Family Limited Partnerships Revisited by Professor Kristen G. Juras University of Montana School of Law 59 th Annual Tax Institute October 28, 2011

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1 I. History of Limited Partnerships. Family Limited Partnerships Revisited by Professor Kristen G. Juras University of Montana School of Law 59 th Annual Tax Institute October 28, 2011 A. Choice of Entities. Once upon a time, long before any of us were born, life was much simpler for the business advisor when confronted with the client s question of what type of entity should I choose to run my business? At the turn of the 19 th century, in addition to the option of a sole proprietorship, there were only two choices of entities: general partnerships and corporations. Today, with an alphabet soup of choices available, countless hours are billed in analyzing the answer to this question. These choices include: 1. A corporation, which can further elect to be: a. A statutory close corporation b. An S corporation. 2. A general partnership, which can further elect to be: a. A limited liability partnership (LLP). 3. A limited partnership (LP), which can further elect to be: a. A limited liability limited partnership (LLLP). 4. A limited liability company (LLC), which can be: a. Member-managed, b. Manager-managed, or c. Single-member. B. Factors to Consider. In answering your client s question as to the best choice of entity for his business, you are going to have to pry out of him some Family Limited Partnerships Page 1

2 answers to a lot of questions, including: 1. Do you want to be protected, individually, from liability for the enterprise s debts and other obligations? 2. Who do you want to be in control of management and operating decisions? 3. Do you anticipate having co-owners, and, if so, how easy do you want it to be for other owners to get in or out of the business? 4. Are the owners of the business all going to be working in the business? 5. How long do you see this business continuing in operation? Do you anticipate transferring the business on to your kids some day? 6. Are you going to need to attract investors as a source of financing the business s operations? Will they be involved in management? 7. How do you anticipate that the owners are going to realize a return on their investment? 8. Do you want to minimize income taxes? All of these factors are important, and the answer to one of them should seldom be the tail that wags the dog. Based on my experience, clients seem to focus in on two concerns: liability and taxes. Ideally, they want to be protected from liability and pay as few taxes as possible. C. The Liability - Management Link. In the early development of enterprise law, the concepts of management and liability were linked. If an owner was involved in making management decisions on behalf of the enterprise, it made sense to hold that owner responsible for the debts and other obligations incurred by the business. 1. In a general partnership, each owner has an equal voice in the management of the partnership s business, and thus each owner is also liable for the debts and obligations of the partnership. 2. In contrast, the shareholders of a corporation do not have the right to manage the business. The right and responsibility of managing the corporation s business are centralized in a board of directors, whom the shareholders elect. 3. Today, the concept that a business owner should be liable for the obligations of an entity if the owner is involved in management has eroded significantly. Many of the business entities now available allow an owner Family Limited Partnerships Page 2

3 to be involved in management, while protecting the owner from liability for the enterprise s debts and other obligations. D. Taxation. With regard to the income taxation of business entities, there are two primary regimes under the Internal Revenue Code: 1. Under the separate entity regime, the business entity is subject to tax on its income. When the entity distributes its profits to its owners, the owner is also subject to tax on the distribution, resulting in the double taxation of the business entity s profits (to the extent those profits are distributed). a. This regime applies to corporations under Subchapter C of the Internal Revenue Code. 2. Under the pass-through regime, although recordkeeping, accounting, and the characterization of income and loss all take place at the entity level, the entity itself is not subject to tax. Instead, each owner is subject to tax on the owner s proportionate share of the entity s income and losses. a. This regime applies to partnerships under Subchapter K of the Internal Revenue Code. b. Subchapter S of the Internal Revenue Code also provides a pass-through regime to corporations who elect to fall within its application. c. Trusts are also subject to a pass-through regime, but are outside of the scope of this outline. E. What Regime Minimizes Income Taxes? There are some of you in this room who are old enough to remember that once upon a time, income taxes were actually minimized under the separate entity regime, because of the low income tax rates imposed on corporations, and the high income tax rates imposed upon individuals. With the reduction in 1981 of the top individual income tax rates from 70% to 50% under the Economic Recovery Tax Act (ERTA), followed in 1986 by a further reduction of the maximum individual rate to 28% under the Tax Reform Act, an exodus from C corporation status to S corporation or partnership status for closely-held businesses began to occur. Family Limited Partnerships Page 3

