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Checkpoint Contents Federal Library Federal Editorial Materials WG&L Journals Business Entities (WG&L) Business Entities (WG&L) Preview Issue in Progress DRAFTING DON'TS: MISTAKES THAT COMPROMISE PARTNERSHIP AND LLC AGREEMENTS, Business Entities (WG&L) PARTNERSHIP AGREEMENTS DRAFTING DON'TS: MISTAKES THAT COMPROMISE PARTNERSHIP AND LLC AGREEMENTS In order to avoid producing compromised work, drafters need to understand the common mistakes made by attorneys when creating new partnership and LLC agreements. Author: TERENCE FLOYD CUFF TERENCE FLOYD CUFF is of counsel in the law firm of Loeb & Loeb LLP in Los Angeles, California, and a member of the Advisory Board of Business Entities. In transactional practices, attorneys can easily do harm when drafting partnership and LLC agreements by making compromising mistakes. 1 The discussion that follows explores what can happen when the drafter decides to draft an agreement quickly and cost-effectively, while failing to consider a partnership's complexities and subtleties. The article is a “how to” guide, which looks at drafting with an emphasis on how the economic and tax-oriented provisions in partnership agreements can be compromised. The common ways discussed in this article that partnership or LLC agreements are compromised are by no means exhaustive, as such agreements provide abundant opportunities to make drafting mistakes. Some readers may encounter additional errors, since each agreement provision offers new opportunities for compromising agreements, and some drafters will take advantage of the practically boundless opportunities. Some of the ways that partnership or LLC agreements can be compromised are by inadequately drafted provisions concerning: • Capital contributions. • Management. • Meetings. • Budgets. • Business plans. • Development plans. • Audits. • Reports. • Tax returns. • Banking. • Transfers. • Dispute resolution. • Securities. • Put/calls and other buy-out rights. • Liquidation. • Amendment. • Fiduciary duties. • Notice. This article refers generally to partnerships, limited partnerships, and limited liability companies as “partnerships.” Partnership agreements, limited partnership agreements, and limited liability company operating agreements are referred to generally as “partnership agreements.” Getting the Economics Wrong The most serious way in which a drafter can compromise a partnership agreement may be to get the economics wrong. Indeed one of the most important drafting objectives should be to get the economics of a deal right. While other drafting mistakes can cause embarrassment, getting the economics wrong easily can lead to an errors and omissions lawsuit, which would be a low point in any person's career—even if the drafter ultimately prevails. 2 In drafting any partnership agreement, attention should be paid to how much is at stake in the partnership and how complicated the economic deal is. 3 The care and review applied should respond to both the dollar size and complexity of the transaction. However, preparing a short agreement for a small deal is not a good excuse for mistakes. While review of a partnership agreement for a small deal typically is constrained by budget considerations, as clients do not want to spend much, this suggests making the agreement shorter and simpler so that the drafter can review it economically. When the agreement is for a large partnership deal, precautions are necessary to ensure that cost concerns or other factors do not hinder the agreement from being thoroughly reviewed, proofed, and verified. It may be surprising to an inexperienced attorney not conversant with the intricacies of partnership agreements that another drafter can get the economics wrong. The task of getting the basic distribution economics right can be easy in a simple 50-50 deal. 4 But the drafting task can become vastly more complicated as the partnership agreement introduces tiered returns, preferred returns, and returns based on internal rates of return. Tax distribution and other special distribution provisions also complicate partnership economics. Economic adjustment provisions triggered by defaults on capital contributions can further increase the difficulty of getting the economic deal right. Also, admitting new partners midway through the deal, or, admitting service partners who receive profits interests, can complicate the economics. Providing for buy-out rights, put rights, liquidation rights, or expulsion rights are other factors that may complicate partnership economics. It is not surprising then that drafters often do not quite get the economic deal right— for any of a number of reasons. Moreover, some manage to get the economic deal dramatically wrong. Disputes among partners based on partnership economics are common. These disputes may be virulent and extraordinarily expensive. Some of the best law firms in the country have drafted partnership agreements with economic provisions that parties have disputed in court. No law firm is so good or so prestigious that clients or the courts automatically accept its drafting of partnership agreements as correct. In fact large, prestigious law firms may have the opportunity to make much larger and more notorious drafting mistakes than small, local law firms. In appropriate circumstances, even a junior associate, an overworked and overloaded partner, or a senior partner with declining drafting skills might draft language that can create tens of millions of dollars of economic exposure to their firm. For that matter, in appropriate circumstances, a highly experienced, talented drafter at the peak of his or her ability, through a few moments of carelessness, can make costly drafting errors. A dispute may make it necessary for a drafter to prove in court that the partnership agreement properly reflects the economics of the deal. The drafter should understand that a client's recollection of the instructions given to counsel might not be consistent with the draftsman's recollection, and be prepared later to demonstrate that the client's concept of deal economics was followed. The drafter should consider how it could later be proved that: • The economics of the partnership agreement was properly explained to the client. • The client understood the economics. • The client approved the economic scheme reflected in the partnership agreement. 5 • The client approved the economic nuances of the partnership agreement. • The client's instructions were properly carried out. 6 A large errors and omissions case for drafting errors can threaten the solvency and continued existence of even a large law firm. This is not a theoretical risk. The threat of an action for errors and omissions is a clear and present danger that every drafter should keep in mind throughout the drafting process for every partnership agreement. Numerical Examples. The drafter should consider working through all of the economic provisions of the partnership agreement, testing each of these provisions with numerical examples. These should include both normal examples that are consistent with economic expectations, and extreme examples that will stress test the provisions of the partnership agreement. Some of the provisions to test include: • Normal distribution provisions for cash from operations. • Distribution provisions for cash from capital events. • Distribution provisions for cash from financings and refinancings. • Distribution provisions for liquidation of the partnership. • Preferred returns. • Returns based on internal rates of return. • Tax distribution provisions. • Provisions that adjust capital accounts and partnership economics on defaults on capital contributions. • Puts, calls, and similar arrangements. • Economic provisions regarding the redemption or retirement of a partner. • Definitions of economic terms. • Checking and rechecking cross-references in provisions that affect partnership economics. It is useful to have the partnership's accountants undertake similar tests, and to circulate spreadsheets with numerical results. The drafter then can seek confirmation from clients and other parties to the deal that the examples correctly reflect how the partnership agreement works. Consider the possibility of attaching