Legal News and Articles

The Pennsylvania Construction Workplace Misclassification Act

February 6, 2012

Thomas J. Barnes, Esquire

1.         Introduction.

There would appear to be a growing trend toward government classification of construction workers as “employees”, even in cases where the general contractor or subcontractor paying for the work and the people performing the labor actually think otherwise. For a building contractor, the unintended result could be the imposition of significant additional cost when the state decides the workers are entitled to workers’ compensation, and the “employer” is obligated to buy workers’ compensation insurance or pay a substantial fine.

In February, 2011, Pennsylvania enacted the Pennsylvania Construction Workplace Misclassification Act.  This statute appears designed to enlarge the number of workers covered by both workers’ compensation and unemployment compensation.  It applies to all projects in Pennsylvania, whether privately or publicly funded.  This article is intended to provide a brief overview of the Act’s requirements as they apply to building and construction contractors.  Of course, we do not intend to provide specific legal advice for anyone here, and the reader is encouraged to consult counsel.

2.         What is an “Employee”?

The Pennsylvania Workers’ Compensation Act requires all Pennsylvania employers to insure their workers’ compensation liability.[1]  Most employers do so with insurance coverage.  A few large concerns are self-insured, and the rest use the State Workers’ Insurance Fund.  Problems arise when employers try to avoid this requirement by attempting to classify personnel as “independent contractors” when they are really employees.

For most employers operating with Pennsylvania employees, some kind of coverage is mandatory. There are some exceptions in the Workers’ Compensation Act, such as for home and domestic workers.[2]

An “employe” (the Workers’ Compensation Act’s antiquated spelling) is a “servant”, and that term includes all natural persons who perform services for another for a valuable consideration.  It does not include people “whose employment is casual in character and not in the regular course of the business of the employer….”[3]

Independent contractors are not employees. The Workers’ Compensation Act does not contain a specific definition for an independent contractor, although it does define the term “contractor”.  A “contractor”, for purposes of the Workers’ Compensation Act, is any “employer who permits the entry upon premises occupied by him or under his control of a laborer or an assistant hired by an employe or contractor, for the performance upon such premises of a part of such employer’s regular business entrusted to that employe or contractor”.[4]  It does not include “a contractor engaged in an independent business … in which he serves persons other than the employer in whose service the injury occurs, but shall include a subcontractor to whom a principal contractor has sublet any part of the work which such principal contractor has undertaken.”[5]

3.         How is an “Employee” Different From an “Independent Contractor”?

Over time, the appellate courts have developed a method for analyzing when a worker is an employee or an independent contractor.  Most of these cases have decided workers’ compensation claims, so the courts have used the Workers’ Compensation Act’s definitions as a starting point.  The analysis is fact-specific and the results have not always been consistent.

The Workers’ Compensation Act does not specifically say that independent contractors are not required to be covered.  Instead, the Pennsylvania courts have developed and refined the concept over the years.  “Any employer who permits the entry upon premises occupied by him or under his control of a laborer or an assistant hired by an employe or contractor, for the performance upon such premises of a part of such employer’s regular business entrusted to that employe or contractor, shall be liable for the payment of compensation to such laborer or assistant unless such hiring employe or contractor, if primarily liable for the payment of such compensation, has secured the payment thereof as provided for in this act.”[6]

Courts in Pennsylvania examine the following factors in determining whether an employment relationship exists:

1. Control of the manner in which work is to be done;
2. Responsibility for the result, only;
3. The terms of the agreement between the parties;
4. The nature of the work or occupation;
5. The skill required for performance;
6. Whether one employed is engaged in a distinct occupation or business;
7. Which party supplies the tools;
8. Whether payment is by the time or by the job;
9. Whether work is part of the regular business of the employer, and also
10. The right to terminate the employment at any time.[7]

The most important factor is the first one: whether the alleged employer had the right to control the work to be done or the manner in which it is to be performed, regardless of whether that right is actually exercised. Universal Am-Cam, Ltd. v. WCAB (Minteer), 762 A.2d 328 (Pa. 2000).In an employment relationship, the employer controls the way work is performed, while in the independent contractor relationship, the person engaged in doing the work controls the manner in which the result is obtained. Feller v.New Amsterdam Casualty Co., 363 Pa. 483, 70 A.2d 299 (1950).

“[C]ontrol of the result only and not of the means of accomplishment” does not transform an independent contractor relationship into an employer-employee relationship.  C E Credits OnLine v. Unemployment Comp. Bd. of Review, 946 A.2d 1162, 1169 (Pa. Commw. Ct. 2008).

