MERGERS, ACQUISITIONS AND CONVERSIONS
WITH PARTNERSHIPS AND LLCS
MICHAEL K. PIERCE
Thompson & Knight LLP
Houston, Texas
michael.pierce@tklaw.com
713-217-2837
State Bar of Texas
TEXAS BUSINESS ORGANIZATIONS:
CHOICE OF ENTITY AND FORMATION 2005
May 27, 2005
San Antonio
CHAPTER 7
Michael K. Pierce
Michael K. Pierce is a senior partner in the Houston office of the law firm of Thompson & Knight LLP. Mr. Pierce is a 1979 graduate of the SMU Dedman School of Law. He joined Thompson & Knight in 1979 and practiced law in the firm's Dallas office until 1991, at which time he relocated to Houston and helped establish Thompson & Knight's Houston office. Mr. Pierce is currently the assistant practice group leader of Thompson & Knight's corporate and securities section. The primary focus of Mr. Pierce's practice is mergers and acquisitions, energy finance and venture capital.
Mr. Pierce has served on the State Bar of Texas Partnership Law Committee since 1985 and was chairman from 1995 to 2002. Mr. Pierce has also served on the State of Bar of Texas LLC Committee since 1993 and on the Ad Hoc Codification Committee since 1995. Mr. Pierce is also a member of the American Bar Association Special Task Force on Revisions to Model Stock Purchase Agreement. Mr. Pierce is a member of the American College of Investment Council and is listed in the Best Lawyers of America, 2003-2004 (Corporate, Mergers and Acquisitions and Securities Law and Natural Resources Law).
i
TABLE OF CONTENTS
I. INTRODUCTION... 1
II. STRUCTURING THE PURCHASE AND SALE TRANSACTION... 1
III. SIMILARITIES IN DOCUMENTING THE TRANSACTION ... 2
IV. CERTAIN KEY CONSIDERATIONS... 2
V. MERGERS INVOLVING PARTNERSHIPS OR LLCS—KEY POINTS ... 9
VI. CONVERSIONS... 12
VII. CONCLUSION ... 14
EXHIBIT A... 15
1
MERGERS, ACQUISITIONS AND
CONVERSIONS WITH PARTNERSHIPS
AND LLCS
I. INTRODUCTION
Many businesses find it advantageous to conduct their operations as a limited partnership or a limited liability company rather than as a corporation. The reasons for this include:
• A limited partnership or a limited liability company (as applicable) will be classified as a partnership for U.S. Federal income tax purposes (i.e., tax will be imposed only at the owner level, rather than at both the entity and owner levels) unless the partners or members of the entity elect otherwise by virtue of the "check-the-box" regulations.
• The limited partners of a limited partnership and the members of a limited liability company will have limited liability with respect to the debts and obligations of their respective entity.1
• The partners or members (as applicable) have considerable contractual flexibility in defining their relationship among themselves, including the rights, duties and obligations of the various owners to each other and to the entity, as well as the allocation among the owners of the entity's profits, losses and distributions.2
In general, legal materials (treatises, articles, etc.) on mergers and acquisitions have focused primarily on transactions involving subchapter-C corporations. The purpose of this paper, therefore, is to discuss generally purchase and sale transactions involving limited partnerships and limited liability companies, with an emphasis on highlighting some of the principal
* The tax related sections of this paper were prepared by Kevin Thomason, a partner with Thompson & Knight LLP, and Todd Keator, an associate with Thompson & Knight LLP.
1
See Texas Revised Limited Partnership Act ("TRLPA)
§3.03(a); Texas Limited Liability Company Act ("TLLCA") Art. 4.03A.
2
See e.g., Delaware Revised Uniform Limited
Partnership Act ("DRULPA") §17-1101(c), which provides that "[i]t is the policy of this chapter to give maximum effect to the principle of freedom of contract and to the enforceability of partnership agreements." §18-1101(b) of the Delaware Limited Liability Company Act ("DLLCA") contains a similar statement with respect to limited liability company agreements.
similarities and distinctions between transactions involving limited partnerships or limited liability companies, on the one hand, and corporations, on the other hand. This paper will also discuss the Texas state law provisions dealing with the ability of partnerships, limited liability companies and corporations to "convert" into another form of entity. Finally, this paper will discuss many of the tax implications surrounding the purchase and sale of partnership and limited liability company interests, as well as tax implications regarding partnership and limited liability company mergers and conversions.
II. STRUCTURING THE PURCHASE AND SALE TRANSACTION
Many of the factors considered in determining whether to structure a transaction involving a limited partnership or a limited liability company as an "interest" or "asset" deal are similar in to those involving the purchase and sale of the stock or assets of a corporation and include the following:3
• Tax—Step Up in Basis or Carryover Basis. Generally, the purchaser of all of the outstanding shares of stock of a corporation will retain the same basis in the corporation's assets, whereas the purchaser of the assets of the corporation may "step up" its basis in those assets.4 This is generally true in the context of the purchase of either the interests or assets of a limited partnership or a limited liability company.5
• Assumption of Liabilities.
A purchaser of a limited partnership's or limited liability company's assets will not assume any liabilities attributable to those assets, absent an express assumption to that effect. This is the same result as in a purchase of assets from a corporation. A purchaser of all of the interests of a limited partnership or a limited liability company in effect acquires all of the assets and liabilities of the entity. This is the same result as in a purchase of all of the capital stock of a corporation although, as discussed in more detail below, the purchaser of a general partner interest in a limited partnership also assumes personal liability for partnership debts and obligations.
3
For a general discussion of non-tax considerations in structuring a purchase and sale transaction, see Kling & Simon, Negotiated Acquisitions of Companies, Subsidiaries and Divisions, §§2.01-2.09 (hereinafter referred to as "Kling & Simon").
4
Kling & Simon, supra note 4, at §3.02. 5
There are, however, nuances to this general treatment discussed in Part IV hereof under the caption "Certain Tax Considerations - Section 754 Election; Disregarded Entity."
Mergers, Acquisitions and Conversions With Partnerships and LLCs Chapter 7
2 • Governmental and other Third Party
Consents.
Typically, the purchase and sale of the assets of a corporation is more likely to trigger rights of third parties to consent to such transfer, whereas the purchase and sale of the stock of a corporation typically (but not always) does not.6 This is also generally true in the limited partnership or limited liability context.
• Owner Approvals.
In the purchase and sale of the capital stock of a corporation (and assuming that merger or share exchange provisions are not utilized), all of the shareholders of the corporation must agree to sell their shares to the buyer. The same result is true in the context of a sale of all of the outstanding partnership or membership interests. Conversely, the sale of all or substantially all of the assets of a corporation typically requires the approval of less than all of the members of the board of directors and less than all of the shareholders.7 This is also generally applicable in the limited partnership or limited liability company context.8
• Transfer Taxes.
Absent an exemption under state law, a sale of assets by a corporation will typically entail the incurrence of applicable state sales or other similar transfer taxes, as well as filing fees associated with recording the various assignments of real property. Conversely, a sale of stock in a corporation typically does not trigger the incurrence of sales or other transfer taxes, nor are there any filing fees since the assets remain with the corporation.9 This is also applicable in the context of a sale of assets or interests in a limited partnership or a limited liability company.
