Partnership Agreements and Operating Agreements (jointly referred to herein as “entity operating agreements”) are contracts that govern the operation of non-corporate businesses entities. These contracts set forth the subject entity’s authorized business activities, management procedures, percentages of ownership by each partner or member, rights relating to distributions, allocation of profits and losses, dissolution, liquidation and termination events. Among the most common non-corporate business structures utilizes in the United States are a partnership, which is governed by a Partnership Agreement, and a limited liability company, which is governed by an Operating Agreement. The sections below discuss these commonly used structures and the issues typically addressed by entity operating agreements in greater detail.
Choice of Structure
State business statutes allow for the creation of a number of non-corporate business entities. One characteristic shared by non-corporate business entities, is that profits are passed to the owners of the entity and are taxed at the individual owner’s level, rather than at the entity level, as is the case with corporations. Structures vary, however, in terms of the amount of liability protection they provide to owners and the level of structural flexibility they provide for managing the entity, among other issues. The sections below discuss some general characteristics of two of the most commonly used non-corporate structures, partnerships and limited liability companies.
Partnerships fall into three types: general partnerships, limited partnerships, and the more rare limited liability partnerships. A general partnership is an entity comprised of two or more parties, each a general partner. General partners share ownership and control over the entity and are involved in the day-to-day management of the same. One major drawback to a general partnership is that each partner is jointly and severally liable for the actions and liabilities of the partnership.
A limited partnership (“LP”) shields certain owners from liability. In a limited partnership there is typically a single general partner and any number of limited partners. The general partner is responsible for managing the day-to-day operations of the business and bears the burden of its liabilities. Limited partners act, essentially, as investors or “silent” partners and, while they may work for the partnership, they are not involved in its day-to-day management. In exchange for giving up the ability to manage the partnership, limited partner liability is limited to the extent of such partner’s investment in the business.
A limited liability partnership (“LLP”) goes a step further, in that none of the partners are personally liable for the liabilities of the entity beyond their investment in the business. Certain states limit this liability protection to negligence claims, thus restricting the liability shield available to the individual partners. Some states further limit this structure to use by professionals, such as lawyers and accountants. The LLP structure does allow for greater flexibility with regard to the management of the entity than the LP. The management of a LLP may be centralized akin to a corporation or an LP, or the entity may be managed jointly by each partner akin to a general partnership.
Limited Liability Company
A limited liability company is the most widely used non-corporate business structure. This structure combines the tax advantages of a partnership and the liability protection of a corporation. The parties forming an LLC are referred to as members. Members of a LLC may participate in management of the company or may act solely as investors.
Characteristics of Entity Operating Agreements
Since entity formation is a matter of state law, the laws and statutes of the state of formation of the entity will set out the parameters by which partnership and operating agreements must be drafted. If an entity is operating without an agreement setting forth these and other characteristics, or if there are items that are not addressed in such agreement, the entity, or those aspects of the entity’s operation, are governed by the rules contained in the relevant state’s statute and developed through its court decisions.
An entity operating agreement would typically address matters such as:
• organizational matters, including name, state of formation and registered office;
• partners/members and classes of partnership/membership interests;
• businesses in which the entity is authorized to engage;
• management of the entity and its affairs;
• capital contributions required by the participating parties;
• allocations and dispositions of net income, net losses and related items;
• rights of partners/members;
• rights, obligations, removal and withdrawal of the general partner/manager;
• tax matters;
• dissolution, liquidation and termination; and
• assorted housekeeping matters such as records and notices.
A major part of an entity operating agreement concerns classes of equity interests, typically referred to as “units.” The agreement will address some or all of the following concerns, among others, with regard to each class or series of units:
• whether the unit-holders have full voting rights, limited voting rights or no voting rights;
• whether any class of units is mandatorily or optionally convertible into other units;
• whether any class of unit-holders has a preference with respect to cash distributions;
• what tax characteristics will be allocated to each class of units;
• what order of preference each class of units will have at the time of any liquidation or winding up of the entity; and
• what, if any, managerial rights and obligations holders of a class of units will have.
• Powers and purposes of the entity
• Identity of the general partner, manager and other managing persons
• Relative rights of the various classes of equity interests
• Tax allocation procedures and preferences
• Rights to transfer or liquefy equity interests
• Events triggering dissolution and related rights in dissolution
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