One of the primary advantages of a partnership (or limited liability company) over a corporation is the flexibility to structure the business deal. Rather than having to deal with unwieldy units of stock or other ownership interests, a partnership agreement permits the economics to be as subtle or complex as can be drafted, and it is done by contract rather than statutorily required and publicly available amendments to articles of incorporation. With that freedom comes the obligation to spell out the real intent and to minimize confusion by using correct terminology. The characterization of economics should be carefully considered and drafted in a partnership agreement.
Funding to a partnership can take the form of capital contributions, debt or fees/other income. The first two are generally without tax effect and are therefore preferable. To forestall any doubt, funding should be characterized specifically to avoid confusion with other types of funding. Often a variation of the terms “pay” or “payment” are used in contribution provisions; while generally understood correctly in the context of the provisions, better clarity does no harm. Likewise, “loan” and “lend” should be used where the funding is to be characterized as debt; it is customary to expressly state that any loans from partners or their affiliates are not in fact contributions. “Pay” and “paid” should be reserved for income-producing receipts where possible. Amazingly, it is not uncommon for contribution provisions to be ambiguous regarding the legal obligation of partners to make contributions. For example, the provision will say that partners “shall” make contributions, even if a later and/or separate provision provides (or suggests) that there is in fact no legal obligation, or states that dilution is the sole remedy. If contributions are not mandatory, then the language should be clear that partners “may, but shall not be obligated to, make” requested (not “required”) contributions.
There are a variety of consequences that can be included and invoked when a partner fails to make a capital contribution. A common consequence is a pro rata dilution of partnership interests based on current fair market value of the existing assets and the new contributions, with a common variation of this being based upon relative capital contributions (including historical contributions) in lieu of requiring a current valuation of the partnership assets to more accurately ascertain the relative economic rights of the partners. Many partnership agreements contain both alternatives as options; however, giving the governing party the ability to pick which method to apply each time could lead to claims of arbitrariness, so the flexibility may not be as substantive as intended. Some agreements provide for “penalty” dilutions or other formulaic adjustments of percentages. So long as such adjustments are on a going forward basis, there is minimal tax impact. However, if not carefully drafted such provisions can constitute (expressly or implicitly) shifts of capital accounts, which may constitute an unintended tax event. The allocation provisions of a partnership agreement should therefore contain some type of “savings” language based upon shifts in percentage interests arising from failure to fund capital contributions.
More detrimental consequences include forfeiture of a portion of a partner’s interest, a forced purchase of the interest at a discount, and “freezing” the interest so that there are no contributions, distributions or allocations, but the interest is not liquidated until the partnership winds up. These are typically reserved for failure to make mandatory contributions. A concern with any type of such “hammer” is whether the application creates taxable income to one or more partners; it typically should not be a taxable event, but only careful drafting can minimize this risk.
A common remedy for failure of a partner to fund a capital call is a loan by another partner, but there are variations on this that can create issues. The easy but erroneous way to draft a loan remedy is to provide for a loan to the partnership to the extent that a partner failed to fund a capital call. This looks beneficial to the partner who funded the amount (by giving its return priority over distributions), but it can also violate existing loan covenants and also skew the distribution provisions by giving (often unintendedly) part of a tranche of funding priority over the other part. The better courses of action are either (i) a deemed loan to the non-funding partner, repaid from distributions to that partner (effectively a non-recourse loan for which the lending partner retains risk that distributions to such non-funding partner will be sufficient to repay the loan, plus any interest, or (ii) convert the entire tranche of funding to a loan, or to a special preferential distribution, with all partners funding that tranche treated equally.
Some partnership agreements give the general partner reasonable discretion regarding future funding requirements, whether by calling capital, requesting loans and/or admitting new partners (sometimes on preferential terms); in each case, existing partners should have the right to participate. However, partners often do not want to contemplate unbudgeted and/or unanticipated needs for funding, or believe they will have better negotiating leverage at a future date, and so leave partnership agreements silent on the matter, often based on the assumption that determining the terms of future funding can be better accomplished when and if actually necessary. The question is whether not addressing the issue at the beginning really saves time and money. Not including some provision for future funding can require amending the partnership agreement at a later time when relationships may not be as good as when the partnership is formed and/or when a need for funding is urgent and therefore time is in short supply; amendments require drafting, negotiation and sometimes third party consent. It is worth remembering that including provisions at the beginning does not prevent future negotiation regarding a different form of funding.