What is a De Facto Partnership?
A de facto partnership, sometimes called an “Ad Hoc Partnership”, is an informal business arrangement between two or more parties. It is a spontaneous and flexible business relationship that is often formed without any written agreement. A de facto partnership is generally used to pursue a common goal or to complete a business task.
Such an arrangement is typically governed by a Partnership Act in most states.
How is a De Facto Partnership formed?
De facto partnerships are formed simply by “mutual agreement”. Essentially, two or more parties agree to collaborate in a specific task or to pursue a common goal. There is no need for the parties to sign a contract or to formalize the agreement.
It’s not necessary that you “formally agree” to create a company or a business. This is the trap: Simply by acting or doing things towards a common goal, you trigger a de facto partnership.
The Legal Dangers of a De Facto Partnership
Strong Possibility of Disputes Between Partners
The lack of a written agreement can be a major legal danger when it comes to de facto partnerships. Without a written agreement, the parties involved in the de facto partnership may not have a clearly defined understanding of the terms of the de facto partnership. This can create numerous situations for conflict, for example:
- One party may feels they have not been properly compensated or they have not been adequately recognized for their contribution.
- What happens if a party wants to leave the de facto partnership? Must they be bought out, and if so, for how much? Can they start a competing business?
- What happens if a party felt they were just “experimenting,” but didn’t actually intend to enter into a long-term business arrangement with someone else? That someone else doesn’t contribute, but comes back later claiming their ownership interest in the business by claiming a de facto partnership?
Additionally, de facto partnerships often involve the sharing of confidential information or resources. If the partnership is not properly managed and documented, it can lead to disputes over ownership of the resources or the disclosure of confidential information.
Significant Liability Exposure
The lack of a written agreement can also create legal problems when it comes to liability. If something goes wrong in the course of the de facto partnership, the parties involved may be held liable for their actions. For example, if a partner driving somewhere in furtherance of the de facto partnership, and get into an auto accident where someone is critically injured or killed, all the partners of the de facto partnership could be held liable for the harm caused by that one partner.
This is true, even if that partner didn’t have authorization to do the act that brought about the injury, or they were told not to do something but did it anyway. This means that liability exposure can be acute with irresponsible or immature partners.
De facto partnerships automatically terminate upon the death or incapacity of a partner.
This can create all sorts of difficult circumstances for a business upon the death of a partner. For example, assets of a partnership aren’t owned by the partnership, they are owned by the partners themselves. When a partner of the de facto partnership dies, it’s not uncommon for the estate (i.e. family) to attempt to take possession of the dead partner’s assets, and oftentimes will drain bank accounts, sell off company assets, and more, without consultation of the other partner (or partners).
Also, because a de facto partnership has no agreement between the partners on termination or exit from the partnership, it creates uncertainties as to whether someone can leave, and if they do, what happens. This is especially difficult for the more productive partners of the de facto partnership, who may not be satisfied with the efforts of the less productive partner (or partners) and wants to go out on their own.
How to Avoid Forming a De Facto Partnership
A signed agreement between the partners indicating something as simple as, “It is the intent of the parties to this Agreement that no partnership is formed, while the parties research and evaluate the ‘business idea’, and that a partnership will only form upon a formally written document evidencing such.”
It would be better to form a limited liability company (or LLC), where an Operating Agreement is utilized. Such an Operating Agreement serves as a Partnership Agreement.
As an aside, this is why it’s important to form your company with an attorney or law firm (like Law 4 Small Business) — because you need a high-quality Operating Agreement to serve as the basis of your Partnership Agreement. A poor template provided by an Internet company could actually do more harm than good.
If you’ve already formed your LLC, but don’t have a good Operating Agreement, consider our Couture Operating Agreement. For only $29, we give you access to our expert system that drafts a high-quality Operating Agreement for you.