• Scope of Documentation.
Generally, the documentation in connection with the sale of all the stock of a corporation, as opposed to the sale of all the assets of a corporation, is less extensive, given (among other things) that it is not necessary to prepare documents to effect the transfer
6
Kling & Simon, supra note 4, at §§2.08[2] and [3]. 7
Id. at §2.03. 8
As previously noted, partners of a limited partnership or members of a limited liability company have considerable freedom of contract. See note 2 supra. This "freedom of contract" extends to the requisite procedures that may be utilized to approve a proposed sales transaction. See Part V hereof and the discussion under the caption "Mergers Involving Partnerships or LLCs—Key Points - Mechanics."
9
Id. at §2.08[4].
and assignment of the assets.10 This is also applicable in the context of a sale of a limited partnership or limited liability company.
III. SIMILARITIES IN DOCUMENTING THE TRANSACTION
In connection with documenting the purchase and sale of a limited partnership or a limited liability company, the basic format and many of the provisions of a typical stock or asset purchase and sale or merger agreement involving corporations may be utilized. Buyer and seller will generally desire to set forth by written agreement (i) the purchase price for the interests or assets to be purchased, as well as any agreed upon adjustments thereto; (ii) the proposed closing date of the transaction and the obligations of the parties at closing; (iii) the representations and warranties of the seller(s) of the interests or assets with respect to title to the interests or assets and the financial and operating aspects of the business being sold; (iv) the representations and warranties of the buyer, particularly with respect to its capacity to consummate the purchase of the interests or the assets; (v) the covenants (both affirmative and negative) of the parties prior to the closing date; (vi) the conditions of each of the parties to close the proposed transaction and their respective rights to terminate the agreement; (vii) the indemnification obligations of the parties post-closing; and (viii) other miscellaneous covenants and agreements (both pre- and post-closing), including the payment of transaction expenses.
IV. CERTAIN KEY CONSIDERATIONS
Although, from a structuring and documentation standpoint, the purchase and sale of a limited partnership or a limited liability company encompasses many characteristics common to the purchase and sale of corporate stock or assets, there are differences and other considerations that should be taken into account. These include:
• Interests are Often Assessable.
In a corporate context, when a party purchases capital stock in a corporation, that party typically is not subject to any further obligation to pay or contribute money to the corporation in respect of the stock. However, in a limited partnership or limited liability context, the owners of the interests in such entity are often subject to provisions in the governing documents that may require them to contribute capital in the future to the entity. Thus, a purchaser of interests of this type will likely want assurances in the purchase documents that the seller has satisfied all prior obligations to make capital contributions to the entity and that all future
10
3 obligations to make capital contributions are known and disclosed.
Under the TRLPA, unless otherwise provided by a written partnership agreement, an assignee who becomes a limited partner also is liable for the obligations of the assignor to make its agreed upon capital contributions to the partnership, but is not obligated for liabilities unknown to the assignee at the time the assignee became a limited partner and which could not be ascertained from a written partnership agreement.11 The TLLCA contains a similar provision with respect to the liability of an assignee who becomes a substituted member.12 The TRLPA also provides that an assignee is not liable for the obligations of the assignor under the provisions of the TRLPA governing wrongful distributions.13
• Partnerships and LLCs are Creatures of Agreement.
The partners of a limited partnership and the members of a limited liability company are typically given considerable deference under their governing statutes to define their relationship by agreement—to "write their own ticket." Accordingly, a purchaser of interests in such entities should carefully review the governing documents to determine the rights, duties and obligations of the parties thereto.14 Further, a purchaser will likely want assurances in the purchase documents that the seller of the interests is in
11 TRLPA §7.04(b). 12 TLLCA Art. 4.07B. 13
Id. §6.07 of the TRLPA contemplates that a limited
partner may have to return a distribution received from the limited partnership if, after giving effect to that distribution, liabilities of the limited partnership (except to partners on account of their partnership interests), exceed the fair value of the partnership assets. §6.07 states that a limited partner who knows at the time of a distribution that the distribution is "wrongful" is liable to the limited partnership for the amount of the distribution; however, there is no liability if the limited partner does not know that a distribution is wrongful. §6.07 further provides that it does not affect any obligation of a limited partner to return a distribution arising under the limited partnership agreement or other applicable law. Art. 5.09 of the TLLCA contains a similar provision with respect to the obligation of a member to return a wrongful distribution from a Texas limited liability company.
14
See note 3 supra. In general, partners or members are accorded flexibility to provide for, among other things, (i) the sharing of profits and losses, (ii) the circumstances under which a party will be compensated or reimbursed for services rendered on behalf of the entity, (iii) the management of the entity, (iv) the assignment of interests and the admission of successor or new partners or members, and (v) the manner in which differences will be resolved.
compliance with its duties and obligations under the governing documents (including the obligation to make any agreed upon capital contributions due and owing prior to closing).
Additionally, for tax purposes, a purchaser of a partnership or member interest will have its distributive share of income, gain, loss, deduction, or credit determined by the partnership or company agreement, unless the allocations are found to lack "substantial economic effect."15 Therefore, the purchaser should verify that partnership allocations have substantial economic effect in accordance with various safe harbors.16 If the allocations do not qualify for such safe harbors, then the purchaser's share of the various tax items will be allocated in accordance with "the partnership's interest in the partnership" whatever that may be.
• Purchase of a GP Interest.
The limited partners in a limited partnership and the members of a limited liability company (like the shareholders of a corporation) have limited liability for their entity's debts and obligations. The general partner of a limited partnership, however, has unlimited liability for the debts and obligations of the limited partnership.17 Thus, to the extent that a buyer is purchasing all of the partnership interests (general and limited) in a limited partnership or solely the general partner interest, the buyer must take into account the liabilities associated with the general partner interest.
15
I.R.C. §§ 704(a) and (b).
16
See Treas. Reg. § 1.704-1(b)(2). 17
§4.03(b) of TRLPA provides that "a general partner of a limited partnership has the liabilities of a partner in a partnership without limited partners to persons other than the partnership and the other partners." Article 3.05 of the Texas Uniform Partnership Act ("TUPA"), however, provides for the "exhaustion of assets rule," meaning that, subject to certain exceptions, a creditor of a partnership must first attempt to satisfy a judgment against the partnership from partnership assets before proceeding against the partners personally. Presumably, this provision is incorporated into TRLPA for the benefit of a general partner of a limited partnership by virtue of the linkage between TUPA and the TRLPA provided in §13.03 of TRLPA ("[i]n any case not provided for by this Act, the applicable statute governing partnerships that are not limited partnerships…govern"). Further, §2.14 of TRLPA permits a limited partnership to register as a limited liability limited partnership. If a limited partnership so registers in compliance with the statute, the general partner of the limited partnership will have the same liability shield for limited partnership debts and obligations as a general partner does in a registered limited liability partnership.
Mergers, Acquisitions and Conversions With Partnerships and LLCs Chapter 7
4 In general, in connection with a sale of a general partner interest in a limited partnership (a "GP Interest"):
(i) Absent an assumption by buyer of pre-closing liabilities attributable to the GP Interest ("pre-closing liabilities"), seller will retain personal liability for such liabilities. Buyer's liability for pre-closing liabilities will be limited to its interest in the partnership.18 (ii) Even if buyer assumes seller's pre-closing
liabilities, seller will nonetheless retain liability therefore absent a release from the subject creditors.19
(iii) Buyer will have personal liability for liabilities attributable to the GP Interest arising after the closing.
