisions. General partner fees should be restricted to normaloperating expenses, and internal commissions should be prohibited. In order toestablish the terms of the partnership and to protect partners in the eventof a disagreement or dissolution of a partnership, a partnership agreementshould be drawn up. Personal savings remain the preferred source of start-up capital forsmall business entrepreneurs. Broad advantages and disadvantages character the partnership form ofbusiness organization. Although parties mayact publicly in such a way that implies to others that they have formed apartnership, it is only sensible for the partners to prepare a formalpartnership agreement that define the rights and obligations of eachpartner. The Tax Court concluded that liquidation value was not anappropriate measure. "Typically, the partner whowants out expects more than the others are willing to pay. The use of family limited partnerships can be a useful tool insuccession planning, investment strategy, and wealth preservation. With respect to both the partnership and corporate forms of businessorganization, there exist a number of areas that may lead to disputes amongthe owners of the business entity. "Unless there is apartnership agreement to the contrary, a partner may quit or retire at anytime, compelling the remaining partners to pay fair value for his or herinterest. The organization and operation of a partnership is primarilygoverned by the statutory law of the state where the partnership is formed. Difficulty in raising additional capital in relation tocorporations. 3. On the same day, the decedent, as annuitant, entered into a private annuity agreement with his son (individually) and the trust, under which the decedent sold a 25 percent remainder interest in his general partnership interests to the son outright and a 75 percent remainder interest to the trust. "The Valuation of Family Limited Partnerships." Trusts & Estates 134 (September 1995): 66-75.Kandel, E., and Lazear, E. As a contractual agreement, thepartnership form of business organization is flexible enough to be easilyadapted to the needs of most business activities. Some court ruling "have supported the application of lack of controladjustments to shares in closely held business entities," such as familylimited partnerships because of the lack of marketability (Higgins 69).The courts have issued decisions containing explicit minority adjustmentsranging from five-percent to 33.3 percent, with the majority fallingbetween 15 percent and 25 percent ("Roy O. Post-withdrawal competition. As fair market valuecan vary over time, it is essential to establish a specific date of value(Higgins 69). 2. Lack of continuity in the operation of a business inrelation to the corporate form of business organization. In Revenue Ruling 93-12, the Internal Revenue Service (IRS) statedthat a lack of control adjustment is not disallowed solely due to a familyrelationship between the various stockholders. 6. 79 T.C. These issue areasare (1) the selection of partnership as the organizational form for abusiness entity, (2) partnership agreements, (3) types of partnerships[including consideration of (a) general advantages and disadvantages and(b) majority owner/minority owner rights], (4) succession [rights ofinheritance], and (5) valuation.Selection of Partnership Organizational Form The generation of capital is one of the most pressing problems facingany enterprise. 3. Essential to the court's finding was thedetermination that the 1985 amendments "were not driven solely bytestamentary motives. b. F. In valuing a partnership, therefore, it important toexamine the economic factors relevant to the partnership. If the remaining partners do not have enough money available,they may be forced to liquidate the business" (Bahls and Bahls 89). Effectiveapproaches to this issue include the designation of a third party to assessthe value of the business or the specification of formula for purposes ofvaluation (examples of the latter approach are a specified percentage ofbook value and a specified multiple of net profit). This research examines issues associated with partnership disputes andthe dissolution of partnerships. The child whowill take over management of the business becomes the general partner. One may want to expand the operation dramatically, whilethe other would rather coast" (Bahls and Bahls 88). The general partner in a limited partnership investment organizationis responsible for the conduct of the organization's business. Source of funds. A partnership arises from any agreementbetween two or more persons to unite their property, labor, skill, capital,or some combination of these resources to establish and carry on a businessas joint owners for the purpose of earning a profit. L. Possible tax advantages. Second, the $25 , initial payment bore no relationship to the actual annuity value, either under the court's or the decedent's asset value estimates. Advantages: a. Andrew Nappi and Jay Vora (24) provided criteria that are both morerestrictive and more useful for defining small businesses