4.         The Impact of the Construction Workplace Misclassification Act.

The new Construction Workplace Misclassification Act applies to “construction”, which is the “[e]rection, reconstruction, demolition, alteration, modification, custom fabrication, building, assembling, site preparation and repair work done on any real property or premises under contract, whether or not the work is for a public body and paid for from public funds.”[8]  It borrows the definition of “employee” (the legislature uses the modern spelling of the word now) from the Workers’ Compensation Act and the Unemployment Compensation Law.[9]

This new Act defines “independent contractor”.  A construction worker is an independent contractor only if he is paid for the work, there is a written contract to perform the work, the worker is free from control or direction over the performance of the services both under the contract of service and “in fact” and, as to that work, the worker is customarily engaged in an “independently established trade, occupation, profession or business”.[10]

An individual is “customarily engaged in an independently established trade, occupation, profession or business” in the commercial or residential building construction industry only if each one of the following criteria is satisfied:[11]

(1) The individual possesses the essential tools, equipment and other assets necessary to perform the services in dependent of the person for whom the services are performed.

(2) The individual’s arrangement with the person for whom the services are performed is such that the individual shall realize a profit or suffer a loss as a result of performing the services.

(3) The individual performs the services through a business in which the individual has a proprietary interest.

(4) The individual maintains a business location that is separate from the location of the person for whom the services arebeing performed.

(5) The individual:(i) previously performed the same or similar services for another person in accordance with paragraphs (1), (2), (3) and (4) while free from direction or control over performance of the services, both under the contract of service and in fact; or(ii) holds himself out to other persons as available and able, and in fact is available and able, to perform the same or similar services in accordance with paragraphs (1), (2), (3) and (4) while free from direction or control over performance of the services.

(6) The individual maintains liability insurance during the term of this contract of at least $50,000.

The fact that taxes are not withheld is irrelevant[12].

These requirements raise the bar to independent contractor status quite a ways, so anyone who before was in between employee and independent contractor will now almost certainly fall into the employee category.

5.         The Consequences of Failing to Comply with the Construction Workplace Misclassification Act.

An employer who fails to properly classify an employee as such violates the Act.[13]  There is an array of powers granted to the Secretary of Labor and Industry to enforce it, ranging from investigations to money fines and referral to the State Attorney General for possible criminal prosecution[14].  There is some relief for the contractor for whom the services were performed: if they believed in good faith that the individual who performed the services qualified as an independent contractor at the time the services were performed, they will be excused.  However, proof of “good faith” is not an easy requirement to meet.  A proceeding before an administrative agency, as many business owners know, can be an expensive and time consuming process.

Criminal sanctions are triggered when the violation is intentional.  A careless or negligent violation is punishable as summary offense, meaning a fine of up to $1,000[15].  Evidence of a first offense, however, can be used in connection with later offenses as proof of actual intent to violate the statute[16].

If the first offense is intentional and not negligent, it is a misdemeanor of the third degree.  Third degree misdemeanors are punishable by a term of imprisonment of up to one year[17].  A second or subsequent offense is classified as misdemeanor of the second degree.  Conviction carries a punishment of imprisonment of up to two years[18].

6.         Some Examples, by Industry.

Sales: documents and tax returns indicated that a worker changed from employee to independent contractor prior to his death.  The documents provided that worker was free to engage in business with other companies.[19]

Construction:  A “mason tender” who was injured while cleaning a cement machine which was used to mix mortar was not an independent contractor, but, rather, was an employee, because the contractor instructed the “mason tender” about how to clean the mixer at end of the workday, and the contractor supplied most of the tools.[20]

Construction:  A sign painter was determined to be an independent contractor and not an employee, for several reasons.  He did not specify an hourly charge for his labor, nor were his charges consistent with an hourly rate.  There was no agreement between the parties that the sign painter was to be the business owner’s handyman; there was no specific agreement as to the rate sign painter would receive for fixing the roof; the business owner did not have the right to control where the roof repair would be done by sign painter; the sign painter’s tax return for the year in which the accident occurred indicated that he was self-employed, the sign painter provided and used his own tools; and the business owner did not carry the sign painter on his payroll, deduct withholding tax, or pay social security benefits on the sign painter’s behalf.[21]

Construction:  A stone installer was engaged by a contractor to install stone as a small portion of the remodeling work being performed by several contractors.  The installer was paid by the job rather than by the hour, he used his own equipment, tools and vehicle, he paid and supervised his own workers on the job and the installation of the stone was a specialized job which very few men could perform.  Therefore, he was an “independent contractor” and not an “employee” of the contractors, who were not liable for injuries suffered when an automobile driven by a third party collided with the installer’s truck as installer was attempting to execute left turn into driveway of a home undergoing remodeling.[22]

Trucking and transporation:  A newspaper carrier was an “independent contractor” rather than an “employee” of the newspaper, and thus was not entitled to workmen’s compensation benefits for injuries sustained when hit by car while delivering papers.  The newspaper did not exercise sufficient control over the carrier’s work and the manner in which it was performed to create an employment relationship.  The newspaper did not prohibit the carrier from carrying a competing newspaper or to require the carrier to provide it with notice or get prior approval when he wished to substitute another person to deliver the papers.[23]  

