Calling an Organization a Partnership Doesn’t Make it One, But Not Calling it a Partnership Doesn’t Make it Not One. Got It?

October 23, 2017

Did you know there’s such a thing as an “inadvertent partnership”?

The basic definition of a partnership, under both the original Uniform Partnership Act (1914) and the most recent version of the Revised Uniform Partnership Act (1997), is “an association of two or more persons to carry on as co-owners a business for profit.” The later Act, in Section 202 (a), adds a caveat not found in the original: “whether or not the persons intend to form a partnership.”

An unintentional partnership? The official comment to Section 202 explains it’s one that can be created inadvertently and even contrary to one’s “subjective” intentions. It also tells us that it’s a universally accepted concept:

The addition of the phrase, “whether or not the persons intend to form a partnership,” merely codifies the universal judicial construction of UPA Section 6(1) that a partnership is created by the association of persons whose intent is to carry on as co-owners a business for profit, regardless of their subjective intention to be “partners.” Indeed, they may inadvertently create a partnership despite their expressed subjective intention not to do so. The new language alerts readers to this possibility.

In other words, it’s what the putative co-owners do in furtherance of a profit-seeking business — rather than what they think or say they’re doing — that evidences intent and determines the existence of a partnership. Hence, in the absence of a written partnership agreement, one or both of two putative co-owners can call it a partnership and refer to each other as partners without it being a legally recognized partnership while, conversely, they can affirmatively disavow a partner relationship yet be found by a court to have created a partnership with enforceable partner rights and obligations.

In the modern era of closely held business entities dominated by S corporations and LLCs, both of which feature limited liability along with pass-through taxation, general partnerships are rarely chosen as vehicles for multi-owner business enterprises (with the exception of professional firms organized as limited liability partnerships). Nonetheless, what we do see with some frequency are lawsuits in which the plaintiff alleges and seeks to enforce an oral partnership agreement where, after an initial period of business collaboration — usually measured in months not years — and before the parties are able to formalize the proposed business entity, the defendant calls it off. Hammond v Smith, decided last summer by the Appellate Division, Third Department, is the latest example.

Hammond v Smith

In Hammond, with one judge dissenting, the appellate panel affirmed a lower court order granting the defendant’s summary judgment motion and dismissing the complaint on the ground no partnership agreement existed between the two parties. The plaintiff had sued for damages for breach of an alleged oral partnership to develop and market a new lithographic tool. The majority opinion set forth and analyzed each of four relevant factors in determining “whether a partnership existed in fact,” with no single factor determinative:

  • the parties’ intent, whether express or implied;
  • whether there was joint control and management of the business;
  • whether the parties shared both profits and losses; and
  • whether the parties combined their property, skill, or knowledge.

The Parties’ Intent.  The court found, notwithstanding the plaintiff’s use of the word “partnership” to refer to the parties’ business relationship in a business proposal and a cover letter sent to the defendant, that the parties “never shared the intent to become partners” based on evidence including the plaintiff’s deposition testimony, the defendant’s affidavit, invoices, a lease, and emails between the parties documenting their contract negotiations. Echoing the lower court’s decision, the court noted that “calling an organization a partnership does not make it one.” The court also highlighted email correspondence between the parties reflecting no finalization of negotiations or meeting of the minds either as to the equity allocation between the two or even whether they would join forces as co-owners of a unified business or structure the venture as a contractual relationship between separately owned entities.

Joint Control and Management.  The initial efforts to develop the proposed lithographic tool were performed by engineers hired by the defendant’s separate company. The defendant alone paid bills though his own company’s bank account, established relationships with vendors, developed management protocols, and directed all assembly and engineering decisions. The plaintiff’s sole contribution was the services of one engineer, the cost of which defendant reimbursed. On these facts the court concluded that defendant “had sole control and management of the business.”

Shared Profits and Losses.  The court found that the plaintiff made no capital contributions, did not share in the venture’s losses, did not share defendant’s liability to creditors, affirmatively indicated he did not want to share personal liability under a proposed office lease for the business, was reimbursed by defendant for all his expenses, and did not receive a share of profits. The court also rejected plaintiff’s contention that he shared in losses — an “essential element” of any partnership agreement, said the court — because he offered his own services for a share of net profits and “risked losing the value of those services.” Such services alone, the court observed, “do not establish that a person shared in losses sufficient to raise an issue of fact concerning the existence of a partnership where, as here, that person invested no capital and was not liable to creditors.”

Combined Resources.  The court found that the plaintiff’s testimony concerning “instances in which he contributed his skill and knowledge related to design and marketing in the engineering industry” was “not dispositive” and did not satisfy plaintiff’s burden to raise an issue of fact sufficient to overcome defendant’s initial showing that no partnership existed.

The Dissent.  The court’s lone dissenter would have denied the defendant’s summary judgment motion, and would have held that the defendant did not sustain his initial burden on a summary judgment motion, based on defendant’s inclusion of plaintiff’s deposition in support of defendant’s motion, in which the plaintiff testified that he and the defendant initially agreed to a 50/50 partnership, after which the plaintiff “voluntarily reduced” his own share to 20%, and that the defendant sought to end their business relationship by telling plaintiff that he “didn’t want to be partners anymore” suggesting that defendant “believed that they had been partners up to that point.” The dissenter also found that plaintiff’s testimony concerning the “unpaid services” he contributed “as an investment” was “sufficient to establish that plaintiff may have been exposed to a risk of losses.”

Closing Thoughts.  The formation of a closely held, joint business enterprise usually goes through a gestation period in which the prospective business co-owners discuss and refine their business and marketing plans, generate a budget, divvy up management and operational responsibilities, identify capital needs and sources, and allocate proposed equity ownership. The smaller the initial venture, the less likely the involvement of lawyers or accountants, at least until the discussions reach critical mass requiring decisions about choice of entity, preparing and filing organizational documents, tax elections, owner agreements, and the like.

Sometimes, as in Hammond, the prospective co-owners allow their eagerness to go operational get ahead of their negotiations. When that happens, and not having brought in professionals to organize the S corporation or LLC that ultimately would have been the vehicle for the new business venture, the party who feels burned when the other calls off the engagement, and who wants to pursue a damages or other remedy, is left with little or no choice but to claim an oral partnership which, as the above discussion shows, can present insurmountable legal hurdles. It also can take on a forced character given the unlikelihood, in the event the parties had arrived at a meeting of the minds on the terms of their new venture, that they would have utilized the partnership form as opposed to a close corporation or LLC.