Business Entities in Virginia: Article 2 of 4
W. Brandon Cowan, Esquire
This is the second in a series of four articles directed at highlighting the characteristics of and differences between business organizations in Virginia. The first article served as an introduction to both the various business organizations in Virginia and introduction to the frequently used terms that pertain to business organizations (capitalized terms herein shall have the meaning delineated in the Definition Sections of Article 1 and this Article, or as further defined herein). This article focuses on Partnerships, while the two subsequent articles will examine Corporations and Limited Liability Companies.
Event Of Withdrawal: An event that causes a person to cease being a partner.
Partnership Agreement: A contract that defines each partner's duties and obligations to each other and the Partnership; but not the partners' relationships with third parties.
Partnership Interest: A partner's share of the profits and losses, and the right to receive distributions of Partnership assets.
Title 50 – Partnership: Sections 50.1 thru 50.75 of the Code of Virginia that governs Partnerships in Virginia.
Virginia Registered Limited Liability Partnership: Either a Limited Partnership or General Partnership, formed under the laws of the Commonwealth and registered with the SCC; in which a partner is neither liable for a negligent act committed by another partner nor by an employee not under the partner's supervision.
It is common for business people to say, "let me introduce you to my partner," or "we are going to partner together on a new project," or "we are in a Partnership." The terms partner and Partnership are generically used in business. Some people refer to themselves as partners when, in actuality, they are Shareholders in a Corporation or Members of an LLC (discussed further in subsequent articles). Regardless of the generic connotation, partner and Partnership denote a specific business relationship and business Entity. More so than other Entities, the Partnership relationship bears certain inherent risks which warrant the considerable attention imparted herein. Perhaps, the most significant risk is encompassed in the, often unknown, potential for personal liability of the individual partners (see herein, the Exposure to Liability section). Always consult an attorney when entering any business relationship to ensure the appropriate Entity is established and unnecessary consequences are avoided.
Sole Proprietorships and Partnerships are the default business organizations. Meaning, if the business is not registered with the SCC, a Sole Proprietorship (one owner) or Partnership (two or more owners) is presumed to exist. Unlike other entities, formalities are not required to become a Sole Proprietorship or Partnership. Each can be formed by conduct alone, though a Partnership is often registered with the SCC.
Any individual operating an unincorporated business is a Sole Proprietor. A Partnership consists of two or more individuals that intend to share proportionally the business's profits or losses. There must be intent to become partners, and the intent must be to share profits, and not just generate revenues. The intent can be either expressed in an agreement or implied through the partners' conduct. Partnerships can also contain capital partners and labor partners. A capital partner provides capital, such as money or property; while labor partners provide work, often imparting their skill or expertise.
For the purposes of this article, the analysis will be limited to Partnerships, knowing that many, but not all, characteristics of a Sole Proprietorship mirror that of a Partnership.
Generally, Virginia recognizes three types of Partnerships: General Partnerships, Limited Partnerships and Registered Limited Liability Partnerships ("RLLP").
Typically, the term Partnership refers to a General Partnership. Here, all partners participate fully in running the business, and share the benefits of the Partnership's profits and burdens of its debts. Remember, intent alone can create a Partnership. Filing with the SCC is not required. The requisite intent is manifested through conduct. Statements like "let me introduce you to my partner," or the simple belief that a Partnership exists, can exemplify conduct that communicates the intent to be in a Partnership; and, as discussed further herein, can lead to unknown and undesired consequences.
A Limited Partnership is composed of one or more persons who control the business and are personally liable for the Partnership's debts (i.e. Partners or General Partners); and one or more persons who contribute capital and share profits, but who cannot manage the business. They only risk the loss of the amount of their Contribution (i.e. Limited Partners). A Limited Partner can over step the bounds of his authority, potentially leading a court of law to determine he was, in fact, a General Partner. This occurs when the Limited Partner becomes too involved in business operations; and as a result, he can be exposed to the liability of a General Partner. A limited partnership certificate must be filed with the SCC, and must include the names of all General Partners.