than thosedeveloped by the White House Conference in 198 . Partnership disputes Part I - Subject From a legal perspective, there are three common types of businessorganizational forms: sole proprietorship, partnership and corporation.Each of these organizational forms has different and important implicationsfor liability, taxation, and succession. With respect to the cost of money, it isdifficult to project advantages and disadvantages between borrowing fromrelatives and friends, on the one hand, and banks, on the other hand. The problem facing afirm in this context is to obtain the capital required, in the amountrequired, and under conditions which enable the firm to continue to fulfillits objectives (Bolten and Conn 117). Financial Management 8th ed. Hinsdale, Illinois: The Dryden Press, 1998.Brunstad, G. 25.2512-5(f) (Table A) of the Internal Revenue Code (IRC) was 15 years. This type of arrangement permits the general partner to earnmoney twice on a transaction, and it permits the general partner todetermine the level of the brokerage commission without regard tocompetitive conditions. As the situation now exists with respect to thelatter, general partners can effectively thwart concerted actions by thelimited partners by preventing the limited partners from learning theidentities of all of the other limited partners in a limited partnershipinvestment. The general partner'sresponsibilities cover the conduct of the day-to-day business activities ofthe partnership. Washington: United States Government Printing Office, 198 .United States Small Business Administration. In return for their management of the partnership, and their riskexposure, general partners are compensated by the partnership with feeswhich are paid as a part of the partnership expenses (Haight 6). v. A limited partnership is created for the purposeof acquiring investment assets. The absence of effective regulation of limited partnership investmentsalso permits general partners the opportunity to conduct operations of theinvestment organization without regard for conflicts of interest. Businesses are dynamic, and so are families. Retirement age. A limited partner share in partnershipprofits according to the specific provisions of the formal partnershipagreement (Zobrist and Bradford 1 ). However, partnershipswed personalities with goals and management styles that often differmarkedly. 2. Chicago: Probus Publishing Company.Higgins, M. Martin, Jr., 5 Tax Court Memo 1985-768.United States Small Business Administration. Potential for the development of conflict betweenpartners. Tow major elements of the Uniform Partnership Act justify thepreparation of a formal partnership agreement. Two or more persons may form a generalpartnership by joining together as co-owners to conduct a business forprofit. One way out of this situation is for the two partners to awarda one-percent interest in the business to a trusted person, who, as a thirdpartner, can break a decision deadlock. Such credit sources, however, typicallyare less certain sources of additional capital as a business enterprisegrows. While a limited partnership must have at least one generalpartner with unlimited liability, it may also have limited partners withliability limited to a specific amount established in the formalpartnership agreement. Additional sources of investment capital. The financial performance of a partnership is directly influenced byeconomic conditions. E. Such items pass through the partnership to thepartners regardless of whether income, deductions, or losses are actuallydistributed by the partnership. The assessment of these advantages anddisadvantages in relation to the objectives and characteristics of theentrepreneur will lead to the selection of the most appropriate businessorganization form.Partnership Agreements Disputes between or among partners may end up in court. With respect to partnerships generally, the emphasis on the need toexecute formal partnership agreements cannot be over emphasized. This approach makes it possible for ownership tobe transferred gradually to the children. If the partnerscannot agree, they may have to ask a judge to set the price. There are both advantages and disadvantages to familypartnerships. Ownership shares. The formal partnership agreement stipulates how profit and loss isshared among partners. A limited partnership also involves general partners who areinvolved in the management of the business of the partnership. Family limited partnerships usually have few partners, whichnarrows the pool of potential buyers of interests in the partnership.Further, the other partners usually are not obligated to purchase theinterests of a limited partner who wishes to sell her or his interest. There are a variety of reasons why formal partnership agreements may notbe prepared. A second type of partnership is a Limited Partnership which involveslimited partners who contribute only capital to the business. A specific process for the valuation of thebusiness upon the withdrawal of a partner should be included in a formalpartnership agreement. A formal partnership agreementshould include a non-compete provision for withdrawing partners. The disclosure of financial information, more so than any othertype of information, has a highly significant impact on investor judgment. 