Alternatives to Incorporation for Persons in Quest of Profit: The Limited Partnership with a Corporate General Partner

New York University School of Law
US corporate and commercial law

Alternatives to Incorporation for Persons in Quest of Profit: The Limited Partnership with a Corporate General Partner

Chrysanth Herr

Table of Contents

I. Introduction ... 1

II. The Limited Partnership ... 2

A. Description of the Limited Partnership ... 2
B. Historic Development ... 5
C. Taxation of the Limited Partnership ... 8

III. The Limited Partnership with a Corporate General Partner ... 11

A. Development of the Corporate General Partners ... 11
B. Control Liability of the Limited Partners – the Main Cases ... 14
1. Delaney v. Fidelity Lease ... 14
2. Frigidaire Sales Corp. v. Union Properties ... 16

IV. Reasons for the Unpopularity of the Limited Partnership with a Corporate General Partner ... 19

A. Uncertain Legality ... 19
B. Uncertain Law Pertaining to Liability of Limited Partners ... 20
C. Diminishing Taxation Advantages ... 21
D. New and Better Alternatives ... 22
1. The Limited Liability Company ... 22
2. The Limited Liability Limited Partnership ... 23

V. Conclusion ... 25

I. Introduction

American company law traditionally offered a group of businessmen in quest of profit only two choices of business associations: a corporation or a partnership. Both forms have their advantages and disadvantages that depend upon various factors: the size of the envisaged business, its riskiness, capital requirements, need for a separation of ownership and management, liability, desired life of the venture, and transferability of share interests.¹ The partnership has generally been used for smaller enterprises associated with less risk and capital requirements.² The corporate form gives businessmen the opportunity to conduct risky business affairs with respect to potential tort liability as well as default risk without being exposed to unlimited personal liability because only the assets of the corporation can be used to satisfy claims.³ The benefit of limited liability came at the price of disadvantageous double taxation because, unlike a partnership, a corporation has been viewed as an independent entity and its income has consequently been taxed on the corporation’s as well as the shareholders’ level. This has driven smart entrepreneurs to conduct their business affairs in form of a hybrid entity, a combination of a partnership and a corporation, the limited partnership with a corporate general partner. In that form a corporation is the (sole) general partner of a limited partnership which results in limited liability for the owners and managers of this hybrid entity and the advantage of the preferential tax treatment of a partnership. Thus, this entity allows combining the benefits of a corporation and a partnership while reducing their shortcomings. In the beginning the legality of this new form was disputed among academics and courts alike. However, over the course of the past four decades new laws have been enacted that explicitly allow this hybrid form and gradually more limited partnerships have been created with a corporation as their sole limited partner. After the legality of the hybrid form was resolved, the liability of limited partners who started to take part in the control of the limited partnership was the main issue which was later on also decided favorably for the limited partners/investors. Surprisingly however, contrary to other countries where similar forms were legally allowed, the limited partnership with a corporate general partner has not significantly influenced the corporate world in the United States and its utilization has largely been confined to certain industry sectors. Instead, new forms of business associations with similar characteristics (among them most importantly limited liability and preferential tax treatment) have
evolved and gained importance.
The goal of this paper is to illustrate the development of the limited partnership with a corporate general partner in the United States over the past four decades and to analyze its advantages and disadvantages. The paper centers on the two main factors that have shaped this form – the recognition of limited liability for its managers and the tax treatment of the limited partnership. For this purpose, the law of the limited partnership will first be described in order to put the reader in the position to evaluate the characteristics of the limited partnership with a corporate general partner more clearly as most of the law, which governs the hybrid entity, stems from the limited partnership. Although this paper is not concerned with details of taxation, I will show the development of the tax treatment of the limited partnership in this chapter as well because tax law has been a major influential factor. Secondly, the development of the hybrid form will be illustrated by means of the pertinent cases and statutory provisions. In this chapter I will focus on the most controversial issue about the hybrid form, the control rule: Do limited partners incur personal liability upon participating in the management of the corporate general partner? In the last chapter, I will elaborate on factors that have contributed to the relative unpopularity of the hybrid form in the United States.
It is important to keep in mind that all law on partnerships in the United States is determined by the individual states and there is no federal regulation as long as antitrust issues and security regulations do not come into play. Most of the law on partnerships is unified through the adoption of uniform acts by each state.⁴ In the analysis I will not focus on the various adaptations of the uniform acts but on the rules in the acts themselves. This confinement is helpful and necessary in order to illustrate the prevailing themes of the time and to prevent digressing from the main objectives.