In consideration of the foregoing, potentially difficult questions can arise as to whether a partnership liability falls into the pre-closing or post-closing category. For example, if an action giving rise to a lawsuit occurs prior to the sale but the lawsuit is not brought until after the sale, is the underlying liability a pre-closing or post-closing liability? Similarly, if a contract is entered into by a partnership prior to the closing but a default thereunder occurs after the closing, is the obligation for such default a pre-closing or post-closing liability? TRPA §3.07 provides guidance in that it states that a person admitted as a partner into an existing partnership does not have personal liability for an obligation of the partnership that (i) arose before the partner's admission to the partnership, (ii) relates to an action taken or omissions occurring before the partner's admission to the partnership or (iii) arises before or after the partner's admission under a contract or commitment entered into before the partner's admission to the partnership. Obviously the most prudent course seller and buyer can take in this context is to sort through the various liabilities, commitments and obligations of the partnership (contingent or otherwise) and determine in writing their respective responsibilities therefore, keeping in mind that such determination will not be binding on a third party absent its agreement.
• Formalities.
Both limited partnerships and limited liability companies, like corporations, must make a filing with a designated governmental entity in order to be formed. While limited partnerships and limited liability companies may thereafter conduct their business utilizing more formal "corporate type" procedures
18
See TRPA Art. 3.07.
19
See TRPA Art. 7.03(a).
(e.g., the limited liability company governing documents require annual and special manager and member meetings, require that notices of meetings be given, require that member and manager minutes or consents be maintained), often times in actual practice they do not. The concern from a buyer's standpoint is essentially two-fold: (i) to verify that it is aware of all major actions that may have been approved by the partners or members, as applicable; and (ii) to verify that if formal "corporate" type procedures are required under the governing documents, such formalities have been complied with.20
20
In this regard, there have been a number of judicial decisions in the limited liability company context involving third parties attempting to "pierce" the liability shield accorded members and managers of limited liability companies, similar to cases involving corporations. See generally Cohen, Theories of the Corporation and the Limited Liability Company: How Should Courts and Legislatures Articulate Rules for Piercing the Veil, Fiduciary Responsibility and Securities Regulation for the Limited Liability Company?, 51 Okla. L. Rev. 427 (1998). For example, in Kaycee Land and Livestock v. Flahive, 46 P.3d 323 (2002), the Wyoming Supreme Court ruled that the equitable remedy of piercing the veil is an available remedy under the Wyoming limited liability act. In its decision, the court stated: "We can discern no reason, in either law or policy, to treat LLCs differently than we treat corporations. If the members and officers of an LLC fail to treat it as a separate entity as contemplated by statute, they should not enjoy immunity from individual liability for the LLC's acts that cause damage to third parties." Kaycee at 328. Courts have generally employed "corporate" type tests or standards in determining whether an llc veil may be pierced: McGovern Capital, LLC v. Papic, 2003 WL 21267436 (2003) (noted that Connecticut courts use the "instrumentality" and "identity" tests in determining whether to piece the corporate veil, and then used such tests to determine whether to pierce the llc veil); Imperial Trading Co. Inc. v. Utter, 837 So.2d 663 (La. App. 1 Cir.) (2003) (ruled that trial court properly refused to pierce llcs' veils since llcs were not disregarded to the extent they could not have been distinguished from members or that actions of members were fraudulent); Hamilton v. AAI Ventures, LLC, 768 So.2d 298 (La.App. 1 Cir.)(2000) (cited decisions in corporate context that the veil may be pierced in the instance of fraud or deceit or where the shareholders have failed to conduct business on a corporate footing and ruled evidence supported the trial court's decision permitting the llc to be pierced on the grounds of "thin" capitalization, common employees, services rendered by the employees of one corporation on behalf of another, common offices and centralized accounting); Westmoreland Associates, LLC v. Kispert, 2002 WL 31777885 (N.Y. City Civ. Ct. 2002) (stated that if a corporate veil can be pierced, an llc veil should be pierceable; further, the court cited the corporate piercing standard (a showing of complete domination that was used to commit a fraud or injustice) in ruling the llc veil should not be pierced).
5 • Duties.
In Texas a general partner of a limited partnership owes to the limited partnership and the limited partners the duties of loyalty and care and the obligation to discharge such duties in good faith and in a manner the general partner reasonably believes to be in the best interest of the limited partnership.21 Further, partners may not eliminate the duties of loyalty and care and the obligation of good faith, although they may by agreement (i) identify specific types or categories of activities that do not violate the duty of loyalty or (ii) determine standards by which the duty of care or obligation of good faith is to be measured, provided that in all events such types or categories (in the instance of the duty of loyalty) or standards (in the instances of the duty of care and obligation of good faith) are not "manifestly unreasonable."22
The relevance of the foregoing in an acquisition context is several-fold:
(i) If a person proposes to purchase the interest of the general partner in an existing limited partnership, the proposed purchaser needs to review and fully understand the provisions in the relevant limited partnership agreement regarding the general partner's duties and obligations and determine whether its business activities and mode of operations will be in compliance with such duties and obligations. To illustrate, what will the proposed purchaser's time commitment be to the limited partnership? To what extent may the proposed purchaser engage in activities potentially competitive with the limited partnership? What standard of care will the proposed purchaser be held to in performing its obligations as general partner?
(ii) In addition, provisions of the type described may come into play in the context of an
In a Texas case, a court ruled that the theory of piercing the corporate veil is not applicable to partnerships. In Pinebrook Properties, Ltd., v. Brookhaven Lake Property Owners Assn., 77 S.W.3d 487 (Tex. Civ. App., 2002), the court overruled the trial court and held that the alter ego doctrine is not applicable to a partnership, stating that "there in no veil that needs piercing, even when dealing with a limited partnership, because the general partner is always liable for the debts and obligations of the partnership to third parties."
21
TRPA Art. 4.04. The TRPA provisions are applicable to a general partner of a limited partnership by virtue of §4.03(b) of TRLPA which provides that "a general partner of a limited partnership has the liabilities of a partner in a partnership without limited partners to the partnership and to the other partners."
22
TRPA Art.'s 1.03(b)(2),(3) and (4).