numerical examples as exhibits to the partnership agreement. These numerical examples can provide guidance to accountants and others in interpreting the partnership agreement in the future. Also, these examples can be useful if there is later litigation concerning the economics of the partnership agreement. In drafting economic provisions for a partnership, the drafter should not confuse distributions of cash with allocations of income and loss. Provisions governing distributions of cash generally should be separate from the provisions for allocating income and loss. Mixing provisions for distributions of cash with allocations of income and loss invites misadventure. Liquidating Distributions in Accordance with Capital Accounts. Tax regulations on substantial economic effect encourage the design of partnership agreements that distribute the proceeds of liquidation in accordance with capital accounts. This works well if partnership capital accounts are consistent with the economic deal, but may not work if capital accounts are inconsistent with the deal. A better practice for the inexperienced drafter may be to distribute liquidation proceeds in accordance with tiers defined by percentages or similar indices (without reference to capital accounts). Even an experienced drafter may worry about inconsistency with the economic deal and determine that it is better to risk the possibility that the IRS will disallow partnership tax allocations, than to risk that cash will go to the wrong partner. Operating Cash Flow and Proceeds of Capital Events. Partnership agreements often are imprecise in establishing and segregating pools of cash for distribution. Two typical pools are operating cash flow and proceeds of capital events. The partnership agreement should clarify what cash the partnership agreement credits to, and what expenses the partnership agreement charges to, each of these pools. Some special considerations apply to economic provisions involving tiers, preferred returns, and internal rate of return conditions in partnership agreements. Tax Distribution Provisions. Tax distribution provisions are difficult to draft and often contain errors. The tax distribution provision merely approximates the tax liability of the partner attributable to the partnership. Tax distributions normally should be advances against a partner's share of distributions. Provisions should clearly charge tax distributions against the cash distributions otherwise payable to the partner, including future cash distributions. The partner otherwise may receive the tax distribution money twice. Drafters should consider some form of clawback at the liquidation of the partnership or the liquidation of the partner's interest in the partnership in case the partnership has not fully recouped tax distributions from other cash distributions to the partner. Defining the mathematics and mechanics of tax distribution provisions can be challenging. Considerations include: • Are tax distribution payments mandatory or discretionary? • At whose discretion does the partnership make the payments? • What happens if the partnership does not have enough cash to make tax distribution payments currently? • What formula should be used to calculate tax distribution payments? • What tax rate should the partnership agreement use for tax distribution payments, or should the partnership agreement use multiple rates in order properly to reflect character of income? • Does the tax distribution provision consider state income tax? If so, what state income tax should the tax distribution provision consider? • Does the formula consider changes in tax law, FICA, Medicare/Medicaid, alternative minimum tax, and tax surcharges? • Should the partnership agreement use the same tax rates for all partners in computing tax distribution payments? • Does the tax rate consider the type of tax person that is the partner (individual, corporation, etc.)? • How does the formula work for pass-through entities that are partners? • What is the tax treatment of tax distributions to a partner? • Should the partnership agreement consider past loss allocations to the partner in computing tax distribution payments to the partner? • Should the partnership agreement consider past loss allocations to a prior partner (but predecessor in interest) in computing tax distribution payments? • What income is subject to tax distribution payments? • Does gain allocable under Section 704(c) qualify for tax distribution payments? • Does gain allocated as if under Section 704(c) qualify for tax distribution payments? • How are offsets of tax distribution payments made against other distributions? • What are the details of the clawback provision? • Are tax distribution payments made after the buy-out of the partner's partnership interest is triggered? • Are tax distribution payments made after the partnership begins liquidation? • When are tax distribution payments made? • When are taxes payable? • How does the partnership agreement handle disputes regarding indemnified events? • How does the partnership agreement handle disputes regarding calculation of tax liability payments? • Is interest payable if a tax distribution payment is paid late? • Does the tax distribution provision take into account the possibility of audit adjustments? Preferred Returns. Drafting the mathematics and mechanics of preferred returns can be challenging. Considerations include: • What is the return rate? • Does the preferred return involve day-by-day computations, or does the partnership agreement group cash flows in weekly, monthly, quarterly, semi-annual, or annual cash flows? • Does the preferred return compound? If so, when does the preferred return compound? • What is the computational year? • What is the day count convention? 7 • Is the preferred return computed for a contribution on the date a contribution is made? • Is the preferred return computed for a distribution on the date a distribution is made? • What is the base of preferred capital against which the return rate is applied? • What distributions reduce the base against which the preferred return rate is applied? • What contributions increase the base against which the preferred return is applied? • When does the partnership credit additions to preferred capital? • When does the partnership debit distributions from preferred capital? • Does preferred capital receive a return for the date of contribution? • Does preferred capital receive a return for the date of withdrawal? • When is the preferred return paid? • Are distributions under distribution tiers below the preferred return tier counted in determining whether a preferred return condition has been met? 8 • Who computes the preferred return? • How do you handle computational disputes? • Are preferred returns taken into account in making both operating distributions and distributions of cash from capital events? • Are preferred returns preferred on liquidation? IRR Provisions. Internal rate of return provisions are a special category of preferred return provisions. 9 IRR provisions can pose these special additional problems (among others): • What formula do you use in computing internal rate of return? • How do you deal with multiple solutions to the internal rate of return equation? • If you are using Microsoft Excel to compute internal rate of return, which Excel function do you use (IRR or XIRR), which version of Excel should you specify, 10 and how do you deal with software errors and limitations in Excel? 11 • What are the constraints on a solution that you wish to consider (such as, do you wish to exclude solutions where the net present value of cash flows is increasing for increasing values of the discount rate?)