Trucking and transporation:  The claimant was determined to be an independent contractor because he entered into a lease agreement in which he agreed to provide trucking services to the employer, but the employer did not direct claimant to use any particular route but, rather, advised the claimant of where the load was to be picked up and delivered.  Also, the claimant’s compensation was based on the load, and the claimant paid for the insurance.[24]

  7.       Conclusion: Be Careful.

Contractors in Pennsylvania are well advised to carry worker’s compensation insurance for everyone working for them.  The relationship with someone who is an independent contractor should be examined carefully, and the particulars of the relationship are often best put in writing, when the cost of such a contract makes sense in light of both its benefits, and of the substantial penalties for failing to comply with the Pennsylvania Construction Workplace Misclassification Act.

For further information, contact Tom Barnes or Jim Egbert at (215) 886-6600.

Usually, the primary reason for forming an S-corporation or an LLC is to protect the assets of the owners from liability exposure.  It is also important to pay attention to the tax needs of the owners, in anticipation of the day when they may wish to sell the business, or just a certain percentage of ownership, or some of the business’ assets.

The reader is asked to bear in mind that the legal principles cited in this article are not a complete exposition of the principles of limited liability company, corporate or tax law, and so may not apply to an individual’s particular situation.  This article is not intended as legal advice for anyone, and is simply intended as an illustration of certain aspects of the law.

Corporations, LLCs, limited partnerships and the other types of entities that can be created under Pennsylvania law, and in most states, all provide this essential protection from liability.   S-corporations have more non-tax related limitations than do LLCs.  For example, S-corporations are limited in the type and number of shareholders.  Classes of stock in a sub-S must be identical except for voting rights, and distributions of profit must be in proportion to each stockholder’s percentage share of ownership.

Most small businesses are organized as S-corporations, LLCs or limited partnerships because they all permit “pass through” taxation, meaning the net income or loss drops directly to the owner or owner’s tax returns.  No tax is paid at the corporate level, so the owners are only taxed once.  C-corporations, of course, are subject to double taxation: corporate income tax and then tax on dividends at ordinary rates.  S-corporations, LLCs, limited partnerships and the other variants of these entity types all allow the owners to elect to be taxed as a partnership, giving them the benefits of pass-through taxation.

LLCs, limited partnerships and even general partnerships (which do not protect the partners from individual liability) are automatically taxed as partnerships for federal and state income tax purposes.  Corporations, on the other hand, are presumed to be C-corporations when formed, unless the corporation makes an election at the federal level to be taxed as an S-corporation.  In this brief and limited discussion of pass through taxation, we will assume we are dealing with either an S-corporation or an LLC.

With both the LLC and the S-corporation, for tax purposes, income is passed through to the owners.  Losses are passed through also, subject to certain restrictions such as limitations on passive investment activity.  In addition, distributions of appreciated assets from an S-corporation are taxable events.

One significant limitation of an S-corporation compared to an LLC or partnership is that there is no method of equalizing the “inside” basis of an asset contributed by an owner to the entity with the “outside” basis.  The “inside basis” is the tax basis of the asset on the books of the entity.  The “outside basis” is the tax basis in the hands of the owner.  This difference can be an issue when there is a sale of all or part of the S-corporation’s stock or a membership interest.

In such a situation, the buyer of stock or a membership interest in an LLC will have a different tax basis than that of the entity, unless the entity is taxed as a disregarded entity, or as a partnership and a Section 754 election is made.  “Inside” basis can be adjusted to “outside” basis with a Section 754 election.   For example, if an LLC has as its only asset real estate with a basis of $100,000 and a fair market value of $5 million, a buyer of half the membership interest for $2.5 million would have a basis of that amount in the membership interest.  The LLC, on the other hand, would retain the $100,000 basis.

The buyer of the LLC membership interest can make an election under section 754 of the Code and equalize the inside and outside basis.  Section 754 applies only to entities taxed as partnerships, such as LLCs, and not to C- or S-corporations.  It applies only upon the transfer of an interest in a partnership by sale or exchange, or upon the death of a partner, and it applies only to the buying partner.  The result is that the basis on the LLC’s books is increased to reflect the new owner’s basis.

Generally, no taxable event occurs upon formation.  At formation, the owners’ basis in the entity’s stock or in the LLC membership Interest is equal to the basis of the assets contributed when they were in the hands of the LLC owners.  There may be some adjustment for any gain recognized upon contribution.   After contribution, the entity’s basis in the assets is the contributing owners’ basis, adjusted for any gain recognized upon contribution.