A RLLP more adequately shields the partners from liability. To establish an RLLP, Virginia requires the filing of a certificate of registration with the SCC, filing of annual reports and the maintenance of sufficient insurance for foreseeable liabilities. Generally, no partners, including general partners, are liable for debts and obligations of the Partnership. Nonetheless, partners are still liable for their personal wrongdoing.
In 1996, Virginia adopted RUPA after previously following the Uniform Partnership Act. RUPA provides default rules for Partnerships. By agreement, partners can diverge from the default rules of RUPA; and can therefore determine, among other things, the allocation formula for profits and losses, management structure, and events triggering dissolution. Otherwise, without considering RUPA's default rules or without entering into such an agreement, issues between partners are likely to arise because the rules of RUPA may not adequately reflect the intent of the Ppartners.
In 1893, the United States Supreme Court issued the following proclamation that still holds true today:
[I]t being well settled that one partner cannot, directly or indirectly, use partnership assets for his own benefit; that he cannot, in conducting the business of a partnership, take any profit clandestinely for himself; that he cannot carry on the business of the partnership for his private advantage; that he cannot carry on another business in competition or rivalry with that of the firm, thereby depriving it of the benefit of his time, skill, and fidelity, without being accountable to his copartners for any profit that may accrue to him there from; that he cannot be permitted to secure for himself that which it is his duty to obtain, if at all, for the firm of which he is a member; nor can he avail himself of knowledge or information which may be properly regarded as the property of the partnership, in the sense that it is available or useful to the firm for any purpose within the scope of the partnership business.
Latta v. Kilbourn, 150 U.S. 524, 541 (1893).
RUPA imposes on all partners the Fiduciary Duties of Loyalty and Care. The Duty of Loyalty forbids the partners from engaging in self-dealing, usurping company business opportunities or making secret undisclosed profits at the detriment to the Partnership or partners. This duty does not prevent a partner from creating or owning an interest in another business, so long as that business does not operate to the detriment of the Partnership or result in the diversion of opportunities from the Partnership. However, the Duty of Loyalty does not follow a partner once he leaves the business, unless he has executed a noncompetition agreement. Still, the former partner may be precluded from using the Partnership's confidential information or trade secrets.
The Duty of Care imposes liability upon a partner when he or she demonstrates nonfeasance, meaning the partner does not act with the care a prudent person would employ when managing his personal business affairs. Nonfeasance requires gross negligence, recklessness or intentional misconduct (e.g. a partner's willful disregard of paying the Partnership's taxes). Conversely, the partner is not liable for the misfeasance of bad business judgment, as he is protected by a legal principle known as the Business Judgment Rule (e.g. a failed acquisition that takes a substantial economic toll on the Partnership).
Fiduciary Duties are imposed to protect the partners and Partnership from the willful or reckless actions of any one partner. These duties provide the damaged partners a legal avenue for recourse against a partner who breaches his Fiduciary Duty. These duties are of magnified importance in Partnerships, since, as discussed further herein, partners are often held personally liable for the actions of their fellow partners.
Absent an agreement to the contrary, each partner is entitled to equal control of the management of the business. Also, partners do not receive a salary. Instead, partners receive only a share of the profits generated by the Partnership. Ordinary Partnership business decisions are agreed to by majority vote. Conversely, decisions outside the ordinary course of business require a unanimous vote. Specific Partnership assets (e.g. land, leases and equipment owned only by the Partnership) may never be transferred by individual partners without approval from the other partners. On the other hand, personal property used by the Partnership, but owned by a partner, can be freely transferred by the owning partner.
Absent an agreement to the contrary, RUPA addresses the transferability of a partner's ownership interest. RUPA § 502 states "[t]he only transferable interest of a partner in the partnership is the partner's share of the profits and losses of the partnership and the partner's right to receive distributions. The interest is personal property." A disadvantage of a Partnership is a partner can not transfer, or sell, his position as a partner; and, therefore can not sell his managerial control in the business. The transferee can only receive a stake in the equity the business produces. The transferee can not acquire the ability to influence the direction of the company. Hence, the value of the partner's interest is limited by this inability to transfer his influence and control of the direction of the business.