"exit" transaction. For example, assume that a general partner is a party to a limited partnership agreement that provides that the general partner has the statutory duty of loyalty and the obligation of good faith, but that also permits the general partner to effectively control whether the limited partnership or its assets will be sold and the terms of such sale. To what extent does the duty of loyalty limit or modify the right of the general partner to control the exit transaction?23
23
In contrast to the TRPA and TRLPA provisions, Art. 2.20B of the TLLCA provides that "[t]o the extent that at law or in equity, a member, manager, officer, or other person has duties (including fiduciary duties) and liabilities relating thereto to a limited liability company or to another member or manager, such duties and obligations may be expanded or restricted by provisions in the regulations." This is the same approach found in both DRULPA (§17-1101(d)) and the DLLCA (§18-1101(c)), although the DRULPA and DLLCA provisions were amended in August 2004 to provide that "the [partnership agreement/limited liability company agreement] may not eliminate the implied contractual covenant of good faith and fair dealing." DRULPA and the DLLCA both provide that a partner/member or other person acting under a limited partnership/limited liability company agreement shall not be liable to the partnership/limited liability company or to any such other partner/member or to any such other person for the partner's/member's or other person's good faith reliance on the provisions of the partnership/limited liability company agreement. DRULPA §17-1101(d) and DLLCA §18-1101(c). In a case involving a Delaware limited partnership, In re Cencom Cable Income Partners, L.P. Litigation, (Del Ch. 1996), the Delaware Chancery Court stated: "DRULPA recognizes [that] partners may modify fiduciary duties through contract. In other words, whether a general partner operates in good faith, with due care, or with requisite loyalty may be determined by the consistency with which the general partner adheres to its contractual obligations. Put another way, the limited partnership agreement may authorize actions creating a 'safe harbor' for the general partner under circumstances that might otherwise be questionable or impose a stricter standard of scrutiny than the norm."
The foregoing discussion has centered primarily on the duties owed by a general partner. However, it should be noted that due to statutory changes in the mid-1980's to early 1990's which permitted limited partners to take an active role in the business of the limited partnership without jeopardizing their limited liability, there has been increased focus on whether a limited partner may owe fiduciary type duties to a limited partnership or the other partners. In several cases, the Delaware Chancery Court has found that limited partners may be subject to fiduciary duties. In KE Property Management Inc. v. 275 Management Inc., Del. Ch. C.A. No. 12683 (July 27, 1993), the limited partnership agreement permitted a limited partner to participate in the
Mergers, Acquisitions and Conversions With Partnerships and LLCs Chapter 7
6
control of the partnership by granting the ability, under certain circumstances, to remove the general partner. The court held that to the extent that a partnership agreement permits a limited partner with the discretion to take actions affecting the governance of the limited partnership, the limited partner may be subject to the obligations of a fiduciary. In James River Pennington Inc. v. CRSS Capital Inc., Del. Ch. C.A. No. 13870 (March 6, 1995), the court held that the limited partner owed a fiduciary duty of loyalty to the partnership and to the other partners because it controlled the general partner through the votes of three of its six directors. In Bond Purchase, L.L.C. v. Patriot Tax Credit Properties, L.P., Del. Ch. C.A. No. 16643 (July 23, 1999), the issue arose over whether a limited partner could be subject to default fiduciary duties in the absence of a fiduciary relationship. The court noted that none of the factors previously recognized as establishing a fiduciary relationship, thus potentially giving rise to fiduciary duties (e.g., limited partner control of the general, power of limited partner to take action affecting the management or operation of the partnership), existed. In the absence of such factors, the inability to find any language in the partnership agreement creating a fiduciary relationship, and the lack of intent to impose fiduciary duties on the limited partner, the court concluded that the limited partner owned no fiduciary duties to the partnership or the other partners. Finally, in Cantor Fitzgerald, L.P. v. Cantor, 2000 WL 307370 (Del Ch. March 13, 2000), the court ruled that a limited partnership by agreement may provide that all partners, including limited partners not active in the management and operation of the limited partnership, are subject to a fiduciary duty of loyalty.
In the limited liability context, cases addressing the duties of members and managers include the following. In McConnell v. Hunt Sport Enterprises, 725 N.E.2d 1193 (Ohio App. 1999), the Ohio Court of Appeals stated that members of an llc are in a fiduciary relationship that would generally prohibit competition with the business of the llc. However, in this instance, the court concluded that members may contractually limit or define the scope of the fiduciary duties and determined that a provision permitting members to compete was unambiguous and enforceable. In Suntech Processing Systems, LLC v. Sun Communications, Inc., 2000 WL 1780236 (Tex. Civ. App. – Dallas, December 5, 2000), a minority member of a Texas llc claimed that a majority member owed it a fiduciary duty as a matter of law. The articles of organization provided that "[m]embers of this Company have a duty of undivided loyalty to this Company in all matters affecting the Company's interest." The court remanded the case, but stated that (i) whether a fiduciary relationship exists is a question of fact and (ii) that the referenced provision in the articles of organization only dealt with duties owed by the members to the llc rather than to the other members, and therefore ruled that neither the TLLCA nor the contractual relations between the members authorized a finding of a fiduciary relationship as a matter of law. In Solar Cells, Inc. v. True North Partners, LLC, 2002 WL 749163 (Del. Ch. 2002), the plaintiff, a member of an llc, sought to enjoin the merger of the llc alleging that the defendant managers of the llc acted in bad faith. One of the points of defense argued by the defendants is that the
• Interests May or May Not be Certificated. Shares of stock in a corporation are evidenced by a stock certificate. Partnership interests in a limited partnership or membership interests in a limited liability company may be evidenced by a physical certificate, although most often they are not.24
• Interests May be Securities.
Limited partnership interests are generally deemed to be "securities" for purposes of both applicable U.S. Federal and state securities laws. Membership interests in a limited liability company may or may not be securities. Generally, if all or certain types of members have delegated the right to conduct the day to day business of the limited liability company to the managers or certain other members, the membership interests of the delegating members will likely be considered securities.25 If the partnership or membership interests being sold are or are likely to be considered securities, the sellers of such interests will need to take steps to insure that the sale is effected in accordance with applicable securities laws.
• Appraisal Rights.
Appraisal or "dissenters" rights are statutorily granted rights of stockholders to receive in cash the value of their shares in lieu of participating in a particular corporate transaction, such as an acquisition.26 In contrast, state limited partnership and
operating agreement of the llc limited any fiduciary duties owed by them to the plaintiff. The operating agreement provided in pertinent part that "both [parties] waive any such conflicts of interest [attributable to the manager's fiduciary obligations owed to the llc and to itself] … and agree that [defendants] shall have [no] liability to [plaintiff] with respect to such conflict of interest, provided that the [defendants] have acted in a manner which they believe in good faith to be in the best interest of the [llc]." In enjoining the merger, the court ruled that the above language did not mean that there was a waiver of all fiduciary duties to the plaintiffs, as it was expressly provided that the defendants "must act in good faith."
24
See TRLPA §7.02 ("[a] written partnership agreement
may provide that a partner's partnership interest may be evidenced by a certificate of partnership interest issued by the limited partnership…."). Article 4.05C of the TLLCA contains similar language.
25
See generally Steinberg & Conway, The Limited
Liability Company as a Security, 19 Pepp. L. Rev. 1105 (1992).
26
Kling & Simon, supra note 4, at §2.06. See Texas Business Corporation Act ("TBCA") Art. 5.11 (rights of dissenting shareholders in the event of certain corporate transactions).
7 limited liability company statutes typically do not provide for appraisal rights.27
• Transfers Typically Require Partner or Member Consent.
In the context of a purchase and sale of one or more, but not all, partners' or members' interests in a partnership or limited liability company (as applicable), consideration needs to be given to the subject assignment and substitution provisions of the limited partnership/limited liability company statute or the subject partnership or company agreement. In general, under statutory law:
(i) A limited partnership or membership interest is freely assignable, but an assignee is only entitled to the profits, losses and distributions attributable to the interest so assigned; further, absent a substitution, the assignor continues to be a partner or member, retains all powers as a partner or member and continues to be responsible for all capital commitments attributable to its interest.28 (ii) An assignee has no liability as a partner or
member solely as a result of an assignment.29 (iii) An assignee may become a substituted
partner or member if, and to the extent, that the partnership agreement so provides or all partners consent.30
• Tax Considerations.
