Occasionally a client comes to me and tells me they have an LLC or a corporation with their friends. When I request documentation to support the LLC or corporation there are no articles of organization, articles of incorporation, nor are there bylaws or an operating agreement. At that point, I have to tell them that they do not have an LLC or a corporation but instead a partnership. When the courts get involved it is called a partnership by estoppel. A partnership by estoppel is normally found where some issue, normally negative, requires a court to be involved in a dispute between people who thought they were partners in a company or an LLC but since there was no actual founding of an LLC or corporation are now partners.
I wrote briefly about the dangers of a partnership in a previous blog. This blog will further explore the dangers of a straight partnership.
Partnership Property
Normally, when there is a partnership by estoppel it is the result of a group of friends owning a certain piece of property. I’ve seen this in the past in groups of friends who hold hunting property in common. Often times they start off by saying they’re going to form an LLC with a group of individuals voting on how to handle and utilize the property. However, they’ve never filed an articles of organization or an articles of incorporation. The failure to file these basic documents and normally the failure to sign bylaws or an operating agreement means that there is no actual LLC or corporation. And all of those rules which were thought to control the entity in the operating agreement or the bylaws do not apply. Most unfortunately, the corporations law and the LLC law do not apply in controlling the company instead the Michigan enactment of the Uniform Partnership Act (UPA) controls how the business must be governed.
If a partnership is formed the partners have three types of property rights (one) interest in the partnership property (two) interest in the management of the partnership due to the unlimited liability of each of the partners for the actions of the other partners and (three) interest in the partnership itself. This can also be considered a relationship which would reflect tenants with undivided property address, i.e. tenants in common.
However, where in an LLC or corporation the interest of the members or shareholders in the LLC or the Corporation is a function of the amount of money contributed by the individuals, in a partnership under the UPA each of the partners own an equal share of the partnership property. Further, you are unable to alienate your interest in the partnership without the consent of the other partners. Normally this consent requires a large payout because the control in the interest of the management of the company is worth a considerable amount of money.
Another attempt to alienate an interest in a partnership is via an assignment of a partner’s interest. UPA discusses this section 27. In essence, and assignments only conveys the ability to collect profits and does not control and does not relinquish management powers to the assignee, this is because the interest in the property or the management of the company is considered to be personal property on alien believed linked to the individual partners. In essence, this section of the UPA requires the original partners to remain partners even in the face of an assignment however any profits or any distributions are given to the assignee instead of the original partners.
Charging Orders
A charging order is normally obtained by a judgment creditor requiring the partnership to recognize that a judgment creditor now owns the judgment debtor’s interest in the partnership. You would get to this results if, the partnership were to default on a mortgage, some sort of injury occurred on the partnership property and the injured party sues and obtains a judgment against the partnership, or some other “misdeed” is committed by the partnership or one of the partners and is related to the partnership property.
Even though a judgment creditor may own an interest in the partnership, the judgment creditor cannot force the partnership to make payments to the judgment debtor. The unfortunate aspect of this is that the individual partner against whom the judgment creditor obtained the judgment is still on the hook for payment of the judgment. This can force one of the partners into bankruptcy, or otherwise place undue strain on that partner and the other partners are not required to indemnify or otherwise protect the other partner. It is possible that the judgment debtor may be able to petition the court for equitable dissolution if the partner can show that the remaining partners are behaving inequitably. However, trying to prove that they are acting inequitably as opposed to simply protecting all of the partner’s interest in the property is very difficult if not impossible.
Dissolution
As many small business owners are aware, the ability to dissolve an entity is almost as beneficial as the ability to start an entity. Often times, businesses change, individuals choose to go and found other businesses, or businesses are sold in asset sales and the old business has to be closed. The ability to dissolve the business pursuant to statute and protect oneself from outstanding debts if debts are still outstanding after the final dissolution of the business is an essential element of both the MBCA and the LLC act. The UPA and the Revised Uniform Partnership Act (RUPA) differ when it comes to dissolution. Upon dissolution under the UPA there can be a situation in which you have two partnerships. Under the UPA the partnership will always have the old partnership, including all assets and all liabilities of the old partnership. If there is anything left over the capital assets of the old partnership will be distributed to the new partnership. This is considerably more complicated than under the RUPA, when any one partner chooses to disassociate the RUPA gives the remaining partners a choice whether to disassociate or to continue the old partnership.
It is important to note that the RUPA and UPA as far as discussed in this blog article only differ in this dissolution area. There are other differences, and one is not interchangeable with the other. It is important to note that only certain states have enacted the RUPA and that the UPA does apply in other states. This blog post is tailored to apply to a wider audience and just Michigan; however it is important to note that Michigan has enacted the UPA and not the RUPA.
This short blog post should make anybody very uncomfortable in doing business as a partnership; it is something that oftentimes leads to substantial potential liability. This is one of the major reasons why I counsel all individuals who want to go into business together to consult a lawyer. The failure to consult a lawyer can lead to very substantial negative outcomes.
As always, the corporate practice group of Hewson & Van Hellemont, PC, and Tim Kaufmann stand ready to assist you in all your business planning needs. We are available via telephone at 248-968-5200 or you can contact Mr. Kaufmann directly at tkaufmann@vanhewpc.com.
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