As previously stated, by agreement, partners in a General Partnership, as opposed to a RLLP, can deviate from RUPA's default rules and direct the operations of much of the Partnership. Even so, General Partners can not agree to shield themselves from personal liability. Any Individual Partner Can Be Found Personally Liable for The Actions of Any Other Partner; Meaning, The Partner's Personal Assets Are At Risk. This is the most significant issue with Partnerships. Considering the consequences stemming from personal liability, an individual should always proceed with caution when entering a Partnership. Remember, intent alone can create a Partnership. Statements like "let me introduce you to my partner," or a simple belief that a Partnership exists, communicates such intent. Again, always consult an attorney when entering any business relationship to ensure the appropriate Entity is established and unnecessary consequences are avoided.
Agency principles apply to Partnerships. According to § 1 of the Second Restatement of Agency (1958), "[a]gency is the fiduciary relation which results from the manifestation of consent by one person [or partner] to another [partner] that the other shall act on his behalf and subject to his control, and consent by the other to act." Through this imposed Agency relationship, the Partnership and all partners are often vicariously liable for the acts of a partner committed within the scope of business operations. By agreement, Partners can have the authority to bind the Partnership and the other partners ("Expressed Authority"). Also, authority to bind is typically manifested by simply being a partner, in that the status of partner implies an authority to bind ("Implied Authority"). Finally, by being held out as a partner by the Partnership, a third party may reasonably believe that the partner has the authority to bind ("Apparent Authority") (collectively, Expressed Authority, Implied Authority and Apparent Authority hereinafter shall be "Partner's Authority"). Virginia holds partners jointly and severally liable, meaning any partner can be sued individually or all partners can be sued collectively. Liability exposure extends to both contract and tort.
The liability of an individual partner does not cease upon his retirement, his Dissociation or the Dissolution of the Partnership. Each partner remains individually liable for Partnership obligations incurred during his tenure as a partner. Furthermore, a Dissociating partner even remains liable for future Partnership debts until either actual notice of Dissociation is provided to creditors, or until 90 days after filing notice of Dissociation with the SCC. Conversely, an incoming partner is usually not liable for the preexisting debts of the Partnership; though, any money contributed by the incoming partner can be used to satisfy the Partnership's prior debts.
Remember, the toxic consequences of joint and several liability customarily only apply to General Partners, not Limited Partners. The establishment of a RLLP or a Limited Liability Company can greatly reduce the risks associated with Partnerships.
Partnerships are "Flow-Through Entities", meaning the Partnership itself is not taxed. The taxation "flows through" the Partnership to another tax return, typically to the tax return of partners, to whom it is treated as ordinary income. The Partnership itself does not pay taxes; and, therefore, avoids the double taxation, subjected to Corporations, that is manifested through salary and dividend tax.
Dissociation signals a change in the relationship between partners that is caused by any partner's cessation of association with the business. A partner can Dissociate through various means, including: express notice, expulsion, bankruptcy, incapacitation or death. Prior to RUPA, and absent an agreement, the Dissociation of a partner would end the Partnership. Now, regardless of a binding agreement, the Partnership can continue after Dissociation.
Dissociation terminates that partner's entitlement to participate in the management of the business. In order for the Partnership to continue, the Dissociated partner must be compensated for his interest in the business; and the partner must be indemnified (i.e. reimbursed) for Partnership liabilities that arise outside the Dissociated partner's tenure. A partner can wrongfully Dissociate, in contravention to an agreement, which can subject the Dissociating partner to damages and defer compensation for the partner's interest.
It is important for the remaining partners to understand that the Dissociating partner can, through the Partner's Authority, bind the Partnership for one year after Dissociation. Similarly, the same Partner's Authority can also bind the Dissociating partner for one year for obligations of the Partnership. A notice of Dissociation, filed with the SCC, reduces the time of liability to 90 days.
