In the last decade, the limited liability company (“LLC”) has become a popular vehicle for business and family planning purposes because it shields its members from personal liability while providing favorable pass-through tax treatment. While other corporate forms continue to be used (such as C and sub-S corporations and, to a lesser extent, limited partnerships), some clients still have general partnerships.
A general partnership (“GP”) is created when two or more people carry on as co-owners of a business for profit, without creating a state-recognized entity for such business. No written agreement is needed, and no filings are required to create a legal GP. The primary problems with this type of business arrangement are that each partner is liable for the debts and liabilities of the GP, and that each partner has the ability to bind and create liabilities for the GP and, consequently, for each general partner.
General partners can take steps to limit their exposure in several ways:
1) Have a written partnership agreement. A written agreement identifies partner responsibilities and can allocate risk among the partners. If a partner dispute erupts, the partnership agreement will govern. Without a written agreement, each partner’s rights and responsibilities will be determined by statutory law which may not reflect the intentions of the parties.
2) Merge the GP with an entity that shields its owners from personal liability. If the general partners form an LLC with the same ownership structure, and merge the two entities so that the LLC survives the merger, the owners (called “members” in an LLC) will have limited liability for the obligations of the LLC. Typically, there are no tax effects to this type of merger. The new LLC can continue to use the same tax identification number as the general partnership, according to IRS Revenue Ruling 95-37. (If the ownership structure under the new LLC is different than that of the general partnership, there may be a deemed distribution of funds by the GP and other tax effects).
3) Become a limited liability partnership. Within the past 15 years, a number of states have amended their partnership statutes to allow a GP to become a limited liability partnership (“LLP”), thereby allowing general partners to reduce their personal exposure for the bad actions of their partners.
Both New York and New Jersey have adopted legislation recognizing the LLP. However, in New York, LLP status is only available to GPs comprised of licensed professionals such as attorneys, accountants and architects.
There may be some issues to confront when making GP changes, however. Lenders typically prohibit borrowers from changing their corporate structure without consent. To obtain lender consent, general partners may need to post additional collateral or a personal guaranty. If the GP owns real estate, the title insurance policy should be examined to determine whether a change in form of ownership would terminate coverage. A recent New Jersey Supreme Court case entitled Shotmeyer v. New Jersey Realty Title Ins. Co., 195 N.J. 72, 948 A. 2d 600 (2008) held that when a GP conveyed its interest in real estate to a limited partnership with identical ownership, the limited partnership did not have an insurable interest in the title policy and could not collect from the carrier on a defect in title which existed when the GP had taken title to the land.
Despite these and other potential pitfalls, general partners should explore with their counsel the feasibility of changing their GPs to limit or eliminate potential personal exposure.
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