For purposes of this section, unless otherwise indicated, all references (i) to a "partnership" means either a limited partnership or a limited liability company and (ii) to a "partner" means a partner in a limited partnership or a member of a limited liability company.
27
Note, however, that §17-212 of DRULPA provides that "[a] partnership agreement or an agreement or merger or consolidation may provide that contractual appraisal rights with respect to a partnership interest or another interest in a limited partnership shall be available for any class or group of partners or partnership in connection with any amendment of a partnership agreement, any merger or consolidation in which the limited partnership is a constituent party to the merger or consolidation, any conversion of the limited partnership to another business form, any transfer to or domestication in any jurisdiction by the limited partnership, or the sale of all or substantially all of the limited partnership's assets."
28
TRLPA §7.02(a); TLLCA Art. 4.05A.
29
TRLPA §7.02(b); TLLCA Art. 4.05C.
30
TRLPA §4.01(a) (general partner) and TRLPA §7.04(a) (limited partner); TLLCA Art. 4.07A.
Character of Gain or Loss. The seller of a partnership interest generally will recognize capital gain or loss on the sale of its interest in an amount equal to the difference between the amount realized and the seller's basis in its partnership interest.31 The amount realized will be measured by the sum of any cash and the fair market value of any property received plus the amount by which the partner or member is relieved of liabilities of the entity.32 The seller must, however, recognize ordinary income upon a sale of its partnership interest to the extent of the seller's allocable share of the partnership's inventory items and unrealized receivables.33 Unrealized receivables include a partnership's potential recapture items, such as depreciation recapture.
Section 754 Election; Disregarded Entity. As previously noted, a cash purchaser of interests of a partnership or a limited liability company will retain the same basis in the entity's assets, whereas a purchaser of the entity's assets may "step up" its basis in the assets. There are, however, several considerations of import to note.
First, in the case of a transfer of a partnership interest, a partnership may make an election under Section 754 of the Internal Revenue Code of 1986, as amended, (the "Code") to adjust the inside basis34 of its assets to reflect the purchase price paid by an acquiring partner for a selling partner's interest.35 In this regard, the partnership will increase the inside adjusted basis of partnership property by the excess of the buyer's basis in its partnership interest over the seller's proportionate share of the partnership's inside adjusted basis in partnership property.36 The inside adjustment to basis will apply only as to the acquiring partner.37
31
I.R.C. § 741.
32
Upon the sale of all of a partner's interest in a partnership, the partner should be able to use certain suspended losses including passive activity losses and losses limited by the “at risk” limitations. I.R.C. §§ 465, 469.
33
I.R.C. §§ 741, 751.
34
"Inside basis" refers to the partnership's basis in its own assets, as opposed to a partner's basis in his own partnership interest (i.e., "outside basis").
35
I.R.C. § 743(a).
36
I.R.C. § 743(b)(1). Alternatively, the partnership will decrease the adjusted basis of partnership property by the excess of the transferee partner's proportionate share of the inside adjusted basis to the partnership of partnership property over the partner's basis in his partnership interest. I.R.C. § 743(b)(2). The amount of the basis adjustment made pursuant to an election under Section 754 is required to be allocated among partnership assets in a manner that has the effect of reducing the difference between the fair market value and the adjusted basis of those assets or in any other manner permitted by the Treasury regulations. I.R.C.
Mergers, Acquisitions and Conversions With Partnerships and LLCs Chapter 7
8 Second, a partnership will become a disregarded entity if one person becomes the sole owner of the equity interests as a result of the transaction. In such a case, the transaction will be treated as an asset purchase to the purchaser, but as a sale of partnership interests to the seller.38 This treatment allows the purchaser to receive a "step up" in basis in the partnership assets to the extent of the purchase price, even though the form of the transaction is a purchase of equity interests.39
Tax Allocations of Items of Income, Gain, Loss and Deduction. The tax consequences of the sale, purchase and exchange of partnership interests are discussed above. However, because a partnership is a flow-through entity for tax purposes, it is important to determine how items of income, gain, loss and deduction will be allocated in the year of the sale of a partnership interest or the year of termination of the partnership as a result of an acquisition.
If there is a sale, exchange or liquidation of a partner's entire interest in a partnership during a tax year, the taxable year of the partnership shall close with respect to that partner.40 Under the default rule, the partnership will have an interim closing of its books and the partnership's items of income, gain, loss and deduction will be allocated to the exiting partner as if the partnership terminated on the date of the sale, exchange or liquidation.41 This interim closing method is very precise, but it is also very burdensome and costly and frequently requires the services of an accountant. The partners may avoid an interim closing of the books if the affected parties agree to share the items of income, gain, loss and deduction by treating the selling partner as having a pro rata share of the partnership for the taxable year (i.e., the "proration method"). This proration may be based on either
§ 755(a). The basis adjustment is allocated (i) first, between capital assets and property described in Section 1231(b) and (ii) second, between any other property of the partnership. I.R.C. § 755(b). The portion of the basis adjustment allocated to each class of property is then allocated among the items within that class. Treas. Reg. § 1.755-1(a).
37
I.R.C. § 743(b).
38
Rev. Rul. 99-6, 1999-1 C.B. 432.
39
In the case of an existing equity owner purchasing all of the interests of the other owners, the purchaser will be treated as if it received a distribution from the partnership of its proportionate share of the partnership assets and then purchased the other partners' share of the assets. This distribution will generally result in a carryover basis in the assets to the extent of the purchaser's share of the assets and a “step up” in basis as to the remaining share of the assets. Rev. Rul. 99-6, 1999-1 C.B. 432.
40
I.R.C. § 706(c)(2)(A).
41
I.R.C. § 706(d)(1), Treas. Reg. § 1.706-1(c)(2)(ii).
(i) the portion of the partnership taxable year that elapses prior to the sale or liquidation, or (ii) any other reasonable method.42 The proration method is easier to administer than the interim closing method, but is not guaranteed to be accurate. The transferee of a partnership interest must use the same method as its transferor in computing its distributive share.
In addition, if there is a sale of more than one-half of the interests in the partnership, the partnership may terminate for federal income tax purposes, in which case it would have to file a final IRS Form 1065.43 A partnership generally terminates for tax purposes when there is a sale or exchange of 50% or more of the partnership interests within a 12-month period.44 If a partnership is terminated by a sale of a partnership interest, the following is deemed to occur: (i) the partnership contributes all of its assets and liabilities to a new partnership in exchange for interests in the new partnership; and (ii) the terminated partnership distributes interests in the new partnership to the purchasing partner and the other remaining partners in proportion to their respective interests in the terminated partnership in liquidation of the terminated partnership, either for the continuation of the business by the new partnership or for its dissolution and winding up.45
Disguised Sales. If a partner transfers property to a partnership, and the partnership transfers money or other consideration to the partner, the transfers constitute a sale of the property by the partner to the partnership if (1) the transfer of money or other consideration from the partnership would not have been made but for the transfer of the property by the partner, and (2) in cases where the transfers are not simultaneous, the transfer from the partnership is not
42
Treas. Reg. § 1.706-1(c)(2)(ii).