4 a. Today, it is possible that the use of a separate entity may not result in higher income taxes than the use of a pass-through entity. There are many variables that come into play. These include, for example, certain tax-free benefits (including health insurance, group life insurance, and the provision of room and board) that are available to employees of C corporations, which are taxable if provided to partners or S corporation shareholders. The preferential tax rates on qualified dividends may also close or eliminate the double taxation gap. F. The Rise of Limited Partnerships. The National Conference of Commissioners on Uniform State Laws (NCCUSL), first approved the Uniform Partnership Act governing general partnerships in Just two years later, in 1916, NCCUSL approved the Uniform Limited Partnership Act. 1. The purpose of the Uniform Limited Partnership Act was to provide a vehicle that would qualify for pass-through taxation, while protecting passive investors (the limited partners ) from liability for the partnership s debts and other obligations. a. Each limited partnership must have one or more general partners. The general partners have the right to manage the business of the limited partnership. The general partners are also personally liable for the debts and other obligations of the partnership. b. Although the limited partners (like shareholders) could vote on certain major decisions (such as a sale of substantially all of the limited partnership s assets), limited partners did not have the ability to make management decisions in the ordinary course of business. By relinquishing management control, the limited partner was shielded from liability for the debts or other obligations of the limited partnership. 2. Limited partnerships were widely used in several industries (such as the oil and gas and real estate development industries). Limited partnerships were also used as an estate planning vehicle for family businesses. The older generation maintained control by serving as the general partners, while transferring limited partnership interests to the younger generation through a series of planned gifts, to transfer value out of their taxable estates. Family Limited Partnerships Page 4

5 a. A corporate general partner was frequently used to limit the liability of the general partner to the corporate assets. 3. The liability shield afforded to limited partners under the Uniform Limited Partnership Act could be cracked if a limited partner participated in the control of the [partnership s] business. Furthermore, creditors of a limited partnership could pursue the individual shareholders of a corporate general partner under a piercing the corporate veil theory, particularly if the corporate general partner were not adequately capitalized. G. The Demise of Limited Partnerships. In 1977, Wyoming enacted the first statute authorizing the organization of limited liability companies. The Wyoming statute was designed to create an entity with limited liability for all of its owners, including owners involved in management. Wyoming deliberately designed its LLC statute to comply with the Kintner regulations, so that any LLCs formed under Wyoming law would be taxed as a partnership rather than as a corporation. 1. In 1977, the classification of a business entity as a corporation or a partnership depended on the extent to which the entity actually resembled a corporation. In United States v. Kintner, 216 F.2d 418, (9th Cir. 1954), an unincorporated association of doctors sought to be classified as a corporation, so that it could establish a tax-favored pension plan (available to entities taxed as corporations but not to entities taxed as partnerships). The IRS argued that the association did not resemble a corporation and thus could not provide tax-favored benefits to its employees. The Ninth Circuit concluded that the medical organization satisfied the corporate resemblance test and should be treated as an association taxable as a corporation. 2. Following the Kintner decision, in 1960 the IRS promulgated the Kintner regulations, which provided that an unincorporated business association would be taxed as a corporation only if it had a preponderance (i.e., 3 out of 4) of the following corporate characteristics: a. continuity of life, b. centralization of management, c. limited liability, and d. free transferability of interests. 3. Although the Wyoming statute had one characteristic of a corporaiton (limited liability to all members, including members who engaged in management), the other three characteristics were not present in the default Family Limited Partnerships Page 5

6 provisions of the LLC statute. Under the default provisions, there was no continuity of life, because the LLC could be terminated at will; there was no centralized management, because all members had a voice in management; and a member s interest could not be transferred without the consent of the other members. 4. The IRS first applied the Kintner regulations to this new entity in Private Letter Ruling (Nov. 18, 1980), concluding that under the Kintner regulations, a particular Wyoming LLC would be classified as a partnership, and not as an association taxable as a corporation, because the LLC lacked the corporate characteristics of continuity of life and free transferability of interests. 5. Aware of the can of worms that it was opening with the favorable PLR, the IRS contemporaneously issued proposed regulations that providing that an organization in which no member has personal liability for the debts of the organization must be classified as an association taxable as a corporation. 45 Fed. Reg. 75,709 (proposed Nov. 17, 1980). In 1983, the IRS withdrew these proposed regulations in the face of public criticism but explained that it would undertake a study of the rules of classification of entities for federal tax purposes with special focus on the significance of the characteristic of limited liability. I.R.S. Announcement 83-4, I.R.B More than ten years after the enactment of Wyoming s LLC statute, the IRS finally published Rev. Rul , C.B. 360, in which the Service concluded that any LLC formed under Wyoming s LLC statute to carry on a business and divide the gains therefrom would necessarily (by virtue of the terms of the LLC statute itself) lack the corporate characteristics of continuity of life and free transferability of interests, and therefore would be classified as a partnership for federal tax purposes. a. Many states began enacting LLC legislation, including the adoption of the Montana Limited Liability Company Act in b. NCCUSL approved the Uniform Limited Liability Company Act in Montana substantially adopted these provisions in In 2006, NCCUSL substantially revised the Uniform Limited Liability Company Act. Montana has not yet adopted these revisions. Family Limited Partnerships Page 6