II. The Limited Partnership

A. Description of the Limited Partnership

In the following I will describe the limited partnership by illustrating its features and comparing them to the two main forms, the general partnership and the corporation. The concept of the limited partnership borrows from both forms but also adds unique elements. A partnership is an association of two or more persons who bind themselves together to pursue a joint economic purpose.⁵ With respect to partnership law, a “person” may be an individual as well as a legal entity, and the definition explicitly includes corporations.⁶ In a general partnership both partners assume joint and several liability for the partnership debts⁷ and both are obliged to carry out the business activities.⁸ The relationship among the partners is characterized as legal, financial, business, and personal.⁹ Limited partnerships resemble general partnerships in many ways. They also involve at least two persons, a general partner and a unique type, a limited partner.¹⁰ Under the Revised Uniform Limited Partnership Act of 1985 (RULPA (1985)), the most widely adopted limited partnership act, natural persons as well as legal entities such as corporations can assume the role of a general or limited partner.¹¹ The most important distinction between the general and the limited partners is that in contrast to a general partner, who is fully liable for the partnership obligations, the limited partner’s liability for partnership obligations is limited to his agreed upon capital contribution.¹² The purpose of the limited partnership is to give passive investors (the limited partners) the chance to contribute capital to a business and to benefit from its profitability without requiring them to actively engage in the management and fearing joint and several liability for all debts.¹³ This rather straightforward separation of a general partner and a limited partner becomes blurred when a general partner also holds an interest in the partnership as a limited partner which is permissible under RULPA (1985) and the Uniform Limited Partnership Act of 1916 (ULPA (1916)).¹⁴ As the limited partners are passive and often numerous,¹⁵ mostly only a financial and no personal relationship exists between them and the general partners. This makes them similar to preferred shareholders of a corporation as both have priority regarding distribution of the business’s profits. Additionally, a limited partnership, in contrast to a general partnership, calls for greater formality and publicity. General partnerships can be created simply by conduct, whereas a limited partnership needs to be registered with its “home state” and every state, where it wishes to do business in, in order to have its limited liability recognized.¹⁶

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1 See WILLIAM T. ALLEN & REINIER KRAAKMAN, COMMENTARIES AND CASES ON THE LAW OF BUSINESS ORGANIZATIONS 81 (2003) for a good introduction to the corporation.
2 See PETER HAY, LAW OF THE UNITED STATES 228-30 (2002) for a concise introduction to US partnership law.
3 This general rule holds in the absence of special circumstances that give rise to the possibility of piercing the corporate veil to satisfy creditors and tort victims. Special circumstances arise when the corporate form was used to perpetuate fraud. There are no strict guidelines when the corporate veil may be pierced, for a collection of important cases on veil-piercing, see ALLEN & KRAAKMAN, supra note 1, at 147-61.
4 The main exception to this is Louisiana, the only state with a civil law system and its own form of the limited partnership, the partnership in commendam. The peculiarities of this exception are too large to be covered in this essay; therefore, I will confine my analysis to the common law form of the limited partnership.
5 UNIF. PARTNERSHIP ACT OF 1914 (UPA) § 6(1); REVISED UNIF. PARTNERSHIP ACT OF 1996 (RUPA) § 202(a).
6 UPA § 2 (1914), RUPA § 101(10) (1996).
7 UPA § 15(a) (1914).
8 See UPA § 8 (1914) in connection with §35.
9 See ALAN R. BROMBERG & LARRY E. RIBSTEIN, BROMBERG AND RIBSTEIN ON PARTNERSHIP 11:4 (2005 ed.).
10 See BROMBERG & RIBSTEIN, supra note 9, at 11:4.
11 It further includes partnerships, limited partnerships, trusts, estates, and associations. See RULPA § 101(11) (1985).
12 RULPA § 303(a) (1985).
13 See F. Hodge O’Neal, Comments on Recent Developments in Limited Partnership Law, 1978 WASH. U. L.Q. 669, 669 (1978).
14 ULPA § 12 (1916) and RULPA § 404 (1985) (stating that a dual limited and general partner has the characteristics of a general partner).
15 In 1979, all partnerships had an average of 5.07 members whereas limited partnerships had 17.28 members; in 1987, the spread increased so that the respective figures were 10.42 and 43.98. See Susan Nelson & Tom Petska, Partnerships, Passive Losses, and Tax Reform in Internal Revenue Service, Statistics of Income Division, Statistics of Income and Related Administrative Record Research 1988 – 1989, 251, 252.
16 See PETER C. KOSTANT, BUSINESS ORGANIZATIONS 49 (1996).