43
Treas. Reg. § 1.706-1(c)(1)(in the case of the termination of a partnership, the partnership taxable year closes for all partners); Treas. Reg. § 1.708-1(c)(2)(a merging partnership that terminates must file a final tax return for the taxable year ending on the date of the termination, i.e., the date of the merger).
44
The sale or exchange of 50% of the partnership interests means the sale or exchange of 50% or more of both the capital interests and the profits interest in the partnership. Thus, if there is a sale of a 30% interest in the partnership capital and a 60% interest in the partner profits, the partnership will not terminate for tax purposes. Treas. Reg. § 1.708-1(b)(2).
45
Treas. Reg. § 1.708-1(b)(4). The deemed contribution of assets to the new partnership and the distribution of the new partnership interests to the partners of the terminated partnership will be disregarded for purposes of maintaining capital accounts. Treas. Reg. § 1.704-1(b)(2)(iv)(l). The capital account of the transferee partner and the capital accounts of the other partners of the terminated partnership carry over to the new partnership.
9 dependent on the entrepreneurial risks of partnership operations.46 This rule is meant to prevent taxpayers from disguising sales of property as tax-free partnership contributions and distributions.
Recently, the Internal Revenue Service proposed to issue new regulations that would extend the disguised sale rules to the disguised sale of partnership interests.47 In general, when a partner receives a cash distribution in exchange for part of his partnership interest, he is allowed to recover the full amount of his basis before recognizing any gain on the distribution.48 However, when a partner sells part of his partnership interest, he may recover only a pro rata portion of his basis before recognizing gain.49 Thus the potential for deferral exists. If a partner desires to sell part of his partnership interest, rather than sell his interest directly to a buyer, the selling partner could instead allow the partnership to redeem his interest (thus taking advantage of full basis recovery), while the buyer simultaneously purchases the redeemed interest directly from the partnership. The proposed disguised sale of partnership interest regulations aim to curb this tactic by recharacterizing the redemption and contribution as a sale, thus causing the selling partner to recognize more gain.50 Practitioners should be aware of these proposed regulations when structuring related redemption and contribution transactions.
V. MERGERS INVOLVING PARTNERSHIPS OR LLCS—KEY POINTS
• Mechanics.
The mechanics for effecting a merger involving a partnership (general or limited) or a limited liability company are generally similar to those employed in a corporate context (i.e., adoption of a plan of merger by the parties, filing of a certificate of merger with the secretary of state, and the effects of the merger).51 Further, the TRLPA, TRPA and the TLLCA provide that a partnership (general or limited) or a limited
46 Treas. Reg. § 1.701-3(b)(1). 47 See Notice 2001-64, 2001-2 C.B. 316 (10/09/2001). 48 I.R.C. § 731. 49 Rev. Rul. 84-53, 1984-1 C.B. 159. 50
Other tax consequences of the recharacterization include: (1) If the partnership holds "hot assets," the sale will be treated under Code section 751(a), rather than 751(b); (2) The buyer will succeed to a portion of the seller's capital accounts and share of inside basis (including any book/tax disparities); (3) If a Code section 754 election is in place, then Code section 743 adjustments must be made; (4) Finally, the disguised sale could cause the partnership to terminate under Code section 708(b)(1)(B).
51
See TRLPA § 2.11, TRPA Art. 9.02 and TLLCA Art.'s 10.01-10.05.
liability company may merge with a corporation, partnership (general or limited), limited liability company or other entity, domestic or foreign.52
There are, however, certain key procedural considerations to take into account when a partnership is involved. In general, unlike the merger provisions governing corporations and limited liability companies, the partnership related provisions do not prescribe a "default" rule in respect of the requisite vote to approve a merger.53 Rather, the TRLPA and TRPA look to the subject partnership agreement to provide for the vote and manner in which the merger is to be approved by a partnership (general or limited).54 If the subject partnership agreement does not contain any such specific provisions, the required vote (and procedures) to amend the subject partnership agreement in effect become the required vote (and procedures) to approve the merger.55 In the limited liability company context, the TLLCA provides that if a domestic limited liability company is a party to the merger, a majority in number of the members must approve the merger, unless the regulations of that entity provide otherwise.56
52
See e.g., TLLCA Art. 10.01A which provides that a
domestic limited liability company may merge with "one or more domestic or foreign limited liability companies or other entities." "Other Entity" is defined as meaning "any entity, whether organized for profit or not, that is a corporation, limited partnership, general partnership, joint venture, joint stock company, cooperative, association, bank, insurance company or other legal entity organized under the laws of this state or any other state or country to the extent the laws or the constituent documents of that entity, not inconsistent with law, permit the entity to enter into [the merger]."
53
See e.g., TBCA Art. 5.03E. 54
TRLPA § 2.11(a)(1) provides that a domestic limited partnership may merge if (i) the partnership agreement contains provisions that authorize the merger and (ii) the limited partnership approves the merger in the manner prescribed in the partnership agreement. Article 9.02(a) of TRPA contains similar language.
55
Thus, if a partnership agreement provides that it takes the unanimous approval of all partners (or a significant percentage in ownership interest or number) to amend the partnership agreement, that becomes the requisite vote to amend the partnership agreement to provide for the merger.
56
TLLCA Art. 10.01A(1)(a). Note this default rule could lead to potentially unintended results if, for example, a limited liability company has five members, two of whom have an aggregate percentage ownership of 95% and the remaining three members have an aggregate of 5%. Under the default rule, if the two majority members want the limited liability company to merge, they cannot cause that to happen in the absence of the agreement of one more member.
Mergers, Acquisitions and Conversions With Partnerships and LLCs Chapter 7
10 • Liability Considerations.
Article 9.02(G)(9) of TRPA provides that a partner of a partnership that is a party to a merger does not become personally liable as a result of the merger for a liability or obligation of another person that is a party to the merger unless the partner consents to becoming personally liable in the plan of merger.57 The TRLPA contains a similar statement with respect to limited partners of a domestic limited partnership,58 as does the TLLCA with respect to members in a limited liability company context.59
Notwithstanding the foregoing, the liability issues are a bit more difficult to sort out when a general partnership is a party to a merger, given that the partners of that entity generally have joint and several liability for partnership obligations.60 In this instance, the TRPA provisions dealing with the liability of an incoming or withdrawing partner,61 plus principals of logic and fairness, are instructive. To illustrate:
Example 1
Assume that a Texas general partnership merges with a Texas corporation, with the Texas corporation as the surviving entity. As a result of the merger, the partnership's liabilities as of the effective date are vested in the corporation.
Question: are the general partners' liability for the partnership's obligations extinguished since the partnership no longer exists and the corporation has assumed liability?
Answer: No. The TRPA provides that a partner in a Texas general partnership that is a party to a merger but does not survive shall be treated as a partner who withdrew from the non-surviving partnership as of the effective date of the merger.62 Thus, the general partners remain personally liable for the partnership's debt in existence at effective date of the merger. They will not have any personal liability for the debts and obligations of the surviving corporation incurred after the effective date of the merger.