7 7. In 1997, the Treasury Department rendered the Kintner regulations obsolete when it adopted the "check the box" regulations. Under these regulations, an unincorporated organization with two or more owners is taxed as a partnership by default, unless the business elected to be taxed as a corporation by "checking the box. Treas. Reg (as amended by T.D. 8697, C.B. 215). a. The authority of the Service to cast out the Kintner factors (which were based on an earlier U.S. Supreme Court case, Morrissey v. Commissioner, 296 U.S. 344 (1935)) and adopt of the check the box was upheld in Littriello v. United States, 484 F.3d 372 (6 th Cir. 2007), cert denied 552 U.S (2008). 8. For closely-held business organizations, LLCs have become the entity of choice. Following is a breakdown of Montana entity registrations for selected years: Year LLCs Corporations Limited Ptshps ,070 (76%) 2,753 (23%) 114 (1%) ,739 (75%) 2,491 (24%) 59 (1%) a. The exception to this trend is publicly traded entities, which continue to be organized primarily as corporations. II. The New, Improved Limited Partnership 3 A. Purposes As stated by NCCUSL in the prefatory note to the 2001 Uniform 1 Data from Rodney D. Chrisman, LLCs Are the New King of the Hill: An Empirical Study of the Number of New LLCs, Corporations, and LPs Formed in the United States Between and How LLCs Were Taxed for Tax Years , 15 Fordham J. Corp. & Fin. L. 459, 465 (2010). 2 Data provided by Tana Gormely, Business Services, Montana Secretary of State. 3 For a thorough explanation of the provisions of the 2001 Uniform Limited Partnership Act as promulgated by NCCUSL, see Daniel S. Kleinberger, A User's Guide to the New Uniform Limited Partnership Act, 37 Suffolk U. L. Rev. 583 (2004). Family Limited Partnerships Page 7

8 Limited Partnership Act: The new Act has been drafted for a world in which limited liability partnerships and limited liability companies can meet many of the needs formerly met by limited partnerships. This Act therefore targets two types of enterprises that seem largely beyond the scope of LLPs and LLCs: (i) sophisticated, manager-entrenched commercial deals whose participants commit for the long term, and (ii) estate planning arrangements (family limited partnerships). This Act accordingly assumes that, more often than not, people utilizing it will want: strong centralized management, strongly entrenched, and passive investors with little control over or right to exit the entity The Act s rules, and particularly its default rules, have been designed to reflect these assumptions. B. Stand-Alone Act. Under prior law, the general partnership act governed those areas not specifically addressed by the limited partnership act. The revised and newly adopted Uniform Limited Partnership Act is a stand-alone act. It is de-linked from the general partnership act. 1. For example, under prior law, the limited partnership act did not specify the fiduciary duties of general partners; instead, those duties were ascertained by reference to the Uniform Partnership Act governing general partnerships. 2. To be able to stand alone, the Limited Partnership incorporates many provisions from the general partnership act and some from the Uniform Limited Liability Company Act. As a result, the new Act is far longer and more complex than its predecessor. C. Partnership Purposes. The prior limited partnership act specified that a limited partnership could carry on any business that a partnership without limited partners may carry on. Under the new act, any reference to a business has been deleted; the limited partnership may be organized for any lawful purpose. MCA (2). 1. This would allow, for example, a family limited partnership to be formed for the sole purpose of owning the family cabin on Flathead Lake Family Limited Partnerships Page 8

9 for use by family members. D. Duration. Under the prior limited partnership act, the term of the limited partnership was the term set forth in the partnership s certificate. Under the new act, the term of a limited partnership is perpetual, unless the partnership agreement provides another term. MCA ; The term of the partnership is not required to be set forth in the certificate of limited partnership. MCA If a limited partnership does not renew its certificate of limited partnership every five years as required under MCA , its term may be shortened by the unilateral action of the Montana Secretary of State, who has the authority to cancel its certificate. E. Name. Under the prior limited partnership act, the name of a limited partner could generally not be used in the name of the limited partnership (with some limited exceptions). Under the new act, the name of the limited partnership may contain the name of any partner, including a limited partner s name. MCA (1). a. The name of a limited partnership must include the phrase limited partnership or the abbreviation l.p. or lp. b. The name of a limited liability limited partnership must include the phrase limited liability limited partnership or l.l.l.p. or lllp. c. Names must be distinguishable in the records of the Secretary of State from the names of other business entities and from any registered assumed business names. d. Names may be reserved. MCA F. Liability of Limited Partners. Under the prior limited partnership act, limited partners were shielded from personal liability for the debts and other obligations of the limited partnership unless the limited partner participates in the control of the business and person transact[s] business with the limited partnership reasonably believing... that the limited partner is a general partner. The prior act provided a safe harbor list of activities that did not constitute participating in the control of the business, such as voting on dissolution and other Family Limited Partnerships Page 9

