A partnership is defined as an association of two or more persons to carry on as co-owners of a business for profit. The premise is built around the notion that the combined power of the partners exceeds the sum of the value the partners could generate independently. It is the old adage that the whole is greater than the sum of its parts. Unlike other legal entity forms that are granted existence by the state (corporate, trusts and non-profits) partnerships may exist without permission. Some states require application and issuance of a certificate to conduct business. The real question is: ‘Is a partnership an entity as a whole or is it a group of persons doing business together?’ This raises several issues including:
A) Does the partnership as an entity or as an aggregate group of partners go to court for legal issues such as lawsuits, civil complaints, criminal conduct or bankruptcy?
B) Who exactly owns the assets such as the cash or property? Do the partners own the assets in common or does the partnership as a whole take title?
C) When a vendor or supplier demands payment, does he demand it from a partner or from the whole group as a single entity?
D) When a customer buys the product or purchases services, who exactly is his image of the ownership – a business or a bunch of individuals selling product/services?
These questions revolve around the two theories of partnership. One theory states that a partnership is merely a group of persons (including legal entities). This is known as the aggregate theory. If this is true then why is it that every state allows a partnership in the partnership’s name to take title to property? Why didn’t the states simply state that the land or asset must be titled as a list of individuals as tenants in partnership. After-all, the states require a married couple to list their names on the title to property. A second theory is totally different. The entity theory states that the partnership is a complete and distinct entity no differently than a corporation. By law (Uniform Partnership Act) any creditor of a partner has no right or ability to attach or execute on a partner’s specific interest in the partnership property. Yet, in the corporate form, a legal entity form, a creditor of a shareholder is allowed to attach to that shareholder’s interest in the company.
This seems to be confusing. Both theories seem to exist with their own set of rules and go against commonly accepted legal and business doctrines.
To answer all this, this article starts out by explaining the quasi existence of partnerships and why some states perceive the partnership as an entity. Other states simply adhere to the common law notion of a group of individuals with an agreed upon profit incentive. The next two sections dive deeper into each theory and some legal cases are used to illustrate advantages and disadvantages. The final section covers how the federal government looks at partnerships and the importance of a well drafted partnership agreement.
The Quasi Existence of Partnerships
The aggregate theory of partnership regards the partnership as merely the sum of the persons who comprise the partnership whereas the entity theory equates the group as similar to a corporation, a distinct and separate entity in and of itself. The reality is that partnerships are neither in the absolute but fall somewhere in the middle of these two extremes.
The Uniform Partnership Act is written such that some sections address procedures as a function of the aggregate of the individuals and other sections deal with issues from the entity perspective out of convenience. An example of convenience is title to specific property. Imagine using the aggregate to title property in a partnership with hundreds of partners or changing the title every time a new partner is added or a partner withdraws. The entity approach simplifies this process.
On the other hand, the aggregate approach is appropriate when addressing issues of ownership and transfer of rights of ownership among the respective partners. Remember, a partnership is a VOLUNTARY association of individuals and no partner should be or can be forced to associate or work with someone he disagrees with. In the corporate entity format, a shareholder may freely sell his interests of ownership to anyone (small corporations may restrict this right via the shareholder’s agreement).
Since all states use the Uniform Partnership Act as the basis of law for partnerships, the states had to decide which approach best suited that state’s concept of partnership. In Texas, the entity approach was adopted. One of the underlying reasons relates to the homestead exemption granted to individuals by the Texas Constitution. Section 25 (2)(c) of the Texas Uniform Partnership Act prevents a partner from claiming the homestead exemption as property belongs to the partnership and not to the individual partners. In Kelley v. Shields, 448 S.W. 2d 135, 138 the San Antonio Court of Appeals held that a widow of a deceased partner had no right to claim the homestead exemption in partnership property due to Texas’ adoption of the entity theory of partnerships.
One state takes the aggregate approach to the extreme and avoids even the concept of convenience. In Missouri, an aggregate theory state, a partnership is not recognized as a “separate or juristic entity”. Therefore when a partnership goes to court to sue, Missouri requires all the partners to join together as party plaintiffs. See Ward v. State Farm Mutual Tornado Ins. Co. of Mo., 441 S.W. 2d 1,5 (Mo. 1969) and Allgeier, Martin v. Ashmore, 508 S.W. 2d 524, 525 (Missouri Court of Appeals, 1974). Imagine a large law firm having to sue, the list of names as plaintiffs can go on for hundreds of pages.
