Beware of the Stealth General Partnership

Beware of the Stealth General Partnership2016-11-16T08:23:34+00:00

by Richard Keyt, Arizona limited liability company attorney

A Common Real Estate Investment Scenario Is a “TIED,” a Ticking Improvised Explosive Device Waiting to be Detonated

People who engage in business activity or real estate investment should do so through an entity that protects the owners from the debts and obligations of the entity. If I own a home that I rent, all of my assets are at risk if somebody gets hurt on my property. If the gas water heater that should have been replaced ten years ago blows up and kills or injures somebody on the premises, I will be sued. If the plaintiff wins a judgment against me that exceeds my insurance coverage, I could lose all of my life savings.

To protect my assets, I should form an Arizona limited liability company to hold title to my rental property. The general rule is that the owners of an Arizona limited liability company are not liable for the company’s debts.

Entities that Shield Owners from Liabilities

In Arizona, the three types of entities commonly used to shield the owners from liabilities of the business are: (i) the limited partnership, (ii) the corporation, and (iii) the limited liability company. Before 1992 when Arizona adopted its LLC law, the limited partnership was the entity of choice for holding real estate. Since 1992, the limited liability company has become the preferred entity for holding real estate and operating active businesses. Since 1992, Arizona corporations have also fallen into disfavor and should be used only in limited circumstances.

The Disastrous General Partnership

The worst type of entity to use to engage in any activity or investment is the general partnership because EVERY GENERAL PARTNER IS 100% LIABLE for all the debts and obligations of the general partnership. For those who are hard of hearing, let me say it again. Never, ever, ever use a general partnership because:

EVERY GENERAL PARTNER IS 100% LIABLE for all the debts and obligations of the general partnership.

Bad Example 1: Tom and Jerry form a general partnership to operate their printing business. Tom asks an employee to go to the office supply store to get some paper. The employee runs a red light and kills a pedestrian making $250,000 a year with 20 years of expected earning life. Because the employee was acting within the scope of his employment, the court awards a judgment against the employee, the general partnership, Tom and his wife and Jerry and his wife for $5,000,000 (20 years times $250,000 a year lost earnings).

If Tom and Jerry had formed an Arizona limited liability company to own and operate the business, it is unlikely that Tom and Jerry and their spouses would have been found liable for the harm caused by the employee.

Lesson of Bad Example 1: Never, ever, ever use a general partnership because:

EVERY GENERAL PARTNER IS 100% LIABLE for all the debts and obligations of the general partnership.

The Stealth General Partnership AKA the TIED

A common scenario involves two people (sometimes there are several people) who decide to pool their resources to purchase a home to rent and hold it for investment. One of them obtains a loan in his or her name and takes title to the home at the closing of the purchase. Sometimes everybody is named on a deed, but more often or not only the borrower (and spouse) is named on the deed.

This is what I call the “stealth general partnership” also known as the “ticking improvised explosive device” because the investors have probably created a general partnership. EVERY GENERAL PARTNER IS 100% LIABLE for all the debts and obligations of the general partnership.

The stealth general partnership is what is known as a “common law partnership.” It arises by operation of Arizona law. Arizona Revised Statues Section 29-1012.A provides that “the association of two or more persons to carry on as co-owners a business for profit forms a partnership, whether or not the persons intend to form a partnership.” Holding joint title to property “does not by itself establish a partnership, even if the co-owners share profits made by the use of the property.” ARS § 29-1012.C.1. However, a person who receives a share of the profits of a business is presumed to be a partner in the business. ARS § 29-1012.C.3.

I call this scenario the stealth general partnership or the ticking improvised explosive device because the partners usually are totally unaware that they have created a common law general partnership until it detonates and then all of the partners are each jointly and severally 100% LIABLE for all the debts and obligations of the general partnership.

Solution to the Stealth General Partnership Problem

The solution to the Arizona common law general partnership problem is to form an Arizona limited liability company and transfer all of the assets of the partnership to the limited liability company then operate the business or own the investment real estate in the LLC.