During the course of entity operations, income and gains are passed through to each member or shareholder.  If there is income or gain, each owner’s basis in the stock or LLC Membership Interest is increased.   If there are losses, they are passed through to the owners.   Each dollar of loss reduces the basis in the stock or membership interest and is deductible to the extent permissible.

When the S-corporation or LLC distributes cash or other assets to the owners, there is a dollar-for-dollar reduction in basis in the stock of an S-corporation or LLC membership Interest.   This will cause the individual shareholder or membership interest holder’s basis to fluctuate.

Thomas J. Barnes, Esquire

Often real estate investors will ask their lender for a loan large enough to finance both the purchase of a property they intend to buy now, and also to finance the purchase of one or more properties in the future.  The loan might take the form of a line of credit.  The mortgage states that property X is covered, and the mortgage is filed in the county where property X is located.  The mortgage might also state that it covers any properties the borrower acquires in the future with the loan proceeds (the “after-acquired property clause”).  There is no trouble at this point.  The mortgage is completely effective against the collateral and there is no barrier to foreclosure if the loan becomes troubled.

It is important to be aware of the situation when the borrower buys another property using the loan proceeds, and no one files any documentation in the land records, either in the original county where property X is located or where new property is located.  The lender is still on solid ground, because the original mortgage is effective against the borrower and the new property (property Y).  This is so even if property Y is located in a different county, or even in a different state.  If the loan becomes troubled, the lender can take back both property X and property Y.

An issue may occur when the borrower conveys an interest in property Y to someone else.  If the borrower sells it outright, the lender will lose any mortgage interest it had in property Y.  The new purchaser would take title to property Y free and clear of the lender’s original mortgage with the after-acquired property clause, because he/she most likely did so without ever knowing it existed.  That new purchaser is innocent in the eyes of the law and the original mortgage is null and void as to him/her.  Similarly, if the borrower does not sell property Y, but does something such as borrow money from someone else without telling the original lender, and uses it as collateral, the original mortgage becomes junior to the new lien.

In Pennsylvania, a mortgage that goes unrecorded is effective between the parties, but is null and void as to someone who gives value for an interest in land and does so without actual or constructive notice of the mortgage.  With a recording statute like Pennsylvania’s, the lender/mortgagee’s lien in after-acquired property (Y, for example) will be subordinate to the interest of someone who pays value and lacks notice of it.  In our scenario, an outright sale of property Y would make the mortgage on property X meaningless.  It would be treated as unrecorded.  If, instead of selling it, the borrower mortgaged property Y to another lender, the original lender’s lien would become junior to the interests of the new mortgagee.

The idea is to protect the person acquiring the land, who probably would not have discovered it until after a reasonably diligent search of the records.  The mortgage is not in the “chain of title”. The original mortgage will only refer to property X.  Forcing a title searcher to check every entry in the grantor-grantee index is considered to be too much to require.  The title searcher for the innocent purchaser of property Y would have to check all the land records in every surrounding county to look for the lender’s original mortgage.  It would be impractical and unfair to require the title searcher checking the chain of title for property Y to research every conveyance ever made to the borrower.  If the borrower is an active land speculator with holdings in several states, the job would be astronomically expensive, time-consuming, and nearly impossible.

To avoid this result, the lender must record a notice in the county where property Y is located that specifically identifies property Y, refers to the mortgage containing the after-acquired property provision, and is in a form that provides record notice under local law.  Of course, this must be done before the new purchaser records the deed.  Recording such a notice has the effect of making the after-acquired property clause part of the chain of title.  Interests in the property that arise after recording will be junior to the lien of the after-acquired property clause.

Under this rule, an after-acquired property clause does not add much value and holds real potential for trouble unless the lender keeps a close eye on associated transactions.  At a minimum, that means setting up systems and procedures designed to make sure loan proceeds are released to the borrower only if the lender gets a description of the new property.  The lender should also make sure that if and when property is acquired, the correct form of notice is filed in the land records in the county in which the after-acquired property is located so that anyone researching the title will be aware of the lender’s original lien.

Thomas J. Barnes is a lawyer who concentrates his practice in commercial real estate finance, commercial transactions, and general corporate and business law.  Mr. Barnes is a partner of the Jenkintown, Pennsylvania firm of Egbert & Barnes, P.C.

There is a December 31, 2011 deadline for the Pennsylvania Decennial Filing for business entities formed in Pennsylvania between January 1, 2002 and December 31, 2011. This filing is required every ten years during years ending with the numeral “1”. The intent for this filing is so that the state can identify business names that are no longer in use and make them available to the public for future use. If your business entity was formed in Pennsylvania, but has not made a new or amended filing with the Pennsylvania Corporation Bureau after January 1, 2002, it may be subject to this requirement.  The possible consequences are that it will no longer have exclusive use of your business name on or after January 1, 2012.

How do I protect my business entity?

