DAVID J. WILLIS ATTORNEY
Copyright © 2015. All rights reserved worldwide.
Partnerships in Texas
By David J. Willis, J.D., LL.M.
Texas partnership law is found in Business Organizations Code ("BOC") Title 4. For real estate investors, it is also important to have a working knowledge of the Texas Property Code. Professional investors keep a paperback copy of the Property Code on their desks.
General partnerships are the focus of BOC Title 4, chapter 152. A general partnership is an association of two or more persons or entities (all of which assume unrestricted liability for partnership debts and activities) who intend to carry on a business for profit. Each partner has equal rights in the management and conduct of the business of a general partnership. In contrast with the common law, the BOC does not specifically require an intention to share profits or losses, although this is an important evidentiary factor in determining whether or not a partnership exists. Ingram v. Deere, 288 S.W.3d 886, 895-96 (Tex. 2009).
A partnership is an entity distinct from its partners, and partnership property is not considered to be the property of the partners (BOC sec. 152.056 and 152.101). A partners may use or possess partnership property only on behalf of the partnership. This ties in with the fiduciary duty of partners both to the partnership and one another, specifically including a partnerís duty of loyalty (BOC sec. 152.205) and a duty of care (BOC sec. 152.206).
The partnership agreement consists of "any agreement, written or oral, of the partners concerning a partnership" (BOC sec. 151.001(5)). To the extent that a partnership agreement does not otherwise provide, the BOC governs. Deere v. Ingram, 198 S.W.3d 96,101 (Tex.App.–Dallas 2006). Fundamentally, partnership agreements are contracts between the partners, and the law applicable to the construction of contracts applies unless the BOC provides to the contrary. Having said that, an oral partnership will likely violate the statute of frauds, so sensible investors will insist on having a clear and comprehensive written partnership agreement that does not require the intervention of a court to interpret and apply it. Exxon Corp v. Breezevale Ltd., 82 S.W.3d 429, 443 (Tex.App.–Dallas 2002, pet. denied).
The most important contrast with an LLC is that a general partnership does not have a liability barrier–no firewall, which is a distinct disadvantage in a business as litigation-prone as real estate investing. When it comes to potential liability, there is no difference between a partnership format and simply owning assets in one’s personal name. For this reason, general partnerships should be avoided unless the partners themselves are LLCs or corporations.
A joint venture differs from a general partnership in its narrower scope, but is otherwise governed by the law of general partnerships. Smith v. Deneve, 285 S.W.3d 904, 913 (Tex.App.–Dallas 2009, no pet.). The practical difference is this: general partnerships are usually created for the long term for a broad range of business purposes. They may contemplate engaging in various enterprises with the intention that the partnership will endure from one transaction to the next into the indefinite future. Joint ventures, by contrast, generally have a specific task or time frame. They perform that task, net profits are distributed, and they are done. One example would be investors pooling resources and efforts in order to buy, rehab, and re-sell either a specific residential house or a commercial project–a flip, in other words. Another example would be investors acquiring raw land to hold for a couple of years and then sell.
The first step is to create the joint venture be means of a written agreement. The second step is usually to deed the subject property into it. A joint-venture agreement dealing with real estate does not, by itself, represent an interest in property or act as a transfer of that property. For that, a deed is required. Sewing v. Bowman, 371 S.W.3d 321 (Tex. App.–Houston [1st Dist.] 2012, pet. filed].
In a limited partnership, the general partner is the only member to assume unrestricted liability. The limited partners have liability only to the extent of their contributions to the partnership. LPs are governed by BOC Title 4, chapter 153, but also chapters 151, 153 and 154 and Title 1, to the extent applicable. At least in the context of real estate investment, all of the partners usually are (or should be) LLCs or corporations. It is important to note that the limited partners are strictly prohibited from engaging in the conduct or management of the business. This job is the sole province of the general partner. Accordingly, LP agreements tend to be heavy in their emphasis upon the powers and duties of the general partner.
In most cases, the general partner is formed and established specifically for the purpose of managing the LP. Our preference is to use a traditional Texas LLC for this purpose. The limited partners may be any sort of entity, including another LP. A series LLC (Texas or Nevada) is more often the best choice, however, since a double firewall may then be built into the structure.
LPs are most common in commercial transactions, but their usefulness in other investment arenas should not be overlooked. A basic LP includes a general partner that owns a 1% interest and a limited partner that owns a 99% interest. There may of course be more partners. If there is more than one GP, then one of them should be designated the managing partner.
An LP is an excellent way to bring in a passive "money partner" who is cautious about incurring liability beyond the amount invested.
As is the case with LLCs, do not rely on a limited partnership to limit your liability if you utilize the entity to commit actual fraud. "As a general matter, a limited partnership is an entity separate and distinct from its partners, with separate, distinct liabilities and obligations. Nevertheless, Texas law allows the separateness of the entity to be ignored if the limited partnership is used as a straw man for the purposes of obtaining an impermissible result under Texas law. . . ." In re Sewell, 413 B.R. 562, 571-72 (Bankr.E.D.Tex. 2009).That being said, "limited partners are generally not responsible for the limited partnership’s obligations unless they take some action to accept or subject themselves to such liability"–such as interfering with management of the business. Peterson Grp. V. PLTQ Lotus Grp., 417 S.W.3d 46, 56-57 (Tex.App.–Houston [1st Dist.] 2013, pet. filed 3-28-14).