Example 2
Assume that a Texas limited liability company merges with a Texas limited partnership, with the Texas limited partnership as the surviving entity. As a
57 TRPA Art. 9.02(g)(9). 58 TRLPA § 2.11(A)(4). 59 TLLCA Art. 10.01(2). 60
See note 15, supra. 61
See notes 16 and 17, supra. 62
TRPA Art. 9.02(G)(9)(B).
result of the merger, the limited liability company's liabilities as of the effective date are vested in the limited partnership.
Question: does the general partner of the surviving limited partnership have personal liability for the pre-effective date liabilities of the limited liability company that vested in the limited partnership?
Answer: No. The TRPA provides that a partner who remains in or enters a Texas or foreign partnership that survives or is created by a merger shall be treated as an incoming partner in the new or surviving partnership as of the effective date of the merger.63 Thus, the general partner's liability for such liabilities is limited to its interest in the limited partnership. The general partner will have personal liability for all debts and obligations of the surviving limited partnership that arise after the effective date of the merger.
• Tax Considerations.
The Code provides that "[i]n the case of the merger or consolidation of two or more partnerships, the resulting partnership shall, for purposes of this section, be considered the continuation of any merging or consolidating partnership whose members own an interest of more than 50-percent in the capital and profits of the resulting partnership."64 If the resulting partnership can be considered a continuation of more than one of the merging partnerships, the resulting partnership is, unless the Commissioner permits otherwise, the continuation of the partnership that is credited with the contribution of the greatest fair market value (net of liabilities) to the resulting partnership.65 Any other partnership merged into the resulting partnership is terminated.66
Under the regulations, the tax years of the partnerships that are considered terminated in the merger are closed, and such partnerships are required to file their returns for the taxable year ending upon the date of termination (i.e., the date of the merger or consolidation).67 The resulting partnership in the merger is required to file a tax return for the tax year of the partnership that is considered to continue in the merger.68 The return must state that the resulting partnership is a continuation of such merging or consolidating partnership, shall retain the employer
63
TRPA Art. 9.02(G)(9)A).
64 I.R.C. § 708(b)(2)(A). 65 Treas. Reg. § 1.708-1(c)(1). 66 Treas. Reg. § 1.708-1(c)(1). 67 Treas. Reg. § 1.708-1(c)(2). 68 Id.
11 identification number ("EIN") of the partnership that is continuing, and shall include the names, addresses, and EINs of the other merged or consolidated partnerships.69 The respective distributive shares of the partners for the periods prior to and including the date of the merger or consolidation and subsequent to the date of merger or consolidation shall be shown as a part of the return.70
Under the regulations, the form of a partnership merger accomplished under applicable state law generally will be respected if the partnership undertakes the steps of one of two forms prescribed for federal income tax purposes in the regulations: the assets-over form or the assets-up form. Both forms are discussed below.
Assets-Over Form. The assets-over form is the default form for partnership mergers, so that if a transaction is effected without undertaking a form for the merger, or the transaction is not characterized under the assets-up form, it will be characterized under the assets-over form (regardless of whether that form is followed). Under the assets-over form, a terminating partnership contributes its assets and liabilities to the resulting partnership in exchange for interests in the resulting partnership and, immediately thereafter, the terminated partnership distributes interests in the resulting partnership to its partners in liquidation of the terminating partnership.71 The form of the merger for state law purposes does not override the mechanical rules of the Code dictating the continuing partnership for federal income tax purposes.72
Assets-Up Form. Under the assets-up form, the merged or consolidated partnership that is considered terminated distributes all of its assets to its partners (in a manner that causes the partners to be treated, under the laws of the applicable jurisdiction, as the owners of
69 Id. 70 Id. 71
Treas. Reg. § 1.708-1(c)(3)(i). See also Treas. Reg. §§ 1.704-4(c)(4) and 1.737-2(b); Treas. Reg. § 1.704-4(c)(4) ("Section 704(c)(1)(B) and this section do not apply to a transfer by a partnership (transferor partnership) of all of its assets and liabilities to a second partnership (transferee partnership) in an exchange described in section 721, followed by a distribution of the interest in the transferee partnership in liquidation of the transferor partnership as part of the same plan or arrangement."); Treas. Reg. § 1.737-2(b)(1)("Section 737 and this section do not apply to a transfer by a partnership (transferor partnership) of all of its assets and liabilities to a second partnership (transferee partnership) in an exchange described in section 721, followed by a distribution of the interest in the transferee partnership in liquidation of the transferor partnership as part of the same plan or arrangement.").
72
Treas. Reg. § 1.708-1(c)(5)(ex. 2).
such assets) in liquidation of the partners' interests in the terminated partnership, and immediately thereafter, the partners in the terminated partnership contribute the distributed assets to the resulting partnership in exchange for interests in the resulting partnership.73 The regulations provide that the form of this merger or consolidation will be respected "[d]espite the partners' transitory ownership of the terminated partnership's assets."74
However, while the regulations provide that the assets-up form will be respected in accomplishing partnership mergers, the Preamble to the final regulations states that the IRS and Treasury do not intend to establish a regime whereby partners essentially can elect between the assets-up form and the assets-over form by creating different documents that have the same legal effect. The Preamble indicates that if the assets-up form is to be respected, a partnership must actually undertake the steps that are necessary, under the laws of the applicable jurisdiction, to convey ownership of the assets that are distributed to the partners.75
Partner Buy-Out Rule. The regulations contain a special buy-out rule to address the situation where one partner would prefer to be cashed out in an assets-over form of merger rather than becoming a partner in the resulting partnership.76 This rule provides that a sale of all or part of a partner's interest in the terminated partnership to the resulting partnership as part of an asset-over form of merger or consolidation will be respected as a sale of a partnership interest if (1) the merger agreement (or another document) specifies that the resulting partnership is purchasing interests from a particular partner in the merging or consolidating partnership and the consideration that is transferred for each interest sold; and (2) the selling partner in the terminated partnership, either prior to or contemporaneous with the transaction, consents to treat the transaction as a sale of the partnership interest.77 Note that the regulations require the selling partner in the terminated partnership to provide the requisite consent prior to or contemporaneous with the transaction.
73
Treas. Reg. § 1.708-1(c)(3)(ii). The Preamble to the proposed regulations cautions that under the assets-up form, partners could recognize gain under sections 704(c)(1)(B) and 737 when the terminating partnership distributes the assets to the partners. Partnership Merger Regs. Notice, 2000-2 C.B. at 460. 74 Id. 75 Preamble, T.D. 8925, 2000-1 C.B. at 497. 76 Treas. Reg. § 1.708-1(c)(4). 77 Id.
Mergers, Acquisitions and Conversions With Partnerships and LLCs Chapter 7
12 VI. CONVERSIONS
• Overview.
The TRPA, TRLPA and TLLCA all contain provisions that permit a partnership (general and limited) and a limited liability company to convert into another form of entity.78
• Typical Circumstances Giving Rise to a Conversion.
A conversion from one form of entity typically arises in the circumstances below:
(i) The owners desire limited liability [e.g., general partnership (owners are personally liable) converts into a limited liability company or corporation (owners have limited liability); a limited partnership (general partner is personally liable) converts into a limited liability company or corporation]. (ii) The owners desire to avoid "double taxation"
[e.g., a corporation (both the corporation and its owners are subject to tax) converts into a limited liability company or limited partnership and elects to be taxed as a partnership for U.S. federal income tax purposes].
