At every event I teach I meet a handful of individuals who refer to themselves as “business partners”. These “business partners”, who typically consist of no more than two or three individuals, plan to invest in real estate together. When making such a reference to “business partners” these individuals are trying to convey a concept i.e., we plan to work together on investing. I doubt anything from a legal standpoint is implied or intended to be conveyed beyond this simple description. However, we often forget that words do have meaning and our failure to adhere to this precept out of a need for expediency to convey a concept may hit you in the head like a boomerang when you least expect it.
In a recent Texas case, Lentz Engineering, L.C. v. Brown, two individuals were hit head on with such a boomerang. In Lentz, William Wilkins and Alden Brown, planned to purchase and develop real estate together. Eager to move forward, Wilkins entered into a contract to purchase some property, followed by Brown and Wilkins meeting with an attorney in February 2005 to form a Texas LLC to carry out the development. In March Brown gave Wilkins $400,000 to purchase the property, and Wilkins acquired the real estate in April. One day later, the attorney filed articles of organization for the LLC, which identified Brown and Wilkins as the LLC’s managers.
Like most partnerships, this one had the shelf life of a tomato and by the summer the parties were at odds. Brown wanted out and his money back while Wilkins entered into a contract in his own name with Lentz Engineering for engineering services on the LLC property. Lentz performed its work under the contract but was not paid.
Lentz then sued both Wilkins and Brown for breach of contract. Lentz’s theory was that Wilkins was directly liable on the contract, and that Brown was liable because he was partners with Wilkins and was therefore fully liable for the debts of the partnership. Of course Brown agued he and Wilkins were not partners but members in a LLC and therefore he was not liable to Lentz. Lentz argued that Wilkins and Brown had formed a partnership to run their business and a LLC to hold the property. Therefore, both parties were liable as a general partnership.
UGH, what a mess. The court looked at the issue and considered several factors in determining if a partnership has been created which include:
- sharing of profits of the business;
- sharing of losses or liability for claims;
- contributing or agreeing to contribute money or property to the business;
- participating in control of the business; and
- expressing an intent to be partners in the business.
Thankfully for Brown the court found that a partnership did not exist because a LLC was formed before Wilkins entered into the contract with Lentz and only two of the factors above existed bewteen the parties. However the lessen to take from this case is be very careful of your actions and terminology prior to forming an entity to conduct your business. If one partner signs a contract before the LLC is formed, and then things fall apart and the LLC is not formed, the organizers may find that as partners they are all jointly and severally liable on the contract.
How to avoid this outcome? Expunge the word “partners” from any description when referring to a business associate. One of the great benefits of LLCs is their limited liability; don’t open the door to personal liability by calling yourselves partners.
Investors who plan to work together should create their entity early before any contracts are signed or negotiated.