10 significant matters. The new Uniform Limited Partnership Act grants a full status-based shield of limited liability to limited partners, including those limited partners who may engage in management activities, similar to the protection granted to members of a limited liability company. MCA As noted in the Official Comments to this Section: The shield established by this section protects only against liability for the limited partnership s obligations and only to the extent that the limited partner is claimed to be liable on account of being a limited partner. Thus, a person that is both a general and limited partner will be liable as a general partner for the limited partnership s obligations. Moreover, this section does not prevent a limited partner from being liable as a result of the limited partner s own conduct and is therefore inapplicable when a third party asserts that a limited partner s own wrongful conduct has injured the third party. This section is likewise inapplicable to claims by the limited partnership or another partner that a limited partner has breached a duty under this Act or the partnership agreement. (Emphasis supplied) 2. This shield for limited partners applies whether or not the partnership is a limited liability limited partnership. 3. Regardless of the choice of entity that you choose, you always remain liable for your own negligence or wrongful conduct. For example, you cannot avoid malpractice claims by forming and operating through a professional corporation. The Montana Supreme Court recognized this principle in White v. Longley, 358 Mont. 268 (2010). In that case, Tom Longley operated a home building business through Castle Homes, LLC. Castle Homes, LLC entered into a contract to build a home for the Whites. Longley, acting on behalf of the LLC, provided engineering and construction services under the contract. The home turned out to be a disaster, structurally compromised from top to bottom, including a roof that could not be supported by the underlying structure. The trial court determined that Longley made misrepresentations as to his qualifications that induced the Whites to enter into the contract, and negligently performed services under the contract. The Montana Supreme Court affirmed the trial court s ruling that Longley was jointly and severally liable (along with the LLC) for the damages suffered by the Whites. The Court noted that the Limited Liability Company Act does not offer blanket protection from liability to a member of an LLC for the member's own Family Limited Partnerships Page 10

11 conduct Attached as Appendix A is a compilation of the Montana s statutes that provide for liability protection for the owners of interests in the various entities. G. Liability of General Partners. Under the prior limited partnership act, a limited partnership was required to have at least one general partner, and the general partner was liable for the debts and other obligations of the partnership if the partnership s assets were insufficient to pay those liabilities. The newly enacted Uniform Limited Partnership Act allows the limited partnership to elect to be a limited liability limited partnership. To make this election, the certificate of the limited partnership must include a statement that it is a limited liability limited partnership. MCA (9), (1)(d). If this election is made, the general partner is NOT liable for the debts of the partnership solely by reason of being a general partner, bringing LLLPs into alignment with the laws governing liability of managing members of limited liability companies. MCA (3). a. The protection from liability is afforded for those debts or obligations incurred while the limited partnership is a limited liability limited partnership, whether arising in contract, tort, or otherwise. b. If the limited partnership does not elect to be a limited liability limited partnership, all general partners are liable jointly and severally for all obligations of the limited partnership unless otherwise agreed by the claimant or provided by law. MCA (1). (i) A judgment creditor must, as a general rule, first satisfy a judgment against the partnership assets before seeking to levy against the assets of a general partner. MCA (3). H. Management Rights. Although under the prior limited partnership act, the right to manage and conduct the limited partnership s business was vested in the general partners, one of the fundamental premises of the new act is strong centralized management, strongly entrenched. Prefatory Note. Except as expressly provided in this chapter, any matter relating to the activities of the limited partnership may be exclusively decided by the general partner or, if there is more than one general partner, by a majority of the general partners. MCA (1). Family Limited Partnerships Page 11

12 1. Unless otherwise provided in the partnership agreement, unanimous consent of all partners, including both general and limited partners, is required to: a. amend the partnership agreement; MCA (2). b. amend the certificate of limited partnership to obtain or relinquish limited liability limited partnership status, id.; c. sell, lease, exchange, or otherwise dispose of all or substantially all of the limited partnership's property, id. Limited partners also have consent rights regarding: d. the admission of a general partner, MCA ; e. the expulsion of limited or general partners, MCA (2)(d), -1018(4); f. redemption of a transferable interest subject to a charging order with limited partnership property, MCA (3)(c); g. causing dissolution by dissent, MCA (2) & (3)(a); and h. approving, amending, or abandoning plans of conversion or merger, (1), -1512(1). 2. Each general partner is an agent of the limited partnership, and has a statutory grant of apparent authority to bind the limited partnership in the ordinary course of its business. MCA a. The fact that a person is not listed in the certificate of limited partnership as a general partner is not notice that the person is not a partner and is not notice that the person lacks authority to act for the limited partnership. MCA (3). 3. A limited partner is not an agent of the limited partnership and has no right or power to act on behalf of or bind the limited partnership. MCA Unless otherwise agreed in the partnership agreement, a general partner is not entitled to remuneration for services performed for the partnership. MCA (6). Family Limited Partnerships Page 12