? Squeeze Down Provisions on Default on Capital Contributions. Common problems in drafting squeeze down provisions include: • Does the formula provide for super-dilution? • What formula does the partnership agreement use to recalculate percentage interests? • What formula does the partnership agreement use to recalculate capital accounts? • What formula does the partnership agreement use to recalculate invested capital? • Does the formula properly take into account partnership interests granted in consideration of the performance of services? • Does the formula adequately take into account book-up adjustments? • Is the formula economically fair? • Do all distribution and allocation tiers work in light of revisions on account of the squeezedown provision? • Is the formula intended to create a penalty? • Will a court enforce a penalty provision? • Will a bankruptcy court enforce a penalty provision if a defaulting partner is in bankruptcy? • Does the formula make numerical sense? • Is the formula unambiguous? • Does the formula take into account the time at which contributions were made? • Does the formula adjust percentage interests? • Will adjustments under the formula result in taxable capital shifts? • Has the formula been modeled with realistic numbers? Withholding Provisions. Partnership agreements may fail to address federal or state withholding on income allocated to partners or distributions distributed to partners. Withholding obligations may exceed the cash distributed to the partner. The partnership agreement should address sources of cash for withholding payments if the partnership may have a withholding obligation that exceeds the distribution to a partner. The partnership agreement drafter may wish to limit the partner to an action against the governmental agency (rather than the partnership) if the partner believes that withholding has been in excess of the amount required by law. The Agreement Looks Wonderful But Cannot Be Understood One of the greatest indictments of a partnership agreement is when clients, accountants, and others cannot understand it. The drafter is responsible for this audience being able to understand the agreement. “My partnership agreement is clear, and they should have understood it” usually is not an adequate defense. Small, seemingly innocent mistakes can prove a problem in a partnership agreement. In addition to ensuring that a partnership agreement is comprehensive, the drafter should ensure that the partnership agreement is readable. Form documents often are larded with legalese. The language can be dense and impenetrable. Paragraphs often are long and forbidding, sentences interminable, in a stilted contractual language that only lawyers can understand. Clients often feel that it takes an attorney to understand such partnership agreements. These agreements may be difficult to enforce if disputes reach arbitration or court trial. A jury can have difficulty interpreting language that it does not understand. The following are common drafting style and drafting language flaws in partnership agreements: • Unreadable English. • Confusing short names for the parties. • Use of “herein,” “hereinafter” “hereof,” “heretofore,” “aforesaid,” “wherein,” “therein,” “thereinafter,” “thereof,” etc. • Terms in Latin or other foreign languages. (Latin terms may be Greek to readers.) • Use of “said” this and “said” that as adjectives. • “Such” this and “such” that as adjectives. • Parties of the first, second, third, fourth, and fifth part. • Excessive “notwithstanding” clauses. • Poorly chosen “notwithstanding anything herein to the contrary” introductions. • Excessive “provided, however” clauses. • Nonparallel use of words or phrases—using them to mean different things in different parts of the document. • Long chain cross-references. • Inaccurate cross-references. 12 • Cross-references to provisions that do not exist. • Inverted sentences that do not begin with the subject of the sentence. 13 • Long, seemingly interminable sentences or paragraphs. • Long verb sequences. • Wordiness—too many words. • Avoidable passive voice. • Strings of synonyms or near synonyms. • Incomprehensible and obtuse language such that general readers cannot understand what the document says. • Ambiguous and imprecise language (particularly, ambiguous pronoun antecedents). • Double negatives. • Lack of conceptual precision—confused drafting. • Lack of white space on the page. • Percentage interests that do not sum to 100%. • Incomprehensible letter abbreviations. 14 • Abbreviations spread through the text of the agreement. 15 • Overlap of provisions where two separate provisions appear to apply, but say different things. • Long agreements with few titles or subtitles. • Long agreements without tables of contents. • Poorly organized partnership agreements, particularly those that discuss the same issue in two different provisions and reach different results. • Omitted or incomplete exhibits. • Improper use of defined terms. • Failure to define defined terms. • Using two different defined terms for the same concept. • Failure to adequately anticipate, think through, and address problems that the partnership will encounter during its life. • Unsigned signature blocks. • Undated agreements. Drafters should consider consulting the Federal Plain Language Guidelines 16 for ideas on drafting language. Understandable writing is commendable, whether one adheres to the concept of “plain English” or not. Recommendations contained in the federal guidelines include: • Write for your audience. • Organize to meet your readers' needs. • Use lots of useful, informative headings. • Write short sections. • Write shorter paragraphs that are easier to follow. • Avoid long, dense paragraphs. • Choose words carefully—be precise and concise. • Use active voice. • Use the simplest form of a verb (which usually is the present tense). • Use the strongest, most direct form of the verb possible. • Use “must” for an obligation, “must not” for a prohibition, “may” for a discretionary action, and “should” for a recommendation. • Do not use words readers will not understand. • Do not use abbreviations that confuse readers. • Avoid or minimize noun strings. • Put information in a logical order. • Use pronouns that clearly refer to a specific noun. If a pronoun could refer to more than one person or object in a sentence, repeat the name of the person or object or rewrite the sentence. • Minimize abbreviations. • Instead of abbreviations, use “nicknames”—a simplified name for the entity you want to abbreviate. This gives readers meaningful content that helps them to remember what is being discussed. • Always define an abbreviation the first time it is used. • Use words and terms consistently throughout documents. • Use short, simple words. • Avoid stodgy, long, dry legalisms and other jargon. • Use the familiar or frequently used word over the unusual or obscure. • Omit unnecessary words. Avoid wordy, dense construction. • Put the definitions section at the beginning or end of documents. • Limit definitions to defining terms. Avoid substantive provisions in definitions. • Do not define words or phrases that are not used. • Use the same term consistently for a specific thought or object. • Avoid legal, foreign, and technical jargon. Do not leave out necessary technical terms, but make sure the other language is as clear as possible. • Do not use jargon or technical terms when everyday words have the same meaning. • When there is no way to express an idea except to use technical language, make sure that terms are defined. • Avoid archaic jargon such as “above-mentioned,” “aforementioned,” “foregoing,” “henceforth,” “hereafter,” “hereby,” “herewith,” “thereafter,” “thereof,” “therewith,” “whatsoever,” “whereat,” “wherein,” and “whereof,” • Avoid “and/or.” • Write short sentences. • Express only one idea in each sentence. “Sentences loaded with dependent clauses and exceptions confuse the audience by losing the main point in a forest of words. Resist the temptation to put everything in one sentence; break up your idea into its parts and make each one the subject of its own sentence.” • Keep subject, verb, and object close together. “The natural word order of an English sentence is subject-verb-object. This is how you first learned to write sentences, and it's still the best. When you put modifiers, phrases, or clauses between two or all three of these essential parts, you make it harder for the user to understand you.” • Avoid double negatives and exceptions to exceptions. • Place the main idea before exceptions and conditions. • Use numbers or letters to designate items in a list if future reference or sequence is important. • Keep subjects and objects close to their verbs. • Put conditionals such as “only” or “always” and other modifiers next to the words they modify. • Put long conditions