Dissolution signifies the Termination of the Partnership's legal existence. Dissolution immediately precedes the liquidation or Winding Up process. Dissolution can be triggered by events delineated in a Partnership Agreement or by consent of all the partners. Also, several events under RUPA trigger dissolution, such as: (i) judicial decree; (ii) an event causing the unlawful existence of the Partnership; and, absent a majority vote of the existing partners to continue the Partnership, (iii) the death of a partner, bankruptcy or wrongful Dissociation.
Winding Up (Liquidating) is the period between Dissolution and Termination, when accounts are settled, obligations concluded, assets liquidated, and any remaining assets distributed to the partners. The Partnership continues through Winding Up. The Partnership is not Terminated until Winding Up is complete; and, until such time, Dissolution can be waived by unanimous vote of the partners, triggering the continuation of business operations.
While Winding Up, any partner can bind the Partnership for contracts and torts pertaining to the Winding Up process. Additionally, through Apparent Authority, all partners and the Partnership can be liable for other acts of a partner. A statement of Dissolution can prevent such liability by providing notice to all potential claimants. The notice is effective, against all potential claimants, 90 days after it is filed with the SCC.
During Winding Up, Partnership assets are liquidated and distributed. The Partnership's creditors are the first to be paid. Second to be paid is any partner who is also a creditor of the Partnership, which occurs if the partner paid more than his share of the Partnership's debts. To make him whole, the partner can seek contribution from the other partners. Third, the partners are reimbursed their capital contribution. Finally, the remaining assets, if any, are divided in accordance to the Partnership Agreement; and, absent an agreement, are divided equally amongst the partners.
Virginia recognizes various categories and sub-categories of business Entities. Choosing the appropriate Entity requires the examination of several issues: business purpose, risk tolerance, formality of business operations, ownership and management control, liability considerations, reporting requirement, existing capital and capital needed, transferability of ownership interest and taxes.
Because of the risks inherent in Partnerships (potential for personal liability, limitations on transference of interests and the deficiencies in formality) there is a heightened importance to examine the potential issues. Misunderstanding of the issues can create undesired results; and, even worse, ignorance of the issues can lead to unknown results. If you have not legally established an Entity, beware. If you are making statements like, "let me introduce you to my partner," or simply believe you are in a Partnership, seek legal counsel to better understand the implication of that business relationship.
 This Article is intended to provide an overview of business Entities in Virginia, specifically focused on Partnerships. This Article does not constitute and should not be treated as legal advice regarding any issue pertaining to legal business issues, generally; and should not be treated as legal advice regarding business organizations in Virginia, and the establishment thereof. Each recipient and reader of this Article should consult with an attorney and other advisors (i.e., tax advisors) regarding issues pertaining to businesses, issues specifically pertaining to the business organization, the establishment of a business organization, and both the tax and non-tax implications and consequences relevant to business organizations.
 Feel free to contact me, Brandon Cowan at CowanGates, for assistance in understanding the significant differences between Entities and assistance in choosing the appropriate Entity.
 Article 3 will be posted on, or about, January 15, 2012; and Article 4 will be posted on, or about, April 1, 2012.
 Alternative Entities may be more suitable than a Limited Partnership or RLLP. Consult an attorney to choose the appropriate Entity for your needs.
 Fiduciary Duties are imposed on leaders and owners of virtually all business Entities (including Corporations and Limited Liability Companies); and the requirements and enforcement of these duties are consistent among the differing Entities.
 Forming a limited liability Entity is the best way for individuals to shield themselves from the harsh consequences of joint and several liability. For most, an LLC is the appropriate Entity, which will be discussed in detail in a subsequent article.
 Any General Partner has the Apparent Authority to enter a contract on behalf of the Partnership, binding the Partnership and co-General Partners to the terms of the contract. Each General Partner becomes personally liable for the obligations of the contract.
 Torts pertain to civil wrongs committed by one person against another; and can either be intentional (e.g. assault and battery), or can arise out of negligence.