What about TICs? How are these different from other partnerships? Our explanation will reveal our bias against these arrangements.
TICs are written up as general partnerships but are nonetheless focused on a specific deal, often a larger project such as an apartment complex or a strip center. Promoters seek out investors, usually affluent novices, who are packaged together in their personal capacities. In other words, these newbie investors do not form an LLC or corporation to act on their behalf in the deal; they sign the TIC agreement individually and then go on to personally guarantee a seven-figure note to a bank. If the value of the investment (often inflated to begin with) declines, the results are almost uniformly awful. Only the promoters–who have since taken their profits and moved on to other schemes–win.
Real estate lawyers are accustomed to counseling TIC investors who have awakened to find that a lender suddenly seeks to hold them individually liable for a very large sum. Few consulted an attorney before signing up with the TIC. Many are otherwise smart and successful professionals who should have known better.
Minimal Contents of a Partnership Agreement
When it comes to drafting contracts and agreements, partnership agreements included, we prefer that the effective date, the name and contact information of the parties, and the subject property all be plainly visible on the first page. The agreement should go on to address the following:
What are the respective percentage interests of the partners?
How will the partnership be managed? By majority vote? Will some issues require unanimous vote? Will there be a managing partner? What are the limits of his authority? What are the specific actions and duties required of each partner?
What about the investment property/project itself? Are there parameters for its rehabilitation and resale that need to be stated?
What will be the term (length) of the agreement? Presumably it will end when the project is finished and net proceeds are distributed, but this needs to be spelled out.
How will funds be handled? Who will sign checks? What about additional, future contributions if necessary?
Will there be loans as well as capital contributions by the partners? What about loans made by banks or hard money lenders? Promissory notes will need to be authorized and executed.
What about meetings of the partners? What constitutes a quorum? Who controls the agenda?
Suppose a partner wants to sell his interest or cash in? Suppose a partner dies? Will remaining partners have a right of first refusal to buy the decedent’s interest? On what terms?
What happens if a partner’s spouse files for divorce? Will remaining partners unwillingly wind up in business with the ex?
Every contract or agreement should have a default paragraph. What constitutes a default by a partner? If default occurs, what is the procedure for expelling a defaulting partner?
A good partnership agreement should address the issue of dispute resolution. Will mediation be required before one partner may sue another? That is usually good policy.
Finally, never underestimate the "miscellaneous" paragraph at the end of a contract. It deals with such issues as amending the agreement, which law applies and where venue will be located if a suit is filed, and so forth.
A complete partnership agreement will address all of these items and more, which is not to say that partnership agreements need to be unduly complex, long, or intimidating. Consult an attorney knowledgeable in the field in order to draft a partnership agreement and before signing one. Never use forms off the Internet for this purpose.
No contract or transaction should ever be entered into without a consideration of asset protection ramifications if the deal fails. It is often the attorney who must counsel a starry-eyed, in-a-rush client that a proposed transaction could fail as well as succeed. In the event of failure, what is the exit strategy? Which of the client’s assets will be exposed and how can that exposure be limited?
Lawyers can often see disaster looming, not because they are prescient but because they have seen this film before. In certain cases, when a happily oblivious client is determined to self-destruct, a lawyer may find it necessary to decline the representation.
Intelligent structuring implies an awareness not only of the mechanics of a proposed transaction but also of potential outcomes and their consequences. A willingness to look down the road, so to speak, where it may fork one way or another. Clients are astonishingly reluctant to this, accusing the attorney of trying to "kill the deal"–an unjust charge in most cases. An attorney’s job is to make the deal work, ideally in the client’s best interest, which brings us back to structuring issues.
Knowledgeable investors will have an entity, perhaps a management company, that (acting through an assumed name) is utilized for business with tenants, vendors, contractors, brokers, and other persons who might one day get riled up and file a lawsuit. The management company is a shell that contains employees, rental furniture, and leased vehicles. It is an equity-free dead-end for creditors. Hard assets reside in a separate holding company that does business with no one. The public does not even know that the holding company exists. In any case, prudent investors avoid signing contracts, leases, and the like in their personal name. All decisions that may have liability implications are made with an eye toward asset protection.
In the context of a partnership, it is therefore preferable for the investor to choose an existing entity (or perhaps form a new entity) in order to participate in the deal, making the enterprise a partnership of entities. This provides the best protection. And when it comes to personal signatures and guarantees, the solution is often to just say no.
The Menace of Family and Friends
Why not collaborate with friends and family members? They know you best, after all. Caution, however, is advised. All lawyers can tell stories of clients who propose doing a transaction with a brother-in-law, or perhaps borrowing money from parents, and declare that no partnership agreement is necessary because the other party is family or a close friend. In fact, the reverse is true. In transactions involving family and friends it is more important to reduce the agreement to a signed writing, not less so. Anyone who has witnessed the agony of intra-family litigation knows this to be true. †
Information in this article is proved for general informational and educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well. This firm does not represent you unless and until it is expressly retained in writing to do so.
Copyright © 2015 by David J. Willis. All rights reserved worldwide. David J. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his web site, http://www.LoneStarLandLaw.com