78 (1986).Estate of Edgar A. Tax Court Memo 1993-459.Estate of William Luton. Although the partnership must compute taxableincome and file a return with the IRS, the return is used for informationpurposes only by the IRS. 6. A family limited partnership may be created well before any successionis to occur. Should they soparticipate, a limited partner jeopardizes her or his limited liabilityprotection. A great variety of capital sources exist, along with anequally great variety of methods by which these sources may be tapped by anenterprise. 2. For small business entrepreneurs just beginning, the safest and leastexpensive sources of capital often are family, friends, and personalsavings. Regulating the General Partner. Typically, the extent of the liability ofthe limited partner is the amount of their investment in the partnership.The partnership rewards the limited partners through the provision of ashare of the partnership's investment income and equity growth, and throughthe pass through of federal income tax benefits (Haight 1 ). Like anylawsuit, this is likely to be expensive and time-consuming. 4. Internal monitoring occurs withinpartnerships. While thisadvantage of the corporate form of business organization over the soleproprietorship and partnership forms of business organization might betempting to small business entrepreneurs, in actual practice, it is likelyto be more of a theoretical advantage than an actual advantage, as lendersand creditors may demand an acceptance of personal liability by the smallbusiness entrepreneur as a price of doing business with them, regardless ofthe legal form of business organization under which the business entity isstructured. The courtdisagreed, however, with the IRS's contention that the 1985 amendmentsshould be ignored and that the partnership interests should be valued atnet liquidation value (Nager, Abbin, and Carlson 7 3). In determining whether a gift occurred, the Tax Court focused on thevalue of the partnership interests (the bona fides of the annuitycalculation). Included among these benefits areopportunities to apply valuation adjustments to fractional partnershipinterests. Among the issues examined are (1) theselection of partnership as the organizational form for a business entity,(2) partnership agreements, (3) types of partnerships [includingconsideration of (a) general advantages and disadvantages and (b) majorityowner/minority owner rights], (4) succession [rights of inheritance], and(5) valuation issues. United States Department of Commerce guidelines,as an example, classify a business as small if its annual sales are lessthan $25 million (United States Small Business Administration, "The Stateof Small Business 1998" 22). Theduration of a non-compete period is determined during the negotiation ofthe formal partnership agreement.The Partnership Types: Advantages, Disadvantages, and Functioning In a General Partnership, two or more owners share the management of abusiness, and each partner is personally liable for all the debts andobligations of the business. 5. In May and August of 1985, thedecedent and his son (the other general partner) amended the partnershipagreements to "(1) eliminate provisions mandating liquidation on thedecedent's death and (2) give the son sole management control over thepartnerships and authorization to expel any partner contesting hismanagerial decisions" (Nager, Abbin, and Carlson 7 1). If one partner should decides to retire from the business at arelatively young age, such a decision could impose a hardship on theremaining partners. As one set of analysts noted,"Partnership disputes are nearly as common as partnerships" (Bahls andBahls 88). c. The limited partnership structure enablessmall and medium investors to gain access to tax benefits which wouldotherwise be denied to them. Thechild or children who will not be active in the business become the limitedpartners. Finally, the Tax Court found that the decedent's reliance on the Regulation Sec. Washington: United States Government Printing Office, 1998.Williams, G. The generalpartner is also exposed to unlimited risk with respect to theorganization's obligations. Commissioner. The family limited partnership provides a number of important businessand estate planning benefits. "When agents interact to produce outputs they acquire low-cost information about colleagues, information not directly available tohigher level agents. 4. The State of Small Business: A Report to the President. General Partnerships. New York: Carlsmith Ball Wichman Case & Ichiki, 1995. Business enterprises included in this definitionaccount for 47.8 percent of non-government and non-farm employment, 42percent of sales revenues, and 38 percent of the country's gross nationalproduct. 