(iii) The owners desire to mitigate potential Texas franchise taxation (e.g., a corporation or limited liability company, each of which is subject to Texas franchise tax, converts into a limited partnership, which is not currently subject to Texas franchise tax).
• Steps to Effect a Conversion.
There are three basic steps to effect a conversion: (i) First, the converting entity adopts a plan of
conversion in accordance with the applicable statute;79
(ii) Second, upon approval of the plan of conversion, articles of conversion are executed by an authorized representative of the converting entity and filed with the Texas secretary of state;80 and
(iii) Three, the Texas secretary of state issues the certificate of conversion.81
78
TRPA Art. 9.01; TRLPA § 2.15; TLLCA Art. 10.08.
79
TRPA Art. 9.05(a); TRLPA § 2.15(a); TLLCA Art. 10.08(a).
80
TRPA Art. 9,05(e); TRLPA § 2.15(e); TLLCA Art. 10.09A.
81
TRPA Art. 9.05(f); TRLPA § 2.15(f); TLLCA Art. 10.10A.
The mechanics to approve a conversion are similar to those in the merger context. In the partnership context, the conversion must be approved in accordance with the terms of the partnership agreement.82 In the limited liability company context, the conversion must be approved by a majority in number of the members, unless otherwise provided in the regulations.83
Note that the conversion provisions include a condition to conversion similar to that contained in the merger statutes, namely that no owner of a converting entity will, as a result of the conversion, become personally liable for the liabilities and obligations of the converted entity without such owner's consent.84
• Effects of a Conversion.
The effects of an entity that is converting (prior to the conversion, the "converting entity," and after the conversion, the "converted entity") are as follows:
(i) The converting entity continues to exist but in a new organizational form.85
(ii) All property of the converting entity continues to be owned by the converted entity without any other action, but remains subject to any existing lien or encumbrance.86 (iii) All liabilities of the converting entity
continue to be liabilities of the converted entity.87
(iv) All rights of creditors with respect to the prior owners of the converting entity, in their capacities as such, that are in existence at the time of the conversion will continue in existence as to those liabilities as if the conversion did not occur.88
(v) Proceedings pending by or against the converting entity or their owners, in their capacities as such, continue by or against the
82
TRPA Art.'s 9.02 and 9.05(a)(1); TRLPA §§ 2.11 and 2.15(a)(1).
83
TLLCA Art.'s 10.01 and 10.08(a)(1).
84
TRPA Art.'s 9.02 and 9.05(a)1); TRLPA §§ 2.11 and 2.15(a)(1); TLLCA Art. 10.11A.(1).
85
TRPA Art. 9.05(h)(1);TRLPA § 2.15(g)(1); TLLCA Art. 10.11A(1).
86
TRPA Art. 9.05(h(2); TRLPA § 2.15(g)(2); TLLCA Art. 10.11A(2).
87
TRPA Art. 9.05(h)(3);TRLPA§ 2.15(g)(3);TLLCA Art. 10.11A(3).
88
TRPA Art. 9.05(h)(4);TRLPA § 2.15(g)(4);TLLCA Art. 10.11A(4).
13 converted entity or such owners without the need to substitute parties.89
(vi) The ownership interests in the converting entity are converted into ownership interests in the converted entity, as provided in the plan of conversion.90
(vii) If, after the conversion, an owner of the converting entity would be liable under applicable law for the obligations of the converted entity, such owner will be liable for all pre-conversion obligations only to the extent that such owner (i) agrees in writing to be liable, (ii) was liable under applicable law, prior to such conversion, for such obligations, or (iii) by becoming an owner of the converted entity, becomes liable under applicable law for such obligations.91
• Federal Tax Consequences of Conversion. In general, the conversion of an entity for state law purposes (e.g., from corporation to partnership, and vice versa) is treated for Federal tax purposes as a constructive liquidation of the converting entity and the formation of the converted entity. As a result of the deemed liquidation, both the converting entity and its owners may be required to recognize gain or loss. However, the "Check-the-Box" regulations give taxpayers the flexibility to by-pass this harsh result.92
General Partnership to Limited Partnership. If a general partnership converts to a limited partnership, assuming the limited partnership does not check the box and elect to be taxed as a corporation, at the entity level, no Federal tax consequences will result from the conversion, for a general partnership and a limited partnership are both subject to the same taxation rules under Subchapter K of the Internal Revenue Code.93 The same is generally true if a general partnership or limited partnership converts to a limited liability company, and vice versa, provided the converting entity was taxed as a partnership and the converted entity continues to be taxed as a partnership.94
However, at the partner level, gain may result from the conversion of a general partnership interest to a limited partnership interest as a result of a
89
TRPA Art. 9.05(h)(5);TRLPA § 2.15(g)(5); TLLCA Art. 10.11A(5).
90
TRPA Art. 9.05(h)(6); TRLPA § 2.15(g)(6);TLLCA Art. 10.11A(6).
91
TRPA Art. 9.05(h)(7);TRLPA § 2.15(g)(7); TLLCA Art. 10.11A(7).
92
See Treas. Reg. § 301.7701-3. 93
See Rev. Rul. 84-52, 1984-1 C.B. 157. 94
See Rev. Rul. 95-37, 1995-17 I.R.B. 10.
constructive distribution of cash arising from liability relief under Code section 752(b). In general, only general partners, and not limited partners, share in partnership recourse liabilities.95 Therefore, if a general partnership has recourse liabilities, and a general partner's interest is converted to a limited partner interest, the converted partner may be deemed to receive a constructive cash distribution equal to the amount of his liability relief, which may result in gain recognition.96
Corporation to General Partnership or Limited Partnership or Limited Liability Company. If a corporation converts to any form of partnership or limited liability company (which, by default, is taxable as a partnership97), the conversion is treated as a deemed liquidation of the corporation and a contribution of the corporation's assets to a newly-formed partnership (or limited liability company).98 As a result, all of the regular tax consequences associated with the liquidation of a corporation and formation of a partnership will be deemed to occur:99 The corporation must recognize built-in gain on the assets deemed distributed in the liquidation, including its goodwill.100 In addition, the corporation's shareholders must recognize gain to the extent the value of the distributed property exceeds their bases in their stock.101 In general, no gain or loss will be recognized on the deemed contribution of the corporation's assets to the new partnership.102
However, the parties to the conversion can avoid the deemed liquidation result simply by causing the converted entity (the partnership or limited liability company) to make an election to continue to be taxed as a C corporation.103
Example Summary Of Conversion Of General Partnership To Limited Partnership
Assume
• A Texas general partnership is owned by four partners in equal shares (25%); each partner has equal rights to manage the partnership
95
Treas. Reg. § 1.752-2(a).
96
See I.R.C. §§ 752(b) and 731(a). 97
Treas. Reg. § 301.7701-3(b).
98
Treas. Reg. § 301.7701-3(g)(1)(ii).
99
Treas. Reg. § 301.7701-3(g)(2)(i).
100 I.R.C. § 336(a). 101 I.R.C. § 331(a). 102 I.R.C. § 721(a). 103