13 I. Limited Partner Duties. The prior limited partnership act was silent as to any duties or obligations owed by the limited partners to the partnership or other partners. The new limited partnership act specifically states that a limited partner does not have any fiduciary duty to the limited partnership or to any other partner solely by reason of being a limited partner. MCA (1). However, a limited partner shall discharge the duties to the partnership and the other partners under this chapter or under the partnership agreement and exercise any rights consistently with the obligation of good faith and fair dealing. MCA (2). 1. The Official Comments describe the obligation of good faith and fair dealing as follows: The obligation of good faith and fair dealing is not a fiduciary duty, does not command altruism or self-abnegation, and does not prevent a partner from acting in the partner s own self interest. Courts should not use the obligation to change ex post facto the parties or this Act s allocation of risk and power. To the contrary, in light of the nature of a limited partnership, the obligation should be used only to protect agreed-upon arrangements from conduct that is manifestly beyond what a reasonable person could have contemplated when the arrangements were made. J. General Partner Duties. As under the prior limited partnership act, each general partner has a fiduciary duty to the partnership as well as to the other partners. This fiduciary duty among partners was famously described by Justice Cardozo in Meinhard v. Salmon, 249 N.Y. 458, 464 (1928), as the finest loyalty, not honesty alone but the punctilio of an honor the most sensitive. Subsequent versions of both the uniform partnership act and the limited partnership act attempt to cabin in this broad description of a general partner s fiduciary duties. Consistent with prior law, the new limited partnership act specifically limits a general partner s duties to the duties of loyalty and care as described in MCA (1). 1. A general partner s standard of care is surprisingly low: she is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law. Mere negligence does not constitute a breach of the standard of care. MCA (3). 2. Under MCA (2), a general partner s duty of loyalty is Family Limited Partnerships Page 13

14 limited to the following: a. to account to the partnership anything derived by the partner in the conduct of the partnership business, or derived from a use by the partner of partnership property (including partnership opportunities) b. to refrain from having an interest adverse to the partnership and other partners, and to refrain from acting on behalf of another party with an adverse interest c. to refrain from competing with the partnership while a partner. 3. Additionally, a general partner must discharge the duties to the partnership and the other partners under this chapter or under the partnership agreement and exercise any rights consistently with the obligation of good faith and fair dealing. MCA (4). 4. The partnership agreement may not eliminate the duty of loyalty or obligation of good faith and fair dealing, but it may define conduct which meets or does not meet these duties, as long as these provisions are not manifestly unreasonable. Similarly, the partnership agreement may not unreasonably reduce the duty of care. MCA K. Allocations of Profits and Losses. Under the prior uniform limited partnership act, profits and losses were to be allocated as provided in writing in the partnership agreement. If there was no written allocation, profits and losses were to be allocated on the basis of the value of each partner s actual contributions, to the extent such contributions had not been returned to the contributing partner. 1. The new Uniform Limited Partnership Act has no provisions allocating profits and losses among the partners. Instead, the drafters of the Act contemplated that the partnership agreement will provide for the allocation of profits and losses in a manner that complies with applicable tax, accounting and other regulatory requirements. Official Comment to Section 503 states that those requirements, rather than this Act, are the proper source of guidance for that profit and loss allocation. a. As adopted, the Montana Uniform Limited Partnership Act has no provisions regarding the allocation of profits and losses. Family Limited Partnerships Page 14

15 b. As adopted, the Montana Uniform Limited Partnership Act has no provisions requiring the maintenance of capital accounts. c. As discussed in more detail in Section IV below, IRC 704(b) provides that a partner s distributive share of income, gain, loss, deduction, or credit shall be determined by the partnership agreement, provided that the allocation has substantial economic effect. If the partnership agreement fails to allocate these items, or if such allocations fail the substantial economic effect test (discussed below), these items will be allocated in accordance with the partner's interest in the partnership (determined by taking into account all facts and circumstances). L. Interim Distributions. Neither the prior Act nor the newly enacted Act grant a partner a right to demand a distribution prior to the dissolution of the limited partnership. MCA Unless otherwise provided by the partnership agreement, it is the general partner who has the right to decide when to make interim distributions. 1. As promulgated by NCCUSL, the revised Uniform Limited Partnership Act provides a default rule for how distributions are to be shared, as follows: Section 503: SHARING OF DISTRIBUTIONS. A distribution by a limited partnership must be shared among the partners on the basis of the value, as stated in the required records when the limited partnership decides to make the distribution, of the contributions the limited partnership has received from each partner. 2. Note that this default rule requires that distributions will be allocated based on the value of contributions at the time of distribution. This is intended to have the same effect as the prior Act, which used somewhat different language, requiring that contributions that had been returned to the partners be taken into account in allocating distributions. 3. Unfortunately, a mistake was made in Montana s enactment of the newest version of the Uniform Limited Partnership. This provision was inadvertently deleted from HB 535. Thus, Montana has no statutory default rule as to how distributions are to be shared amongst partners. This oversight is easily corrected by making sure to include in your limited Family Limited Partnerships Page 15