However, the courts do not fully take the aggregate approach to the extreme as it may impact negatively common business transactions such as insurance contracts. In McKinney Truck Ins. Exch., 324 S.W.2d 773 (Missouri Court of Appeals, 1959) the court stated:
Thus for the purpose of applying the theory of the aggregate or entity existence in partnership, no state takes a purely absolute position. The reality is that states will lean in favor of one over the other and in some states, the position is heavily weighted towards a particular approach (as with Missouri with the aggregate theory).
In Scott v. United States, 173 Court of Claims 650, 354 F.2d 292, 16 A.F.T.R. 2d (P-H) 6087 (1965), the court observed:
This quasi state of existence is amplified in the various cases denoted in the sections below explaining each theory in detail. For the purpose of assisting the reader, based on research completed, here is a list of a few states and their respective accepted theory of partnership in application of law.
State Partnership Theory
District of Columbia Entity
The aggregate theory of partnership is grounded in the definition of a partnership, ‘An association of two or more persons to carry on as co-owners of a business for profit’. The definition doesn’t say a separate entity, it states This approach impacts several principles of business including:
1) Rights to sue and be sued
2) Ownership rights
3) Interaction with third parties
4) Separation of the partners from the entity or whole
To help clarify the aggregate theory this section will address both ownership rights and interaction with third parties.
Under tenancy in partnership a partner actually purchases three distinctly separate rights when participating in a partnership. The first is the right to own a share of specific property as a joint tenant with his fellow partners. The second right is a say in management of the business and the third right is for an interest in the profits and surplus of the partnership.
Partnership agreements limit the ability of a partner to sell his ownership rights because of the ‘voluntary association’ principle of partnership. Therefore, the first two rights are nontransferable without permission of the other partners. In effect, transfer of either the right to specific property or management without permission is no longer a voluntary association. Therefore, transferring either one triggers a dissolution of this voluntary association. It is the third right that creates confusion.
This third right is strongly similar to an ownership of stock. The holder of stock is entitled to his share of dividends when authorized. Furthermore, it is common in business to use this ownership of profit as collateral for a personal loan. Thus, the transfer of this right to profits and surplus doesn’t trigger dissolution of a partnership because the partner continues to retain the other two ownership rights.
In Ohio, the Revised Code §1775.26 permits a partner to assign his interest to another and allow the assignee to receive the partner’s interest in the partnership but excludes
the assignee from taking part in managing partnership affairs. Section 27 of the Uniform Partnership Act is based on early case law stating:
The key here is that under Ohio law, a partnership is regarded as the sum of the persons who comprise the partnership (aggregate theory) not the whole as exemplified in the
entity theory. Any change in a partner automatically dissolves the partnership with the exception of assigning a partner’s right to profits and surplus.
With the entity theory, ‘Any individual partner’s rights to any property are subordinated to the partnership entity’; see Texas Revised Civil Statues Annotated Article 6132b.
Interaction With Third Parties
Robert Treegoob, a minor, was struck and killed by an auto insured by Nationwide Insurance. Robert’s father, Warren Treegoob had an auto policy from U.S.F. & G. covering the business autos. The Treegoob family had no personal automobiles. Endorsement #10 of the United States Fidelity & Guaranty Company policy, defines “Eligible Person” as ‘(a) the named insured or any relative who sustains injury while occupying or as a pedestrian struck by, any motor vehicle’. Nationwide seeks recovery from U.S.F. & G. for losses associated with the death of Robert.
U.S.F. & G. asserts that the policy does not cover Warren Treegoob as an individual, it covers ‘Harold and Warren Treegoob T/A Treegoob’s’. Treegoob’s is a partnership in Pennsylvania. Pennsylvania is an aggregate theory state based on a Supreme Court of Pennsylvania case, Morrison’s Estate, 343 Pa. 157, 22 A.2d 729 (1941).