after the main clause. • Write short paragraphs. • Include only one topic in each paragraph. • Use examples to clarify complex subjects. • Use vertical lists to present items, conditions, and exceptions. • Minimize cross-references. • Organize material to minimize the need for cross-references. • If a cross-reference refers to brief material, repeat that material and eliminate the crossreference. • A cross-reference to long and complicated material will avoid repeating that long and complex material. • The reference should clearly describe the referenced material. • Consider putting cross-references at the end of the text, like a reference, rather than in the middle. • Design your document for easy reading. • Avoid cluttered and dense documents. Just Start Drafting? The natural inclination of many drafters is to start the drafting process by talking to their clients, taking notes on the deal, marking up a form partnership agreement, preparing a draft, and sending the product to their client for review. Negotiations then begin with the draft partnership agreement. This model provides the illusion of drafting efficiency and of being inexpensive. This model may not produce the best finished product. Simply starting the drafting process by marking up a draft can lead to inconvenience. Consider instead the possibility of moving from the drafter's initial notes to a written deal outline. When following this model, the deal outline should discuss and summarize the basic provisions of the partnership agreement. The outline serves to highlight basic deal points and should, after being circulated to the client, be refined to ensure that it represents the client's view of the transaction. Next, the outline should be circulated to the other parties to the partnership agreement, and negotiated until all agree with its content. In this model, drafting of the partnership agreement begins only after the deal outline has been finalized. Rely on the Form Agreement Few partnership agreements are drafted completely from scratch. The drafter may mark up a form from a prior deal or a generalized partnership agreement form. The use of forms in modern legal practice is inevitable and good forms make drafting more economical. A good form can serve as an outline of points that you should consider and provide useful language for the new partnership agreement. Practically every drafter uses forms of one type of another. Reliance on form agreements from prior transactions or reliance on general forms is in fact practically inevitable. 17 Relying innocently on a partnership agreement from a prior deal, a form book, or a firm form library can create problems. Overreliance on forms can be a good way to compromise a partnership agreement. Thus, while using a form agreement may be inevitable, the drafter needs to take the time necessary fully to understand the form. Blind reliance on form agreements is particularly a problem when done by an inexperienced associate who may not easily detect subtle problems in a partnership agreement form. It is important to keep in mind that an agreement used in a prior deal often has negotiated language reflecting its own nuances. The parties made many decisions in drafting the form agreement. Simply copying an old form without thought can result in provisions or language inappropriate for the current partnership agreement. Copying can result in incorporating decisions that may not be the best decisions for the current deal, and sometimes lead to the improper carrying over of party names and economic provisions. Even generalized forms from law firm form libraries or from forms books can have provisions that are not fully appropriate to the current partnership agreement. Using a form, particularly a familiar form, is a good starting point. The form needs to be reread from beginning to end, provision by provision, in order to determine what language is valuable for a current deal and what language may not be appropriate. Review the prior form as an outline of decisions. Make sure that the decisions incorporated in the prior form are appropriate for the new transaction, and that the prior form has been thoroughly questioned, before using it as a basis for a current drafting project. Drafters should be particularly careful when their clients instruct them to use the client's own form as a starting point in drafting a partnership agreement. The client often is infatuated with inferior work incorporated in that prior partnership agreement—or with judgment calls that may have been appropriate for a prior deal, but may not be appropriate for the current deal. The drafter may find his or her client fighting any drafting improvements. The drafter will need to spend extra time seeking fully to understand the client's form, and may find real errors in it. Thus, using a client's form typically increases the cost of drafting a partnership agreement if the drafter does a diligent job. Since using the client's partnership agreement form can result in the perpetuation of errors or ambiguities across transactions, consider these steps: • Review the form with particular care if it has not been personally used before. • Make sure that the form is appropriate for the state in which the partnership is to be formed. A Michigan state form may not work well for a Delaware partnership. • Seek to verify whether the form has been updated for current changes in the law. • Make sure that the form is designed for the type of business for which an agreement is currently being drafted. A form designed for one business may not work well for a partnership conducting a different business. Provisions may be industry-specific. • Ensure that the “weight” of the form (i.e., short form, medium form, or long form) is appropriate for the current purpose. • Make sure not to carry forward names, addresses, economics, and other information from a prior deal. Do It Yourself Many drafters draft partnership agreements entirely on their own. Independence has merits but it also can create problems. For instance, some drafters prefer to isolate accountants from the drafting process and believe that the accountants can review the partnership agreement when the time comes to prepare the partnership's tax returns. Isolating accountants from the planning and drafting process usually is false economy however. In fact isolating accountants from the process is a good way to compromise the partnership agreement. Accountants can provide benefits to the planning and drafting process, including the following: • Bring understanding about the client and his or her business. • Bring understanding of the current project. • Bring financial sophistication to the business deal. • Bring understanding of assets to be transferred to the partnership agreement. • Prepare economic projections and models. • Undertake basis projections. • Model the effects of Section 704(c). • Undertake disguised sale computations. • Model economic provisions of the partnership agreement. • Model tax allocations in the partnership agreement. • Review the partnership agreement and determine whether they understand it. • Determine effects of the formation of the partnership under generally accepted tax principles. • Identify and help to resolve tax, accounting, or business issues that the drafter may have missed. It also is useful to have secretaries, paralegals, and other attorneys review the draft partnership agreement. It sometimes is surprising what problems they will discover. Problematic Tax Issues The formation of each new partnership gives the drafter abundant opportunity for tax problems. The following is a partial list of common tax issues, by which the drafter can compromise the partnership: • Sales tax. • Property tax. • Documentary transfer tax. • Disguised sale rules. • Section 704(c). • Gain from relief of liabilities. • Potentially invalidating an exchange under Section 1031(a). • Potentially invalidating a nontaxable involuntary conversion under Section 1033. • At risk and at risk recapture. • Effects of passive loss rules in the new partnership. The partnership agreement should clarify who will bear transaction taxes associated with the formation of the partnership. Ignoring Disguised Sale Rules The formation of a partnership provides many opportunities