16 partnership agreement a provision as to how distributions shall be shared amongst partners. M. Transfer of Partnership Interests. Like all other partnership statutes, the revised Uniform Limited Partnership Act dichotomizes both a partner s rights into (i) the right to receive distributions (which is transferable, MCA (22)) and (ii) other rights, such as the right to manage or vote, which are not transferable. 1. Absent an agreement otherwise, the only interest of either a general partner or a limited partner that is freely transferable is the partner s transferable interest (i.e., the partner s right to receive distributions). MCA The partnership agreement can impose greater restrictions upon a partner s right to transfer her transferable interest. a. The transferee of a transferable interest has the right to receive distributions to which the transferor would otherwise be entitled. MCA (2)(a). 2. The transferee of a transferable interest does not have the right: a. To participate in management; b. To require access to information, except as to the limited partnership s transactions in winding up after a dissolution; c. To inspect a limited partnership s records. MCA (1). 3. Unless otherwise agreed in the partnership agreement, a transfer by a partner of her transferable interest does not, in and of itself, cause the transferring partner s dissociation or a dissolution of the partnership. Id. a. However, unless allowed by the partnership agreement, a transfer of all of a general partner s or limited partner s transferable interest (other than a transfer for security purposes) could lead to the expulsion of the transferring general or limited partner with the unanimous consent of the other partners. MCA (2)(d)(ii); (4)(b). Family Limited Partnerships Page 16

17 4. If the partnership agreement does restrict a partner s ability to transfer her transferable interest, the violation of such restriction is ineffective unless the transferee had notice of the restriction at the time of transfer. MCA (7). a. See MCA for rules regarding notice. N. Dissociation of a Limited Partner. In addition to strong centralized management, a second fundamental premise of the new uniform limited partnership act is to create a vehicle for passive investors with little control over or right to exit the entity. Prefatory Note The new Uniform Limited Partnership Act distinguishes between a right and a power. Under the uniform version of the Act, a limited partner has no right to dissociate from the partnership prior to the partnership s termination; however, the limited partner may have the power to dissociate. If a partner exercises a power to withdraw in violation of the partnership agreement, the exercise of the power is wrongful, and may give rise to a claim for damages on the part of the partnership against a limited partner who wrongfully dissociates. a. Whereas a partnership agreement may not take away the power of a general partner to dissociate (discussed below), there is no prohibition against taking away from a limited partner the power to dissociate. See MCA (h), which provides that a partnership agreement may not vary the power of a person to dissociate as a general partner, but does not contain a similar prohibition against varying the power of a limited partner to dissociate. 2. Because of some confusing language inadvertently incorporated into the 4 Whereas the prior uniform version of the Uniform Limited Partnership Act gave a limited partner the right to withdraw and to have her interest purchased for fair value within six months of withdrawal (unless otherwise provided in the partnership agreement), Montana s prior version of the limited partnership act only allowed a limited partner to withdraw from the partnership at the time of the partnership s dissolution, unless the partnership agreement provided otherwise. Family Limited Partnerships Page 17

18 Montana version (MCA (1)), 5 it is especially important to specify in your limited partnership agreements not only the events that may give rise to dissociation, but which dissociations will be considered wrongful. a. For example, it may be appropriate to treat a voluntary withdrawal by a limited partner prior to dissolution as wrongful, but not a dissociation resulting from the death of an individual limited partner. b. See MCA (2) for a list of default events that cause the dissociation of a limited partner. The partnership agreement can modify this list. 3. Regardless of whether the dissociation of a limited partner is rightful or wrongful, unless the partnership agreement provides otherwise, the limited partner has no right to demand a distribution or buy-out of her limited partnership interest. Instead, the limited partner has no further rights as a limited partner and becomes a mere transferee. MCA (1); As a transferee, the dissociated limited partner is entitled to continue to receive distributions relating to her interest in the partnership until the partnership terminates. a. Consistent with the no exit principle behind the Act, a limited partner who dissociates, either voluntarily or involuntarily, will not be entitled to have her interest purchased by the limited partnership unless the partnership agreement provides otherwise. b. For dissociations resulting from an individual partner s death, the deceased partner s personal representative does have a right to obtain information. MCA The Uniform Limited Partnership Act provides: A person does not have a right to dissociate as a limited partner before the termination of the limited partnership. The Montana version states Except as provided in subsection (2), a person does not have a right to dissociate before the termination of the limited partnership. This gives rise to the question of whether a dissociation under subsection (2) (including dissociation by a limited partner s providing notice of his express will to withdraw) is rightful or wrongful. The confusion can be clarified if the limited partnership agreement makes a voluntary dissociation wrongful. Family Limited Partnerships Page 18

