Why it’s time to dust off those partnership docs

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But fights happen.

One partner secretly signs a lease with the sister-in-law of her cousin’s wife. Another partner files for personal bankruptcy, and lenders start demanding a seat at the table. A third partner doesn’t want to reimburse a fourth for business-related expenses.

It’s not easy to resolve any one of these situations, and relatively vague laws don’t help matters.

But the rules for settling disputes have gained new clarity under Act 170. Enacted last year and taking effect this spring, it puts into law provisions that before had to be spelled out in partnership contracts.

The act took effect on Feb. 21. It applies initially to all new limited liability corporations, limited partnerships, limited liability limited partnerships and general partnerships. It will apply to all existing entities as of April 1, though they can elect to be covered sooner.

The law preserves the flexibility enjoyed by Pennsylvania-based partnerships, a popular corporate structure that offers more flexibility and tax benefits than traditional business structures. But it lays out clearer standards for some potential flashpoints, like which partners should have the authority to sign leases, local attorneys said.

“It should also make any type of litigation over the issues more streamlined, easier to resolve, less expensive to resolve,” said Josh Cohen, an attorney in the Lancaster office of Harrisburg-based law firm McNees Wallace & Nurick.

In some ways, the changes address the unanticipated consequences of the growth in partnership entities, said Ron Hershner, managing partner and chair of the business group at York-based law firm Stock and Leader.

“Particularly in the last 10 or 15 years, LLCs have gone from being this new creature to being the entity of choice,” Hershner said. “We probably set up nine or 10 LLCs for every corporation anymore. More and more businesses are gravitating toward that.”

Hershner and other attorneys expect partnerships will at least want to review their documents and decide from there how best they can incorporate the new law.

“I suspect that once we wade through this, we will conclude that at least some of our clients would be well-served to amend their documents to have some of this increased flexibility and protection,” Hershner said.

Balancing protection, flexibility

The appeal of the LLC lies in the tax treatment of profits, lawyers said. In general, profits from a partnership are taxed at Pennsylvania’s lower rate for personal income instead of the higher corporate net income tax.

Business partners also get to set up their own governing contracts instead of having to follow the litany of state rules that govern traditional corporations. A traditional corporation, for example, has to designate officers and board members, schedule board meetings and keep minutes.

Flexibility has value, but it can result in gray areas.

One has been what happens to a partner’s interest when he or she declares bankruptcy and creditors move in, Hershner said. Can creditors demand more than just the financial stake in a partnership? Banks, for example, wondered what rights they have if a borrower used a partnership interest as collateral on a loan.

“It was an open question,” Hershner said.

Act 170 answers it by allowing creditors to take only an economic stake in a partnership, not a governing stake.

“Other partners don’t want a creditor coming in as a partner so they essentially bifurcate and cleave apart the economic interest from the voting and governance rights,” said Ben Haverstick, a Lancaster-based attorney with McNees Wallace.

The law also allows nonprofits to form as partnerships, attorneys said, a structure that could make it easier for them to run for-profit subsidiaries.

“This would be an ideal way for them to organize that,” Hershner said, noting earlier law was silent on the issue.

Brian Korman, an attorney at Lancaster-based law firm Barley Snyder, pointed to provisions offering protection to a limited partnership’s general partners.

Under the new law, general partners remains liable for a partnership’s debts and obligations, but they are now statutorily entitled to reimbursement from  the partnership as long as they adhere to appropriate standards.

A partnership agreement may already provide for reimbursement in some form. But, Korman added, “To the extent that the provisions in the partnership agreement were ambiguous or even silent in that respect, it would help in that situation.”

One new feature of the law is the creation of a new kind of filing, called a certificate of authority. The certificate is a public record identifying the partner or member who has authority to sign contracts, deeds and other documents on behalf of the partnership or LLC, said Cohen, the McNees Wallace attorney.

That person is typically identified in a partnership agreement or LLC operating agreement, but third parties do not necessarily have access to that document, Cohen said. Now, he added, “They know the person signing the contract has the authority to sign the contract.”

In the past, the law presumed that all members in a member-managed LLC had authority, Cohen said. To be certain, third parties would have needed to review the original operating agreement. Now they can rely upon a certificate of authority, if one is filed.

“The goal, I think, of Act 170 was to remove areas where there has been ambiguity so that it’s clearer both to business entities and to third parties who deal with them,” he said.