to compromise the partnership under the disguised sale rules of Section 704(c)(2)(B), Section 707(a)(2)(B), and Section 737. In the absence of detailed discussion of this concern, the following are particular areas in which the drafter can compromise the partnership under disguised sale rules: • Contributions of property by one partner and a distribution of cash or property to the partner within two years before or after the contribution of property. • Contributions of property secured by liabilities. • Contributions of property by a partner, with the partnership assuming unsecured liabilities of the partner. • Distributions of proceeds of borrowing to the partner within two years after a contribution of property by the partner. • Contributions of property by a partner followed by distributions to the contributing partner within seven years. Ignoring Section 704(c) Issues Drafters often forget to consider the tax consequences of the contribution of property with a low tax basis to a partnership. Section 704(c) will take over automatically and affect how tax allocations are made. Section 704(c) can dramatically affect how depreciation and gain or loss are allocated among partners. The choice of a method under Section 704(c) can have a dramatic effect on depreciation and gain or loss allocations. These are some of the ways that a drafter can compromise the partnership agreement under Section 704(c): • Failing to encourage the client to have their accountants prepare Section 704(c) projections. • Failing to select a method under Section 704(c) and to provide for that method in the partnership agreement. • Failing to address the contribution of contributed property to a subsidiary partnership and the effects of the contribution on Section 704(c). • Failing to restrict distributions of contributed property. • Failing to schedule in the partnership agreement the fair market value of each item of property contributed to the partnership. 18 • Aggregating assets when asset aggregation is not permitted under the Section 704(c) regulations. 19 Drafters also should consider the effects of Section 704(c)(1)(C). This provision can apply when built-in loss property is contributed to the partnership. Carelessly Drafted Definitions Specially defined terms are important in most partnership agreements. Careless, imprecise, or erroneous definitions are common drafting mistakes. Careless, imprecise, or erroneous definitions are often carried over from prior partnership agreements that are used as drafting forms. These definitions can lead to interpretive difficulties and, in appropriate circumstances, can lead to economic disputes among the partners. Some definitions in the partnership agreement can have tax or economic significance. The drafter should pay great attention to these definitions. Imprecision or errors in definitions of economic terms in the partnership agreement can lead to misadventure. The drafter should define economic terms with care and precision. Some of the definitions that readily admit errors include: • Capital contribution. • Adjusted capital contribution. • Capital account. • Adjusted capital account. • Minimum gain. • Nonrecourse deductions. • Preferred return. • Internal rate of return. • Unpaid return. The drafter should consider: • Are definitions consolidated in one place? • Are defined terms capitalized? • Are definitions complete? • Are definitions understandable? • Are definitions that have economic significance clear and precise? 20 • Are defined terms short and sensible? • Is substantive material included in the definitions section? 21 Carelessly Drafted Cash Capital Contribution Terms Drafters often compromise provisions concerning additional capital contributions. Such provisions in partnership and LLC agreements are often off-hand and badly developed, creating later difficulty when the partnership seeks to enforce them. Partnership interests can be adjusted if some but not all partners make discretionary capital contributions. Interests may also be adjusted if a partner defaults on his or her obligation to make capital contributions. The adjustments can include changes in basic partnership percentages, adjustments in capital accounts, shifts in capital accounts, adjustments in unrecovered investment, shifts in unrecovered investment, and other changes in partnership economics. The drafter should think through, and test with numerical models, all of the economic provisions that can be affected when one partner defaults on a capital contribution or fails to make a discretionary capital contribution. Drafters particularly should consider and model the consequences of provisions that adjust interests where the partnership includes partners who received their partnership interests in consideration for the performance of services. 22 Partnership and LLC agreement provisions concerning cash contributions should address: • In what form are capital contributions required to be made (personal check, cashier's check, wire transfer, etc.)? • Consequences of carried interests on dilution provisions. • Consequences of capital contributions and dilution provisions on capital accounts. • Consequences of capital contributions and dilution provisions on percentage interests. • Consequences of capital contributions and dilution provisions on tier shifts. • Consequences of capital contributions and dilution provisions on preferred returns. • Consequences of capital contributions and dilution provisions on internal rates of return. • Enforceability of dilution provisions. 23 • Tax consequences of dilution. • The partnership agreement should detail all of the mechanics of a call for additional capital. • Does the partnership agreement clarify the purposes that can be used as the basis for a call for additional capital? • Does the partnership agreement require the partnership to try to borrow funds (and specify the terms at which the partnership must seek to borrow) prior to making a call for capital? • Does the partnership agreement properly distinguish between capital contributions and partner loans? • Must the partnership first have endeavored to borrow before call is made? • What are any other conditions to the call? • What vote is necessary to approve a call for additional capital contributions? • Who makes the call? • Is there a cap on the amount that can be called? Lifetime cap? Cap on each individual call? • Is there a minimum time period between calls? • In what ratio are additional capital contributions made? • What is the form of notice of the call? • What is the timing for contributions to be made after a call? • What form of transmission of capital contributions is required? • Are additional contributions mandatory? • What happens if a partner does not make his required additional capital contribution? 24 • What is the effect if additional capital contributions are made early? • What is the effect if additional capital contributions are made late? • What is the effect if additional capital contributions are not made at all? • Can nondefaulting partners make the additional capital contribution of a defaulting partner? What is the result? • Are additional contributions by nondefaulting partners treated as partner loans? Are loans treated as made to the defaulting partner or to the partnership? What are the loan terms? • Does the partnership agreement provide examples of the operation of dilution provisions? Careless Terms for In-Kind Contributions of Property In-kind contributions of property are more complicated. They involve practically all of the considerations of cash capital contributions, plus the special considerations of property transfers. The prevailing standard of practice among drafters is not necessarily a high standard. Common tax errors and omissions with respect to property contributed to a partnership by a partner include: Failure to memorialize any agreement concerning the separate fair market value of each • contributed asset. This information is critical to applying Section 704(c). • Failure to include adequate due diligence provisions. • Failure to provide adequate warranties and representations. • Failure to include adequate provisions regarding closing. • Failure to allocate transfer expenses. • Failure to allocate transfer taxes. • Failure to