How to Avoid a Bad Partnership Agreement
The next and final installment of accounting horrors is a bone-chilling tale about business clients whose handshake agreement frighteningly doesn’t reflect what’s in their legally binding documents.
As accountants, it’s sometimes tough to get those really small, really fast-moving entrepreneurs to give us copies of their documents. But what happens when the document they signed doesn’t reflect the handshake understanding they had?
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Two successful real estate investors and businessmen — we’ll call them “Big Joe” and “Little Al” — had several business ventures in common. We began working with them just after they put several pieces of real estate into a partnership that we’ll call “Metro Properties.” They had tenants in several of the buildings, while other properties were high-end shopping centers.
Big Joe’s property made up about 60 percent of the total fair market value to Little Al’s 40 percent. Dutifully, their CPA CFO, who oversaw all of their complex business ventures, gave us the signed partnership agreement. The agreement, which looked a whole lot like a boilerplate template someone had downloaded from the web, clearly stated that income and losses were to be divvied up according to capital balances.
All of our dealings with Big Joe and Little Al were through their CFO, who also handled all of Big Joe’s personal finances. I never met either of them in person, and I never spoke with Little Al.
It was a chaotic time in their businesses.
One of their entities was going through an expensive and ugly buyout with a former partner, who had also absconded with stock certificates owned by the business. Torrential rains collapsed the roof of one of the shopping centers. The CFO had just come on board and discovered that their prior accountant had made a serious mess of their books. A building at one of the shopping centers that had been demolished two years earlier was still on the books and still being depreciated.
Despite this, Big Joe and Little Al’s multiple businesses thrived. Metro Properties was throwing off lots of cash, so the partners were taking healthy distributions, split 50:50. The cash distributions were pretty close to the cash basis net income from all the properties. This meant Big Joe’s capital was being increased each year by 60 percent of the net income and decreased by about 50 percent, while Little Al’s capital was increasing by 40 percent and decreasing by 50 percent.
You can see where this is heading.
Because of the complexity of their business affairs, those returns for their multiple companies were almost always among the last ones we completed. It was generally a race to get everything done and get the efile documents signed by the deadlines.
Several years passed, and we developed a routine for getting the work done. Then, Little Al decided he wanted to completely retire and cash in all of his business interests. The partners and their CFO — who was a great CFO— made plans to sell most of Metro Partners’ real estate to an REIT. Big Joe would take back a couple of the small properties he’d contributed. Metro Partners would dissolve.
We started making estimates of the capital gains and tax liabilities each would have. The CFO was baffled at the disparity. For the first time, she started looking at the income distributions on the K-1s. “Why is Big Joe getting so much more income than Little Al?” she asked.
We directed her to the partnership agreement she’d sent us. She and Big Joe looked at it in detail for the first time and realized it didn’t reflect the agreement the two partners had made when they began Metro Partners.
Even though the fair market value of the real estate they contributed was in a 60:40 ratio, their handshake agreement was to split income and losses 50:50. Worse still, it seemed that neither of them had actually read the agreement before they signed it. And because all of our interactions were through the CFO, we’d never had a meeting with them to discuss their companies. We also assumed that since both men were successful and prominent businessmen, they had full knowledge of their affairs.
Here are a few of the lessons learned:
Besides making sure you have all of the relevant operating agreements, it’s a good idea with new businesses to verify that those documents reflect their understanding. Even when you’re working with a great CFO, it’s not a bad idea to meet the actual business owners in person to make sure you understand all of their operations and to review the results of their companies and their long-term goals.
Liz Farr, CPA, spent 15 years in tax and accounting at small firms in Albuquerque, NM. Besides tax returns of all flavors, she worked on audits of governmental entities and not-for-profits, business valuations, and litigation support. Now she's a full-time freelance writer specializing in content marketing for accountants and bookkeepers around...