You can either file directly with the State of Pennsylvania or by contacting our office. Either James Egbert or Tom Barnes will fill out the appropriate paperwork to ensure that your business entity is protected. We will charge you a flat fee of $200, which includes the $70 Department of State filing fee. Please call us immediately if you would like us to help. You can call us at 215-886-6600 or email Jim Egbert at jegbert@egbertbarnes.com or Tom Barnes at tbarnes@egbertbarnes.com.

Who is required to file?

All domestic and foreign profit and nonprofit corporations, limited liability companies, limited liability partnerships that are not also limited partnerships, business trusts, insignias and “marks used with articles and supplies” that have not made a new or amended filing with the Corporation Bureau from January 1, 2002 through December 31, 2011 shall during the year 2011, file in the Department of State a report that they continue to exist. 54 Pa.C.S. § 503(b)(1), § 1314(b), § 1515(b). Fictitious names and trademarks are not required to make decennial filings.

What if I’ve missed the December 31, 2011 deadline?

If you’ve missed the December 31, 2011 deadline, you still need to file. Contact us and we will help.  You can call us at 215-886-6600 or email Jim Egbert at jegbert@egbertbarnes.com or Tom Barnes at tbarnes@egbertbarnes.com.

If you are an LLC member, do you know what you would do if a co-member of the LLC either retired or died? Would you have the money to buy out the other member’s interest? Having a “Buy-Sell Agreement” in place is imperative for the survival of an LLC past one member’s departure. This agreement can also cover other business arrangements between members. If you don’t have an agreement in place the time to consider discussing one with legal counsel is now.

Written by Thomas J. Barnes, Esquire

1.      What is the legal definition of a partnership?

The general rule in Pennsylvania is that a partnership is an association of two or more persons to carry on as co-owners a business for profit.[1]  Many of the rules applicable to partnerships also apply to registered limited liability partnerships, limited partnerships and limited liability companies.[2]

This discussion is intended to apply to a general partnership in which the partners have no partnership agreement (or a very limited one), and have made no provision for the unexpected death of one of the partners.  In these situations, the law governing partnerships fills in the blanks by providing rules for paying the partnership creditors and distributing the remaining assets to the partners.  In the case of a deceased partner, the executor of his estate or other legal representative stands in the shoes of the deceased partner.

The reader is asked to bear in mind that the legal principles cited in this article are not a complete exposition of the principles of general partnership law, and so may not apply to an individual’s particular situation.  This article is not intended as legal advice for anyone, and is simply intended as an illustration of certain aspects of the law.

2.      Determining whether a partnership exists

As a general rule, where two or more people are sharing gross revenue or profits, there is a strong inference they are a partnership.  Without any formal partnership agreement, oral or written, real estate can be owned by two or more people as a joint tenancy, a tenancy in common, tenancy by the entireties (married persons).

However, joint ownership by itself does not establish a partnership, even if the co-owners share profits made by the use of the property.[3]  Likewise, the sharing of gross returns does not of itself establish a partnership whether or not the persons sharing them have a joint or common right or interest in any property from which the returns are derived.[4] For example, there is no partnership where profits are received in payment for a debt, by installments or otherwise, as wages of an employee or rent to a landlord, as an annuity to a surviving spouse or representative of a deceased partner, as interest on a loan though the amount of payment varies with the profits of the business, or as the consideration for the sale of the goodwill of a business or other property, such as by installment payments.

The intention of the parties is the determining factor.  Obviously, the best way to eliminate uncertainty is to have a written agreement between the participants, stating clearly whether or not the relationship is a partnership.

3.      Identifying the partnership’s property

All property originally brought into the partnership stock or subsequently acquired, by purchase or otherwise, on account of the partnership is partnership property.[5]  Unless the contrary intention appears, property acquired with partnership funds is partnership property.[6]  Title to real property may be acquired in the partnership name, but title so acquired can be conveyed only in the partnership name.[7]   A conveyance to a partnership in the partnership name, though without words of inheritance, passes the entire estate of the grantor unless a contrary intent appears.[8]

4.      The Relationships of the Partners to One Another

 a.      Determining rights and obligations of partners

Absent a written agreement, the rights and duties of the partners in relation to the partnership are subject to certain rules.  The following is an oversimplification, but, generally, each partner is entitled to be repaid his contributions of capital, and to share equally in the profits and surplus remaining after all liabilities, including those to partners, are satisfied.  On the other hand, a partner is obligated to contribute towards the losses, whether of capital or otherwise, sustained by the partnership, according to his share in the profits.[9]

b.      The partners’ duty to render information to each other

Partners are obligated to report, on demand, true and full information of all things affecting the partnership to any partner, or the legal representative of any deceased partner, or of a partner under a legal disability.[10]  In the proper circumstances, a partner has the right to a formal accounting as to the partnership affairs.  For example, if he is wrongfully excluded from the partnership business or possession of its property by his copartners, or whenever other circumstances render it just and reasonable.[11]

c.       The Property Rights of a Partner

The property rights of a partner are (1) his rights in specific partnership property, (2) his interest in the partnership and (3) his right to participate in the management of the partnership.[12]  A partner is a co-owner with his partners of specific partnership property, holding as a tenant in partnership.[13]  Absent a written agreement, the features of this tenancy are as follows:

(1) A partner has an equal right with his partners to possess specific partnership property for partnership purposes, but he has no right to possess the property for any other purpose without the consent of his partners.[14]

(2) The right of a partner in specific partnership property is not assignable except in connection with the assignment of the rights of all partners in the same property.[15]

(3) The right of a partner in specific partnership property is not subject to attachment by creditors or execution except on a claim against the partnership.[16]

(4) On the death of a partner, his right in specific partnership property vests in the surviving partner or partners, except where the deceased was the last surviving partner, when his right in the property vests in his legal representative. The surviving partner or partners, or the legal representative of the last surviving partner, has no right to possess the partnership property for any but a partnership purpose.[17]  The interest of a partner in the partnership is his share of the profits and surplus and that interest is personal property.[18]

According to the Supreme Court of Pennsylvania, “At the death of a partner, not only does his estate acquire no greater right in specific partnership property than the decedent had during his lifetime, but the above limited right which the partner had in such property during his lifetime is vested at his death in his surviving partners and not in his estate.  Further, where a partner dies and the business is continued without a settlement of accounts, … the [Uniform Partnership] Act specifically limits the estate to (1) ascertainment of the ‘value of [decedent's] interest at the date of dissolution’ and (2) receipt ‘as an ordinary creditor [of] an amount equal to the value of [decedent's] interest.’” [19]

5.      Partnership dissolution (termination)

A partnership is dissolved by six kinds of events.

(1) Without violation of the (oral or written) agreement between the partners:

(i) By the termination of the definite term or particular undertaking specified in the agreement.

(ii) By the express will of any partner when no definite term or particular undertaking is specified.

(iii) By the express will of all the partners.

(iv) By the expulsion of any partner from the business bona fide in accordance with such a power conferred by the agreement between the partners.

(2) In contravention of the agreement between the partners, where the circumstances do not permit a dissolution under any other provision of this section, by the express will of any partner at any time.

(3) By any event which makes it unlawful for the business of the partnership to be carried on or for the members to carry it on in partnership.

(4) By the death of any partner.

(5) By the bankruptcy of any partner or the partnership.

(6) By court-ordered dissolution. [20]

6.      The effect of the death of a partner: dissolution of the partnership

The dissolution of a partnership is the change in the relation of the partners caused by any partner ceasing to be associated in the carrying on, as distinguished from the winding up, of the business.[21] Death is one cause of dissolution, but there are several other causes.

On dissolution, the partnership is not terminated but continues until the winding up of partnership affairs is completed.[22]

7.      The winding up process: the distribution of its assets

The partners may agree in a partnership agreement that on the death of a partner, the surviving partner or partners, if there are any, can buy out the deceased partner and continue the partnership without dissolving it and starting over.  There are many ways to set the value and price of the buyout, and many mechanisms for making sure it takes place smoothly and fairly.

Without such an agreement, the surviving partners or the legal representative of the last surviving partner, not bankrupt, have the right to wind up the partnership affairs.[23]  In the case of the death of a partner, the surviving partner or partners have the right to wind up the partnership.  They also have a fiduciary obligation to the estate of the deceased partner.  Since the death of one partner leaves the survivor in a position of absolute control with only the duty to account, the survivor must proceed with utmost caution and use the highest degree of care in the liquidation of the partnership.[24]

In settling accounts between the partners after dissolution, the following rules are observed, subject to anything contained in the partnership agreement to the contrary:

The assets of the partnership are the partnership property itself, and any contributions the partners that are necessary for the payment of all the liabilities.

The liabilities of the partnership rank, in order of payment, as follows: (i) those owing to creditors other than partners; (ii) those owing to partners other than for capital and profits; (iii) those owing to partners in respect of capital; and (iv) those owing to partners in respect of profits.  The assets shall be applied, in the preceding order, to the satisfaction of the liabilities.

The partners are obligated to contribute the amount necessary to satisfy the liabilities in the relative proportions in which they share the profits.  The individual property of a deceased partner is liable for these contributions.

Where a partner has become bankrupt or his estate is insolvent, the claims against his separate property shall rank in the following order: (i) those owing to separate creditors, then (ii) those owing to partnership creditors, then (iii) those owing to partners by way of contribution.

Arthur and Bob are co-owners of a business, A&B Corporation.  A&B manufactures specialized steel components for use in mining and oil and gas well drilling projects.  Arthur founded the business thirty years ago, and later took on Bob as a co-owner.  The business has grown.  In recent years, Arthur and Bob have been approached by larger competitors and other industry members who have sought to buy the business from them, but Arthur and Bob have politely refused these overtures and so have never received an offer.