address prorations and adjustments. • Problems with any tax protection agreement if the property is sold. These include: • (1) Failure to clarify events eligible for tax protection payments. • (2) Failure to anticipate changes in the tax law. • (3) Failure to deal with disputes concerning calculations or whether an event is subject to tax protection payments. • • (4) Failure to provide for dispute resolution. • (5) Failure to address tax treatment of protection payments with a gross-up. Failure to consider the many other issues typically addressed in a purchase and sale agreement. The in-kind contribution of property to a partnership poses practically all of the challenges of a purchase and sale of property. The partnership agreement or a separate contribution agreement can serve as a surrogate for a purchase and sale agreement. Partnership agreements too often fail to address problems that a purchase and sale agreement normally would address. Ignoring Other Laws—State and Otherwise The drafter easily can get into trouble in drafting a partnership agreement by failing to consider all of the applicable laws. 25 Considering specialized laws is particularly important with a partnership agreement that performs a specialized function (such as a partnership agreement for a rock band, a motion picture, or Broadway production). Take into account other laws and general agreements (such as labor or guild agreements) that may affect the partnership agreement and its business. These laws (and regulations) may include (among others): • Agriculture law. • Antitrust law. • Banking law. • Bankruptcy law. • Commerce and trade law. • Commercial law. • Communications law. • Conservation law. • Corporate law. • Energy law. • Entertainment law. • Environmental law. • Fiduciary law. • Financial law. • Food and drug law. • Foreign laws (including laws of foreign states and foreign nations). • Insurance law. • Labor law. • Marital property and family law. • Patent, copyright, and trademark law. • Procedural law concerning arbitration and other alternative dispute resolution. • Professional regulatory law. • Public health law. • Public resources law. • Public utilities law. • Real estate law. • State and federal securities law. • State law concerning liquidated damage provisions and other agreed remedies. • Tax law. • Transportation, trade, shipping, vehicle, and navigation law. • Usury law. • Water law. Ignoring Audit Issues The Code may subject partnerships to tax audits at the partnership level. The TEFRA audit rules make an exception for any partnership having ten or fewer partners, each of whom is an individual (other than a nonresident alien), a C corporation, or an estate of a deceased partner. The rules treat husband and wife (and their estates) as one partner for this purpose. The TEFRA audit rules exempt these small partnerships from the consolidated audit rules unless these small partnerships make a specific election. Partnerships otherwise are audited at the partnership level in a consolidated proceeding, often referred to as a “TEFRA audit.” The tax treatment of any partnership item (and the applicability of any penalty, addition to tax, or additional amount that relates to an adjustment to a partnership item) is generally determined at the partnership level for partnerships subject to TEFRA audits. 26 A key person in a TEFRA audit is the “tax matters partner.” The tax matters partner coordinates the partnership audit efforts for the partnership and has various notice and filing responsibilities. The responsibilities of the tax matters partner do not extend beyond the audit of the partnership and resolution of tax disputes. 27 The tax matters partner does not have any special obligation to file partnership tax returns or to make partnership elections. The partnership agreement should appoint a qualifying partner as the tax matters partner. The partnership agreement should be careful to designate only a qualifying partner as tax matters partner. TEFRA audit provisions in partnership agreements typically are deficient. Some small partnerships that do not elect the TEFRA audit rules are not subject to TEFRA audit rules. Extensive TEFRA audit provisions are not useful for a partnership that is not subject to TEFRA audit rules. If the partnership is subject to TEFRA audit rules, the audit provisions in the partnership agreement should provide a workable structure for running the audit. This structure might include: • Selection of the tax matters partner. • Replacement of the tax matters partner. • Responsibilities of the tax matters partner. • Provisions for funding the audit (including funding after the dissolution of the partnership). • Extension of statute of limitations. • Authority to compromise the partnership audit. • Partner rights to participate in partnership audits. Careless Allocations Partnership allocations often show signs of compromise. Indeed, the state of the art in drafting partnership allocations of partners' distributive shares of income, gain, loss, deduction, or credit (or item thereof) is dismal. Poorly drafted allocations can result in adverse audits. However, the capabilities of the IRS in auditing partnership allocations similarly is dismal. Some advisors in fact wonder whether they should spend much time seeking to perfect partnership allocations if the Service does not audit partnership allocations effectively. The IRS has shown little interest in partnership allocations since publishing regulations under Section 704. Many partnerships have been saved from problems only because the Service has a poor record of training and performance in auditing partnership allocations. Not many IRS auditors have deep expertise in the Section 704(b) area, and the Service has substantially ignored training and specialization in the area of partnership allocations. The performance of the IRS in this area is so poor that many drafters appear to believe that the Service routinely avoids intermediate or advanced allocation issues entirely, except in the case of partnerships identified with tax shelter transactions. Indeed outside of identified tax shelter cases, the Service generally has little interest in partnership allocations. Thus many agreement drafters believe that practically anything goes in partnership allocations, as they have practical impunity from audit attack on account of the Service's disinterest in partnership allocations. The IRS has drafted extensive regulations under Section 704(b) setting forth rules of substantial economic effect for specific allocations of tax items. Few practitioners understand the nuances and deep structure of these rules. Additionally, the area of substantiality is in substantial confusion on account of the weakness of the regulations and the apparent failure of the regulations to provide the Service with an effective audit tool. Comparatively few partnership agreements fully comply with the basic rules of economic effect. These rules require both (1) distribution of proceeds of liquidation in accordance with capital accounts and (2) partner deficit capital restoration at liquidation of the partnership. Many partnerships follow the alternate test of economic effect for failure to require deficit capital account restoration upon liquidation. Properly drafted, these allocations can work well. Drafters need to be careful to ensure that, under all circumstances, capital accounts accord with the economic plan at the liquidation of the partnership. The drafter otherwise may be embarrassed when the partnership distributes the proceeds of liquidation in accordance with positive capital account balances when those capital account do not conform to the planned economic deal. Drafters who rely on the alternate test of economic effect should consider having the accountants model their allocations and test this model with a wide variety of scenarios to ensure that the allocations work properly. Partnership agreements often do not liquidate in accordance with capital account balances. Many partnerships use what are commonly referred to as “target allocations.” These allocations allocate items of income and loss so as to set up capital accounts (as adjusted) to correspond with the distribution scheme in liquidation. After the target allocations for the year, each partner's capital account should equal the amount that the partner would receive if the partnership sold its assets for “book” value and distributed the proceeds in liquidation. Most advisors rely on these target allocations satisfying the rules of partners' interests in the partnership. Some advisors rely on the economic effect equivalence test to bless target allocations; however, that matter is much in controversy. The tax situation of target allocations is practically staggering. Many practitioners use target allocations routinely. Standards of practice, however, have not settled on how to draft target allocations. There is no commonly accepted “school solution” form for target allocations. Many target allocation provisions in common use are not very good. A laundry list of issues burden target allocations. These are merely a few of those issues: • Do target allocations have any tax effect at all, or are allocations merely made in accordance with partners' interests in the partnership without considering explicit target allocations? 