Bill Klein comments on Kovacik's application to cases where there are both operating and capital losses

My friend, colleague, and coauthor Bill Klein comments on the partnership law issues I discussed the other day:

It seems to me necessary to state your facts more clearly to avoid the distinction between capital losses and operating losses, which to my mind only confuses matters.

Suppose Abel contributes $20,000 to the initial partnership checking account. During a year of operations expenses exceed revenue by $30,000. The initial $20,000 was used to reduce the remaining amount owed for expenses to $10,000. Baker does not take a salary.

In this situation, which the Kovocik opinion does not explicitly address, is Abel required to pay the entire $10,000—for which, presumably, both partners are liable (jointly and severally)?

I would suppose not, and if Abel in fact pays the entire $10,000, Baker owes him $5,000. That seems fair enough.

These facts, and those in Kovacik, suggest the need for agreement at the time of formation of the partnership. Lots of luck with that, but to my mind the problem is largely attributable to the failure to pay a salary to Baker for his services or at least to accrue a salary. If, for example, the parties had agreed that Baker was entitled to a salary of $20,000, and if that amount had been owed rather than paid to him, then on my facts that amount would have been part of the expenses (but let’s leave the total the same); Baker would, on liquidation, be entitled to $20,000 as a creditor (maybe subordinated?); Able and Baker are on the hook for a total of $30,000 including $20,000 owed to Baker and $10,000 owed to others; Baker can treat his accrued salary as a capital contribution so Able and Baker are even on that score; each has lost the $20,000 capital contribution and each must contribute $5,000 to pay off the other creditors. That might be more of a burden on Baker than the parties might have wanted at the outset, so a simpler approach might be simply to provide at the outset that Baker would not be liable for any additional contributions to the partnership during its operation or on liquidation.

This suggests that there is another problem that “should” be addressed at the formation stage—namely, the need for additional capital during operation. Again, lots of luck with that, at least with a small operation.