A&B has designed several highly successful drilling equipment components, but none of them are protected by patents.  The know-how that went into the products is captured in a library of engineering drawings.  None of the testing results are documented, and the rest of the company’s knowledge resides between the ears of the two men.

Arthur and Bob have enjoyed a strong personal and business relationship over the years, with no stresses or conflicts between them.  Arthur owns 70% of the business, and Bob owns the remaining 30%.  The business is an S-corporation.  The corporate records sit in a binder on the shelf in Arthur’s office, never touched.  There are bylaws, but they say nothing about when and how each shareholder’s stock can be sold by the shareholder.

Both Arthur and Bob are married with children.  Two of Arthur’s four children are actively involved in the business.  Neither of Bob’s two children has indicated any interest in the business, preferring to pursue other careers.  Neither Arthur nor Bob’s wife is employed by the business or takes any active role in it.

Arthur and Bob both have wills.  Each will gives all their assets to their wives.  The wills give nothing to the children unless their wives die before the husbands, or die at the same time.

This fall, Bob went on a hunting trip in mid-state Pennsylvania, where he collapsed and died of a heart attack.  His widow now is a 30% owner of the business!  She needs money and wants to liquidate her husband’s stock in A&B Corporation, but Arthur has told her that is impossible because he cannot personally afford to buy her out.  Bob’s widow does not receive his salary and has no idea as to what is going on in the business.  She feels isolated and neglected, and is worried that Arthur will not pay her anything.

Arthur and Bob did not take the time to consider what would happen if one of them dies, became incapacitate, ill, bankrupt or simply wished to retire.  They had no buy-sell arrangement between them, so there is no specified series of steps to take to buy Bob’s widow’s interest, or to fund the purchase price on Arthur’s behalf.

This scenario outlines several issues that commonly plague business owners. In upcoming articles we will elaborate on this case and discuss alternatives and solutions that may be available. Please contact Thomas Barnes for more information.

Written By Thomas J. Barnes, Esquire

In 1984, the Superior Court of Pennsylvania decided a loan foreclosure case that turned on the enforceability of a loan guarantee.  The guarantee was given by the corporate borrower’s stockholders, who pledged their houses as security.  The lender had the opportunity to collect from a readily available fund of cash collateral belonging to the corporate borrower, which would have extinguished the loan guaranty.  The lender neglected to do so, and decided instead to enforce the guaranty by foreclosing on the guarantors’ homes.  The case is an illustration of the differences between what the law classifies as a guarantor versus a surety and, in particular, the rights and obligations of someone standing behind the loan when the borrower defaults and the lender comes knocking on the door.

Background.  Ten years before the Superior Court decided the case[1], Gerald McCrossan and Paul Brutsche, owners of a pharmacy business, borrowed about $72,000 from First National Consumer Discount Co.  The loan was made to their jointly owned corporation, McCrossan’s Pharmacy, Inc.  It was secured by a promissory note from the corporation, mortgages on each owners’ home, and a “Guaranty” signed by McCrossan and Brutsche.  The bank also filed a UCC financing statement covering inventory, furniture and fixtures in the store.  As a result, the collateral included both the business’ assets and the owners’ homes.

The next year, 1974, the pharmacy obtained another loan from First National for $13,890.00.  This loan was secured by a second mortgage on the McCrossans’ home.  After a few months, the pharmacy defaulted on this second loan.

In an effort to preserve the business, First National suggested that the pharmacy extend its payments and refinance the 1974 loan.  The McCrossans signed another promissory note for the modified loan, both individually and on behalf of the corporation.

In March of 1977, the corporate borrower sold the pharmacy business operation for almost $50,000, an amount far short of the $85,000 it still owed to the bank.  The corporate borrower filed an interpleader action in the Court of Common Pleas of Delaware County, depositing the money with the Court and asking the court to supervise the division of the cash proceeds among its creditors.  The money generated from the sale was placed in the court’s custody for ultimate distribution to secured and unsecured creditors.

For reasons not made clear, the bank never seriously pursued its rights to seize the cash in the fund.  It had an undisputed right to do so.  The lender had a perfected UCC Article 9 security interest in the corporate borrower’s non-real estate assets, which had been converted to cash and deposited with the court in Delaware County.  The court distributed the money to other creditors, paying a little more than $3,000 to the lender.

Whether the lender’s next move was planned or not is unclear.  The bank moved to foreclose on the mortgages on the McCrossans’ and Brutsches’ homes, and they naturally objected.  The trial court in Delaware County halted the foreclosures, concluding that the bank’s failure to collect from the cash collateral fund barred it from trying to foreclose on the mortgages.  The trial court said it was the bank’s fault that the collateral was lost, and so it would be unfair to allow the bank force the McCrossans and the Brutsches to make good on the Guaranty because their right to turn to the cash collateral for reimbursement had been destroyed.