28 • What adjustments to capital account need to be made for purposes of target allocations? 29 • Are target allocations subject to the substantiality rules? 30 • Are target allocations necessarily in accordance with partners' interests in the partnership? 31 • Do target allocations bless fill-up allocations for retiring partners? 32 • Should target allocations be made from gross income and loss or from net income and loss? 33 • Is a partnership using target allocations permitted to rebook assets in accordance with the Section 704(b) regulations? 34 • Is a partnership using target allocations required to rebook assets in accordance with the Section 704(b) regulations? 35 • What adjustments to target capital accounts should the partnership agreement made for purposes of target allocations? Further development of these issues is beyond the scope of this article. Other partnerships may rely on some other scheme of partnership allocations of partners' distributive shares of income, gain, loss, deduction, or credit (or item thereof) or perhaps do not allocate these items at all. These partnerships implicitly rely on partners' interests in the partnership. A simple allocation can simply say that: A partner's distributive share of income, gain, loss, deduction, or credit (or item thereof) shall be determined in accordance with the partner's interest in the partnership (determined by taking into account all facts and circumstances). That is not necessarily such a bad thing to rely on. The many partnership agreements using target allocations may well rely on partners' interests in the partnership. A partnership agreement with no tax allocations at all may well fare just as well as a partnership agreement with exquisitely drafted target allocations. In any event, all of these partnerships likely rely on partners' interests in the partnership. The problem is that partners' interests in the partnership often is not well defined. The partnership accountants may be unsure in many situations how to complete the partnership tax returns. Conclusion This article offers many ideas concerning how the drafting of a partnership agreement can be compromised. Lack of care can severely damage clients and perhaps also one's firm. In contrast, by being mindful of these problems and using this article as a roadmap, practitioners can position themselves to avoid compromising partnership agreements. 1 This article uses the term “compromise” generically and in a lay sense rather than as a technical legal concept. In this sense, an immaterial typographical error usually might be a “small compromise” or perhaps a “glitch,” while a major economic error in a partnership agreement might be a “major compromise.” This article contains recommendations and often uses the verb “should” or “will.” Readers should take these recommendations as suggestions. No one should infer that the author suggests that these recommendations establish (or necessarily reflect) the prevailing standard of care—or that these recommendations necessarily reflect generally accepted best practices. The author leaves it to every drafter to determine his or her own drafting and to apply the appropriate standard of care. 2 Errors may be used in an errors and omissions lawsuit to suggest that the drafter's work was below the accepted standard of care. The errors might also help to cast a shadow on other work in the partnership agreement. Any errors in a partnership agreement (even seemingly innocent errors such as misspellings, inconsistent but immaterial provisions, and incorrect crossreferences) could prove embarrassing. 3 Practitioners should not make small economic deals more economically complex when drafting. 4 Even a simple percentage-based partnership agreement can become much more complicated when new partners are admitted midway in the history of the partnership. 5 In this regard, the drafter should consider preserving proof that will convince a jury in an errors and omissions action. 6 The drafter should consider the contents of, and preserving, notes, memoranda, letters, drafts, spreadsheets, schedules, electronic mail, time sheet entries, and other evidence of the drafting process. In this regard, the drafter should consider discussing with litigation colleagues the appropriateness of preserving raw notes and annotated drafts. These colleagues may be able to provide useful insights. Circulating numerical models of economic provisions and securing written confirmation that they accurately reflect the economic deal can be useful. 7 Conventions differ by the manner in which they treat the number of days in the year, the manner in which they treat the first or last day of the interest calculation period if the first or last day of the month is the 30th or 31st day, and the manner in which they treat February 28 and 29. There are at least three accepted actual/actual methods for computing bond interest accrual on a 365/366 day computational year: the International Securities Market Association (ISMA) method (Actual/actual (bond)), the Association Francaise des Banques (AFB) method (Actual/actual (AFB)), and the International Swaps and Derivatives Association (ISDA) method (Actual/actual (Historical)). Each method can produce different interest or preferred return accruals. See International Swaps and Derivatives Association, Inc., “EMU And Market Conventions: Recent Developments,” http://www.isda.org/c_and_a/pdf/mktc1198.pdf; SWX Swiss Exchange, Accrued Interest & Yield Calculations and Determination of Holiday Calendars (03/11/2003); International Swaps and Derivatives Association, Inc., “The Actual/Actual Day Count Fraction” (6/3/1999); Mendle, “Alternative compounding methods for Over-the-Counter Derivative Transactions,” (2/5/2009) (working paper published by the ISDA); Mayle, Standard Securities Calculation Methods, Fixed Income Securities Formulas for Price, Yield, and Accrued Interest, (Securities Industry Association 2007). 8 The partnership agreement may provide for this tiering of distributions (to be applied on a cumulative basis from the formation of the partnership): first, to partner A until partner A has received sufficient cumulative distributions to give partner A an 8% preferred return, second, 50% to partner A and 50% to partner B. In year 1, the partnership makes sufficient distributions to satisfy partner A's 8% preferred return. The partnership also distributes $100,000 to partner A and $100,000 to partner B under tier 2 in year 1. The partnership must calculate distributions in year 2. Does the partnership count the year 1 distribution to partner A under tier 2 in applying the 8% preferred return condition in year 2? 9 The mathematics of internal rate of return is complex. Computations involve elements of Descartes' rule of signs, the Newton-Raphson iterative method, and Sturm's theorem. 10 Methodology and results may differ among different versions of Microsoft Excel. The drafter also should consider the possibility that the version of Excel that he or she prefers may not be generally available in the future. 