The federal court in Nationwide Insurance Company v. United States Fidelity and Guaranty Company, 529 F. Supp. 194; 1981 Eastern District of Pennsylvania ruled that Pennsylvania law doesn’t recognize partnerships as entities and therefore the insureds were merely a group of individuals. In effect USF&G covered individuals and not an entity. USF&G must reimburse Nationwide Insurance.
The District Court of Appeal in Florida held even though it appears as a “legal entity” to third-party commercial vendors. When dealing with third parties, the two theories are distinctly different. The aggregate theory states that debts are ‘jointly and severally liable’ by the individual partners. The entity theory approaches this issue as ‘joint’ obligations and the issue of any remaining owed balance to the parties is based on the legal document (loan document) signed.
Therefore, if so many states approach the partnership as a group of individuals, why does the entity theory exist?
The entity theory advocated by some states grants more credence to the whole than to the individual partners. One of the primary differences is with the separation of partners as individuals from the partnership. Under the entity theory responsibility for acts of partners tends to mimic agency law whereby the partnership is held accountable. The aggregate theory leans toward holding the individual partner accountable first before looking to the partnership for responsibility. This is important when drafting the “Acts Discreditable” article for the partnership agreement. Under the entity theory, any act discreditable requires reimbursement to the partnership for the financial cost. In aggregate based states, the perpetrator of the act assumes all financial responsibility for his actions.
Another key difference relates to ownership of specific property. The entity theory advocates ownership by the whole partnership whereas the aggregate theory tends towards individuals owning the property as tenants in partnership.
It is important to understand that the courts are not absolute in interpreting the laws of the respective states as it may conflict with common sense. The Montana Supreme Court in Decker Coal Co. v. Commonwealth Edison Co., 220 Montana. 251, 714 P.2d 155, 157 (Mont. 1986) wrote:
Many of the aggregate theory states allow the partnership to own property in the partnership’s name, sue and be sued under the common name. This right to sue and be sued has some interesting twists under the two theories. In Wierzbinski v. The Celina Mutual Insurance Company and Lochner Manufacturing Company, 426 F. Supp. 27; 1976 U.S. District Court of Eastern Wisconsin the Lochner brothers, sons of Peter Lochner, formed the partnership after the deaths of their father and uncle (former partners). The father and uncle’s partnership built a machine back in 1941 that cut off the arm of Daniel Wierzbinski in an accident. Daniel is suing Lochner Manufacturing for a tortuous act related to the production of the equipment from back in 1941. The Lochner Brothers argue that ‘continuing liability’ is a function of the entity theory of partnership. In Wisconsin, an aggregate theory state, the death of a partner automatically terminates the partnership that built the machine causing the tortuous act. Myron L. Gordon/U.S. District Court Judge states . The partnership being sued did not exist in 1941.
Federal Government Interpretation
Both the judicial and executive branches of the federal government interpret these two theories similarly. The federal judicial branch interprets the theories based on state law for the respective district court. Furthermore, federal cases requiring adherence to a theory will cite state case law and state that the federal court has no legal right to override state law.
The executive branch’s interpretation is via Chapter 26 of the Federal Code – The Internal Revenue Code. The code defines a partnership as a syndicate, group, pool, joint venture or an unincorporated association conducting business. It must contain two or more entities (individuals, corporations, trusts or other partnerships). Sub-chapter K of the Code defines the tax implications for partnerships. Simply stated, partners, not the partnership are subject to taxation. The partnership is merely a tax reporting entity via Form 1065 and the respective reports. Each of the respective taxable items of income, gains, losses, special deductions and credits (including tax credits) are assigned to the respective partners in accordance with the partnership agreement. Distributions are tax-free except for amounts in excess of tax basis. In effect the tax code utilizes the entity theory for information exchange and the aggregate theory for tax liability determination.
Summary – Aggregate and Entity Theories of Partnership
There exists two distinct theories of partnership as promulgated by the Uniform Partnership Act. Each state in the union will align their interpretation with either the aggregate (a partnership is a business of individual partners) or the entity (a partnership as a whole) theory. At a minimum, all states allow the specific partnership property to be titled to the partnership. However, the legal matters begin to diverge from this point depending on the respective accepted theory of existence. The end result is a quasi existence of partnership in each state. Both owners and legal professionals must understand their respective state’s interpretation to draft an appropriate partnership agreement. ACT ON KNOWLEDGE.