19 O. Dissociation of General Partner. The newly enacted Uniform Limited Partnership Agreement makes it clear that you may not take away the power of a general partner to voluntarily dissociate. MCA ; (2)(h). 1. However, a general partner s dissociation may be wrongful if: a. it is in breach of an express provision of the partnership agreement; or b. it occurs before the termination of the limited partnership and: (i) the person withdraws as a general partner by express will; (ii) the person is expelled as a general partner by judicial determination; (iii) the person is dissociated as a general partner by becoming a debtor in bankruptcy; or (iv) in the case of a person that is not an individual, trust other than a business trust, or estate, the person is expelled or otherwise dissociated as a general partner because it willfully dissolved or terminated. 2. If a general partner dissociates, her right to participate as a general partner terminates. MCA She remains personally liable for any obligations incurred while she was a general partner. MCA The limited partnership is obligated to amend its certificate of limited partnership to reflect the dissociation of a person as general partner. MCA (2). 4. The general partner s interest becomes the interest of a mere transferee. MCA (e). If the general partner also owned interests as a limited partner, she continues to own those interests as a limited partner. 5. MCA sets forth a list of events that would result in dissociation of a general partner including, for example, judicial expulsion because the general partner engaged in wrongful conduct. The partnership agreement, however, may alter the events giving rise to the dissociation of a general partner. Family Limited Partnerships Page 19

20 P. Dissolution. At common law, one of the hallmarks of a partnership was the ease with which it could end. Absent an agreement otherwise, the withdrawal of any single partner would result in a dissolution of the partnership and sale of its assets. One of the purposes of the new limited partnership act is to enhance and protect the durability of a limited partnership. 1. Under the default rules, all of which may be modified, a nonjudicial dissolution may occur: a. On an event specified by the partnership agreement; b. With the consent of all of the general partners and a majority of the limited partners. MCA (1)-(2). 2. The dissociation of a general partner does not itself cause the limited partnership to dissolve. a. If at least one general partner remains, there is no dissolution unless "within 90 days after the dissociation... partners owning a majority of the rights to receive distributions as partners" consent to dissolve the limited partnership. MCA (3)(a). b. Even if no general partner remains, dissolution can be avoided if, within ninety days after the dissociation, a majority of partners consent to continue the activities of the limited partnership and admit at least one general partner, and at least one person is admitted as a general partner in accordance with the consent. 3. If all limited partners dissociate, the partnership will continue if, within 90 days, it admits at least one limited partner. 4. On application by a partner, a limited partnership may be judicially dissolved if it is not reasonably practicable to carry on the activities of the limited partnership in conformity with the partnership agreement. MCA If a partnership does dissolve, the general partner has authority to wind up the partnership s business and sell its assets. Unless otherwise agreed in the partnership agreement, any surplus remaining after payment of creditor s claims must be paid in cash as a distribution. MCA Family Limited Partnerships Page 20

21 Q. Mergers and Conversions. There are provisions in the new Act which address the conversion of a limited partnership into another entity, and visa versa, and the merger of a limited partnership into another type of entity. See MCA through R. Derivative Actions. The new Act contains expanded provisions regarding derivative actions that may be brought by any partner on behalf of a limited partnership. See MCA through S. Foreign Limited Partnerships. For provisions governing the registration of foreign limited partnerships who conduct business in Montana, see MCA through T. Renewal of Certificate. To avoid the cost of having to make changes to the Secretary of State s computer system, Montana has adopted a non-uniform provisions. Whereas the uniform act requires limited partnerships to file annual reports, Montana s statute (MCA ) provides that a Certificate of Limited Partnership is only effective for a term of 5 years, and it must be renewed every 5 years. a. At least 90 days prior to the expiration of a Certificate of Limited Partnership, the Secretary of State must provide notice that the partnership s certificate will expire. b. If the partnership fails to file an application for renewal of its certificate before its expiration, the Secretary of State must cancel the certificate. c. If a certificate of limited partnership is canceled for failure to renew, the limited partnership may file for reinstatement within 5 years after the effective date of cancellation. MCA U. When is a Writing Required. The new limited partnership act removes virtually all writing requirements for a limited partnership, with the following exceptions: 1. A written certificate of limited partnership must be filed with the Secretary of State. The only required contents include: a. the name of the limited partnership; Family Limited Partnerships Page 21

22 b. The name and address of the partnership s registered agent (or the name only if the agent is a commercial registered agent); c. The name and the business mailing address of each general partner; d. whether the limited partnership is a limited liability limited partnership; and e. Any additional information required under the conversion or merger provisions of Title 35, chapter 12, part 15. f. The initial certificate of limited partnership must be signed by all general partners listed in the certificate. MCA To the extent that the certificate of limited partnership is inconsistent with the underlying partnership agreement (whether written or not): a. The partnership agreement prevails as to partners and transferees; and b. The certificate prevails as to third parties who relied on the certificate to their detriment. 3. The limited partnership must keep at its principal office certain information in written form or tangible form, including: a. a current list showing the name and address of each general and limited partner -- in alphabetical order; b. a copy of the initial certificate of limited partnership and all amendments; c. a copy of the limited partnership's federal, state, and local income tax returns and reports, if any, for the 3 most recent years; d. a copy of any partnership agreement made in a record and any amendment made in a record to any partnership agreement; Family Limited Partnerships Page 22