11 A drafter without experience in calculating IRR using Excel can have difficulty drafting provisions that can be precisely applied for partnership agreements. Drafting adequate provisions using XIRR or IRR requires precise specification that rarely is present in partnership agreements. It is not adequate practice simply to say that IRR will be calculated using the Excel IRR or XIRR functions. The precise application of these functions should be set forth in the agreement. 12 It is good practice to verify all cross-references in the partnership agreement. 13 A simple form of drafting a sentence that starts with the subject, follows with the verb, and ends with the object can produce understandable partnership agreements. 14 Consider using understandable short names, rather than letters, as abbreviations. Letter abbreviations, however, are appropriate for entities that have commonly used abbreviations, such as NFL for the National Football League. 15 Consider compiling all abbreviations in a section of the agreement. 16 See Federal Plain Language Guidelines (March 2011, Revision 1, May 2011), found at http://www.plainlanguage.gov/howto/guidelines/FederalPLGuidelines/index.cfm?CFID=9249420& CFTOKEN=70a18db74f537a49-59B7B5FE-1372-41328D008AB5F11FA123&jsessionid=bc3016026241c6ad312941d766b30d59605a. 17 For most drafters, the form agreement is considerably less dangerous than simply starting to type a partnership agreement from scratch, without any guide at all. It is doubtful that many have tried this approach. 18 Drafters typically provide an aggregate net value for contributions by each partner. Section 704(c) requires knowing the fair market value of each separately contributed asset. 19 This is particularly an issue with securities partnerships. Considerable doubt exists in relation to securities partnerships on how to apply Section 704(c) on an aggregate basis. This particularly relates to using Section 704(c) allocations to make stuffing allocations to retiring partners. 20 Preferred returns are particularly difficult to draft. 21 Most drafters discourage putting substantive terms of the partnership agreement in the definitions section. 22 The percentage interests of most partners may be based on their unrecovered capital contributions. The percentage interest of a service partner usually is larger than what their percentage interest would be, if that interest were based on their unrecovered capital contribution. Adjustment provisions that are based on unrecovered capital contributions often fail to give the service partner proper consideration for the value of their services. 23 A partner might assert that a particular dilution provision acts as a liquidated damages provision, but that provision may not meet the legal requirements for liquidated damages provisions. 24 Partners often desire that the partnership agreement contain harsh remedies if a partner defaults on a cash capital contribution. Some partners would like to strip the defaulting partner naked, slather him in honey, and bury him up to the neck in a mound of fire ants. Other partners wish to fit the defaulting partner with concrete overshoes and drop him into a deep body of water. An important consideration however is whether state courts or bankruptcy courts will enforce a default remedy. The default remedy may do the partnership little good if a court will not enforce it. The partnership will then be left to remedies such as fire ants or concrete overshoes. Each of these alternative remedies has its own disadvantages. 25 The drafter naturally will not be able to consider all possibly applicable laws. The drafter should consider those laws whose application would be identified by a reasonable draftsman who is similarly situated. 26 Section 6231(a)(7). 27 See Reg. 301.6223(g)-1 (responsibilities of the tax matters partner). 28 In a particular economic situation, it is possible that partners' interests in the partnership necessarily produce a unique set of allocations. Otherwise, it is difficult to know how a court could apply partners' interests in the partnership in the absence of allocations in the partnership agreement. If partners' interests in the partnership produce a unique set of allocations in a particular situation, then it is not clear how target allocations can affect the allocations at all and still qualify under partners' interests in the partnership. 29 Adjustments presumably should be made for shares of minimum gain and partner minimum gain. In appropriate cases, target allocations should consider qualifying partner contribution obligations. Advisors debate whether capital account adjustments are proper for partner contribution obligations that do not generally qualify under the Section 704(b) regulations. Partner or affiliate guarantees of partnership debt might result in adjustments to capital accounts. Capital accounts perhaps should be adjusted on account of partner loans to the partnership. The tax world has not reached general agreement on all of the adjustments to capital accounts that need to be made for target allocations to work properly, if they can work at all. 30 The rules of substantiality expressly apply to allocations that have economic effect. Most advisors believe that target allocations do not have economic effect. Many advisors, however, believe that substantiality cannot be avoided by using allocations designed to qualify under partners' interests in the partnership. The rules for applying substantiality to partners' interests in the partnership have not been well developed. 31 Some advisors believe that target allocations, drafted properly, necessarily satisfy partners' interests in the partnership. Other advisors do not share this belief. Most advisors concede that target allocations, drafted properly, frequently satisfy partners' interests in the partnership. 32 A fill-up allocation to a retiring partner ensures that the retiring partner receives allocations, in his or her year of retirement, so that his or her capital account equals the amount that he or she will receive in retirement. This scheme often results in a substantial income or gain allocation to the retiring partner in the year of requirement. The retiring partner may be tax-indifferent to this gain or income allocation, since the allocation increases the retiring partner's capital account. The special allocation to the retiring partner does not affect the dollar amount that the retiring partner will receive in retirement. Some advisors question whether this fill-up allocation should be respected for tax purposes. 33 This issue is important when the partnership does not have sufficient items for those target allocations made on a net income or loss basis. Must the partnership then shift to allocations of gross items in order that capital accounts conform to the projected cash distribution scheme? 34 The system of rebooking partnership assets is designed for partnerships that maintain capital accounts in accordance with the Section 704(b) regulations and that liquidate in accordance with capital accounts. Rebooking partnership assets would have no economic effect if the partnership does not liquidate in accordance with capital accounts. Similarly, there is no reason to believe that partners would have economic adversity when partnership assets are rebooked if the partnership does not liquidate in accordance with capital accounts. This partner adversity is an important component of keeping partners honest in the rebooking transaction. Rebooking partnership assets when using target allocations, if permitted, arguably shifts allocations from a partners' interests in the partnership scheme to a Section 704(c) scheme. That, however, is a matter that can be debated. The regulations on partners' interests in the partnership do not explicitly address rebooking partnership assets. 35 The concept of partners' interests in the partnership arguably could require regularly rebooking partnership assets to fair market value on permitted rebooking events. Regular rebooking of partnership assets on permitted events may be so intertwined with the deep structure of Section 704(b) that partners' interests in the partnership may require this regular rebooking in order properly to reflect partners' interests in the partnership. This matter, however, is not clarified in the Section 704(b) regulations. © 2013 Thomson Reuters/RIA. All rights reserved.
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