2. A valuation process for the business should be inserted in a formalpartnership agreement to preclude the development of disputes. Insome instances, relatives and friends loan money at less than prevailingrates, while in other instances, higher than prevailing rates are demanded(Bolten and Conn 118). The primary disadvantage toa general partnership is that each partner has unlimited personal liabilityfor all debts and obligations of the partnership, including thosewrongfully incurred by another partner (Zobrist and Bradford 1 ). Both general and limited partners have an economic interest inthe business but only the general partner has a voice in management of thebusiness (Williams 78). A partnership is an agreement in which two or more persons combinetheir resources in a business with a view to making a profit. The courts have indicated that an appraisal mustenumerate the specific facts, circumstances, and empirical evidence thatsupport the valuation opinions offered. 938 (1982).Haight, G. Business Entities & Formation. When valuing family limited partnerships for transfer tax purposes,the standard of value applied is fair market value, which is defined as theprice at which the property would change hands between a willing buyer anda willing seller, neither being under compulsion to buy or sell and bothhaving reasonable knowledge of the relevant facts. Relatively low cash entry requirements (for the individualinvestor), limited liability, and the promise of sheltering ordinary incomefrom federal tax proved to be a powerful lure for thousands of smallinvestors across the country. The capital contribution of a limited partner may consist ofcash or property, but not services. Martin, Jr." 768; "Charles W.Ward" 87; "Northern Trust Co." 87; "Estate of Evelyn Wildman" 1 6; "Estateof Edgar A. Typically, a formal partnershipagreement specifies that the value of a withdrawing partner's share of thebusiness will be paid at market interest over a specified number of years.A lump-sum payment typically is avoided to assure that the business is notharmed financially. e. Boston: Houghton Mifflin Co., 1995.Brigham, E. The investment assets are intended toprovide investment income, principal protection, principal growth, andfederal income tax benefits (Haight 2 4). 25.2512-5(f) tables of the IRC was misplaced, because his medical condition was such that he was not expected to survive more than one year beyond the transaction date. Further, unless specificallyprohibited by the partnership agreement, any partner may enter intocontracts that are binding on the partnership. The partnership form also avoids thedouble tax effect of the corporate form of investment in which tax isimposed on corporate income and again on the dividend of after-tax profits. The use of the partnership form of business organization has becomeincreasingly popular because the conduct of business through a partnershipcan offer substantial flexibility. On 5 March 1986, the decedent established a trust for the benefit of his three daughters and named his son trustee. While a limited partnership, as is true of the general partnership, isnot itself a taxable entity, it does serve as a conduit through whichfederal income tax benefits flow to the individual investor partners.Thus, limited partnerships are typically structured with federal income taxbenefits in mind. The major disadvantage of the family limited partnership isthe lack of marketability. Family limited partnerships frequently invest inundiversified assets, decreasing the attractiveness of interests in thepartnership. T., and Vora, J. General partners are also exposed to unlimited liability. Further, where a dispute among partnerscannot be resolved among themselves or through arbitration, any partner maypetition a court of competent jurisdiction to dissolve the partnership(Zobrist and Bradford 8). v.Commissioner" 255).Succession The family partnership technique can be used as both a successionprocess and to reduce estate taxes. Mutual (internal) monitoring systems tap thisinformation for use in the control process" (Kandel and Lazear 821).Because partners are interdependent, this "mutual monitoring" may beexpected to promote work behaviors that eventually lead to the attainmentof organizational goals and objectives (Kandel and Lazear 822). The New Limited Partnership Investment Advisor 3rd ed. The assets held by family limited partnerships frequentlyproduce little income. Depending on the assets and time each partner contributes to thebusiness, other ownership share distributions may be included in the formalpartnership agreement. A partnership may be formed for a definite or an unlimited term.Unless the formal partnership agreement specifies otherwise, however, thedeath or bankruptcy of a partner automatically dissolves the partnership.Further, the sale of a partner's interest usually gives the other partnersthe right to terminate the partnership unless otherwise stated in theformal partnership agreement. The decedent wanted the businesses to continue afterhis death and was convinced that only his son could manage them. 61 Tax Court Memo 1991-2949.Estate of Evelyn Wildman.
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