The lower court also concluded that the Guaranty document made the McCrossans and the Brutsches “sureties”.  Under surety law, the bank had an obligation to the sureties to preserve the collateral in the fund for the sureties, so they could collect from it if forced to pay the bank in order to make good on their surety obligation.   Since the bank had lost the collateral, the lower court excused the McCrossans and the Brutsches from liability to the bank.  The bank appealed.

First Issue: Was This a Guaranty or a Suretyship Relationship?  The initial question raised by the lender was, were the McCrossans and the Brutsches guarantors or sureties?  Sureties are primarily liable to the lender; that is, liable instantly when the borrower defaults, even if the bank makes no effort to collect from the borrower/debtor.  Guarantors, on the other hand, are secondarily liable; that is, liable to the bank only if the bank first tries to collect from the borrower/debtor and fails completely or in part.  The distinction mattered in this case because, if the borrowers were sureties, then the bank’s failure to pursue collection from the fund would have damaged the sureties’ right to collect from the fund if the McCrossans and Brutsches were unable to pay the bank.

If the Guaranty document made the McCrossans and the Brutsches guarantors of the loan, instead of sureties, the bank would not have been able to foreclose on the mortgages, but would have first been required to try and recover whatever it could from the business’ asset base.  Those assets were sold for cash and were deposited in the court’s account.  Since the bank never followed up on its claim against that money, the lower court barred the bank from getting the full amount of its claim, and only allowed it to collect about $3,000 from the fund.

The lower court determined instead that the McCrossans and the Brutsches were sureties, meaning the bank had no obligation to try and recover from the corporate borrower first.  Under Pennsylvania law, a written agreement made by one person to answer for the default of another makes that person a surety and not a guarantor, unless the agreement contains in substance the words “this is not intended to be a suretyship.”  No such language was in the “Guaranty” involved in the case.

Because McCrossans and the Brutsches were sureties, the bank had an obligation to preserve the cash collateral in the fund for them.  That is, if the bank demanded payment from the McCrossans and the Brutsches as sureties and collected from them, the McCrossans and the Brutsches then would acquire a right of subrogation against the borrower corporation.

Under surety law, the bank had a duty not to impair any security in its control which may have provided the means of satisfying the debt.  “The creditor in such a situation must not prejudice the right of the surety to resort to the security when the surety pays the debt and becomes entitled to subrogation. Impairment of the collateral discharges the surety to the extent that the unimpaired security would have paid the principal debt or to the extent of the surety’s injury.  This principle applies even when the surety was not in a position to enforce its subrogation rights when the impairment occurred.”[2]  Here, the bank had a perfected security interest in the property of McCrossan’s Pharmacy, Inc.: the cash paid into the escrow account.

Second Issue: Did the McCrossans and Brutsches Waive the Defense of Impairment of Collateral?  The second question before the court was, given there was a surety relationship with the bank, did the borrowers waive their right to have the bank preserve the collateral?  The court noted that the “Restatement of Security, § 132 (1941) summarizes the defense of impairment of collateral as follows:

Where the creditor has security from the principal and knows of the surety’s obligation, the surety’s obligation is reduced pro tanto if the creditor

(a) surrenders or releases the security, or

(b) wilfully or negligently harms it, or

(c) fails to take reasonable action to preserve its value at a time when the surety does not have an opportunity to take such action.”[3]

The language of the “Guaranty” provided that the bank reserved its right to exercise any remedy “with respect to any security held by [the bank], and to release, substitute or surrender and to enforce, collect or liquidate, or to fail to refuse to enforce, collect or liquidate, any security of any kind held by [the bank] at any time.”

The court said it was “persuaded that the waiver provision of the “Guaranty” is an unconditional one whereby the sureties (McCrossans and Brutsches) agreed to pay on default of the principal debtor/pharmacy without limitation.”[4]  So the defense of impairment of collateral took a back seat to the “proposition that an explicit waiver precludes a guarantor [or a surety] from asserting them in an action to recover under the guaranty”.

In support of its conclusion, the court said, “under certain circumstances if the creditor has not exercised reasonable (due) diligence in preserving the security, then the obligation of the appellees would be reduced to the extent that they were injured.  However, because the guaranty agreement in the instant case is an absolute and unconditional one, and because the contract of guaranty did not require the creditor to take such action, the foregoing rule of law has no applicability.”  This principle continues to be the law in Pennsylvania.[5]

In commercial financing transactions, the courts give no artificial protections to the borrower, as they often do in consumer loan cases.  Instead, they elect to respect the clear language of the parties’ agreement, made in the context of a transaction between alert and attentive parties with a motive to carefully scrutinize the language of their agreements.