Dear Fred and Grady,
The agreement that the two of you, both partners of FG Partnership, would be able to allocate the $100, 000 recourse debt equally between yourselves is valid. However, further provision of the agreement requiring Fred to make up any deficit balance within 90 days of liquidation of the partnership is questionable. According to the Internal Revenue Code (IRS), in order for partnership allocations to be respected they must either be made in accordance with the partners’ interests in the partnership or they must meet the requirements for the substantial economic effect safe harbor.
Although partnership is inherently flexible, there are some restrictions to its flexibility. The partners, will not be able to allocate tax benefits among themselves in a manner that is divorced from their allocation of economic profit or loss. Fred, given the scenario may benefit from the agreement over Grady and over the IRS. “A partner who is economically enriched by an item of partnership income or gain is required to shoulder the associated tax burden” (IRS). If Fred would shoulder the loss right after FG Partnership’s dissolution, he would be the sole benefactor of the tax effect when in fact, he is liable to losses in the same amount with Grady. In effect, Grady who is also economically hurt by an item of partnership loss deserves to be allocated its tax benefit.
The provision proposed by Fred is called shifting allocation This allocation system would reduce the tax liabilities of Fred right after the partnership is dissolved even though his capital account balance is the same. If Fred is having a higher tax bracket in that certain year, his net taxable income would be severely affected by the amount of loss that he would be declaring causing his tax bracket to be reduced.
For more information and guidance regarding your partnership agreement, please see the attached article by Paul L. Warner chairperson of the litigation department at Jeffer, Mangels, Butler and Marmaro in San Francisco. This was published California Lawyer Magazine.
Lawyers would never let their clients operate without some kind of written agreement, however, the smaller the partnership or corporation, the less likely that there will be a written agreement at all.
Partnership assets, including undistributed profits and capital, are subject to claims by creditors, although the partners’ non partnership assets generally are not, thus, an agreement between or among partners is very important.
1. Governance Structure
a. Division of profits is not usually a problem when a law firm is formed; the partners must resolve this issue before commencing business. But without a written agreement or formula, there is often no mechanism either to change the split of profits or to set the profit share of a newly admitted partner.
b. A written agreement might change the voting structure, giving more votes to someone with a larger profit percentage or requiring a supermajority for certain decisions.
2. Voting Shares
a. By default, an issue in the ordinary course of partnership business is resolved by a majority decision, whereas an act outside the ordinary course of business requires a unanimous decision.
b. Approval of financial affairs is another issue that should be addressed in a well-drafted partnership agreement. The principals usually put a limit on the amount any partner (or the managing partner) can spend on any one item without majority approval; and the agreement will define how many signatures are required on checks (usually two if over a certain amount).
c. A related issue that should be addressed in the firm’s agreement is the kind of cases that can be accepted.
3. Death and Disability
a. Under the Revised Uniform Partnership Act, the death of a partner, or appointment of a conservator, automatically causes his or her disassociation (the equivalent of a voluntary withdrawal) from the partnership.
b. The process of drafting a written partnership agreement will force the partners to consider whether they should fund the buyout of a deceased partner’s share with life insurance.
c. A written agreement will also define the firm’s obligations to the disabled partner.
4. Firm Dissolutions
a. Serious problems can arise when a law firm needs to reorganize or dissolve. Often this occurs when the firm is in financial trouble, and, without a written agreement, the results can be unsatisfactory to everyone.Par