23 e. a copy of any financial statement of the limited partnership for the 3 most recent years; f. a copy of any record made by the limited partnership during the past 3 years of any consent given by or vote taken of any partner; and g. unless contained in a partnership agreement made in a record, a record stating: (i) the amount of cash and a description and statement of the agreed value of the other benefits contributed and agreed to be contributed by each partner; (ii) the times at which or events on the happening of which any additional contributions agreed to be made by each partner are to be made; (iii) for any person that is both a general partner and a limited partner, a specification of what transferable interest the person owns in each capacity; and (iv) any events, upon the happening of which, the limited partnership is to be dissolved and its activities wound up. V. Effective Date. 1. Limited Partnerships Formed on or after October 1, This Act governs all limited partnerships formed on or after the Act s effective date, which is October 1, Limited Partnerships Formed Prior to October 1, Montana adopted a non-uniform provision regarding the applicability of the new limited partnership act to existing limited partnerships. 6 All pre-existing limited partnerships are subject to new act, except as follows: a. The perpetual duration default rule of MCA (3) does not apply. A pre-existing limited partnership has whatever duration 6 The uniform version of the uniform limited partnership act provides for a transition period of several years (the exact number of which is to be selected by the adopting state), during which pre-existing limited partnerships could consider the new act and elect to be governed by them. After that transition period, some (but not all) of the provisions of the new uniform limited partnership act apply to all pre-existing partnerships. Montana did not provide for a transition period. All pre-existing limited partnerships in Montana are subject to many (but not all) of the new act s provisions, and there is no opt-in transition period. Family Limited Partnerships Page 23

24 it had under prior law. Under the prior limited partnership act, there is no specified duration for a partnership. The term of a limited partnership is the term specified under the partnership agreement or certificate of limited partnership. If no term is specified, the Montana Uniform Partnership Act fills the gap, and provides a default rule of a partnership at will. MCA (7). b. The rules under the new act relating to dissociation of either a limited partner or a general partner under MCA and do not apply. Prior law governs the consequences of dissociation, unless those rules have been modified by the partnership agreement (in which event the partnership agreement will apply). c. MCA (4), which allows expulsion of a general partner with the unanimous consent of all other partners in certain situations, does not apply. d. MCA (5), which allows the limited partnership to bring a judicial action to expel a general partner upon certain circumstances, does not apply. e. The more liberal rules of MCA (3) allowing the continuation of a limited partnership upon the dissociation of a general partner do not apply. 3. Electing In. A pre-existing limited partnership can elect to be governed entirely by the new act, and thus the exceptions noted above would no longer apply. The vote required to make such an election would be made in accordance with the partnership agreement. If the agreement is silent as to amendment procedures, MCA (2) (which is operative as to all pre-existing limited partnerships) requires unanimous consent of all partners to amend the partnership agreement, the certificate of limited partnership, or to obtain status as a limited liability limited partnership. a. If a pre-existing limited partnership elects to become a limited liability limited partnership, it is not required to file an amended certificate of limited partnership that contains a statement that it is a limited liability partnership as otherwise required by MCA Family Limited Partnerships Page 24

25 III. Election of Tax Status (1)(d). However, in my humble opinion, a partnership would be fool-hardy not to do so. A. An IRS View of Entities. The Internal Revenue Code recognizes three types of business entities: 1. Sole proprietorships, who report their business income and losses on Schedule C of their individual income tax returns; 2. Partnerships, who file a Form 1065 and pass through items of income and loss to the owners pursuant to the regime established under Subchapter K of the Internal Revenue Code; and 3. Corporations, who report income and loss on Form 1120 under the regime of Subchapter C of the Internal Revenue Code, unless the corporation has made an election to be governed by the pass-through rules of Subchapter S of the Internal Revenue Code. B. Choices Based on Number of Owners. Under Treas. Reg : 1. A business entity with two or more members is classified for federal tax purposes as either: a. a corporation or b. a partnership. 2. A business entity with only one owner is either: a. classified as a corporation or b. is disregarded (in which event its activities are treated in the same manner as a sole proprietorship). C. Mandatory Classification for Corporations. An entity must be classified as a corporation for tax purposes if it is a domestic entity organized under a Federal or State statute, or under a statute of a federally recognized Indian tribe, if the statute describes or refers to the entity as incorporated or as a corporation, body Family Limited Partnerships Page 25