Business Life After Death

With a partnership protection strategy, it is possible to reduce the impact of the loss of a key partner on a firm, says Matt Haswell.

If a business partner dies or becomes ill, failure to protect a firm and its partners could have dire consequences.

The death or critical illness of a business partner can cause considerable disruption to a firm. In addition to the emotional turmoil and potential knowledge gap triggered by a death, there are the financial implications to consider.

A partnership may have debts repayable upon the death or critical illness of a partner, including bank overdrafts, hire purchase agreements, bank loans and a partner’s capital account. Therefore the remaining partners will need to decide what happens to the deceased’s share of the business and resolve any problems relating to the deceased’s spouse or estate.

A suitably structured partnership protection strategy can ensure that the business remains in the control of the active partners while assisting the deceased’s dependants. Partnership protection allows business continuity by ensuring that a commercial purchase price is obtained for the deceased partner’s share of the business, payable to his/her spouse or estate, without undue delay.

What happens if a partner dies?

Most conventional situations of this type are dealt with under the Partnership Act 1890, whereby, on a partner’s death or retirement, the partnership must be dissolved unless the partnership agreement advises to the contrary.

The deceased partner’s share will pass to his/her estate, which could mean the partnership share going to the deceased partner’s spouse. This might present some serious problems. For example, the spouse could end up owning a share in a business that he/she does not want. In turn, the continuing partners will have a partner who cannot or does not want to participate in the business. Another likely scenario is that the spouse needs income and wants to sell the inherited share. The surviving partners could then face the possibility of a replacement partner who they did not choose. So, ideally, the remaining partners need to acquire the deceased partner’s share.

What should a partnership agreement include?

A partnership agreement should detail how the firm’s profits are to be shared, the duties allocated to the various partners, and how to treat intangible assets and goodwill. Consideration should also be given to what would happen to a partner’s capital account and share in the business if he/she leaves or dies. If it is not already in place, a partnership agreement should be drafted under the direction of a solicitor.

It is important to assess the current provisions of the partnership agreement to understand the clauses that would operate in the event of the death of a partner, particularly regarding any restrictions on the disposal of shares in the business. There are various methods that could apply, namely automatic accrual, a buy and sell agreement or a double option agreement.

Under this type of arrangement the partners agree that in the event of one of them dying, his/her interest in the business will pass automatically to the remaining partners. This ensures that control of the business is retained by those people with the necessary skills and experience to continue to manage it as before.

However, it is important that the deceased’s heirs are financially compensated as, in many cases, the value of the late partner’s share may form a major part of his/her estate and the value of this inheritance could be lost to the heirs.

This is a written agreement stating that the deceased’s share of the business must be sold to the surviving partners who must purchase it. Although this is a relatively simple agreement, it should be borne in mind that business property relief available for inheritance tax purposes will be lost if such an agreement is used as it constitutes a binding agreement of sale.

This is generally accepted as the most appropriate arrangement in normal circumstances. It is similar to a buy and sell agreement in that an agreement exists, but as an option rather than a legal obligation.

In the event of either the surviving partners or the heirs wishing to exercise their buy and sell option, the other party must comply. HM Revenue and Customs (HMRC) does not see a double option agreement as a binding contract for sale, so there is no loss of business property relief for inheritance tax purposes.

Adequate cash resources must be available to allow remaining partners to purchase a deceased partner’s share in the business. The most effective way of doing this is for each partner to take out a life assurance policy on his/her own life and for the policy to be placed into a specially designed partnership trust arrangement that favours the remaining partners.

In the event of a partner’s death, the policy proceeds would be made immediately available to the trust’s beneficiaries, free of any inheritance tax liability. The trust deed must be drafted to allow the monies to pass to the partners in proportion to their interest at the time of the death. This means that the trust will automatically adapt to take account of new or retiring partners and any changes in the partnership structure.

The types of policies normally used in connection with such agreements are level term assurance policies or whole of life policies. The level term assurance option provides low-cost life cover and is normally written to the partner’s expected retirement date. Naturally, it is important for such provisions to be reviewed frequently throughout the term of the policy to ensure that the cover represents a realistic valuation of the partner’s interest.

A whole of life policy provides cover throughout the partner’s life. On retirement the terms of the trust allow the policy to revert to the partner and may form part of the provision for the partner’s dependants.

Another aspect of this type of policy is the provision of benefits in the event of a partner suffering a critical illness, which could mean that the partner is unable to work or may no longer wish to participate in the running of the business. Such a policy would enable the remaining partners to buy that partner out and retain effective control of the business. It would also relieve the critically ill partner of some of the financial worry. This type of cover is available as an extra benefit to a whole of life policy or on a temporary basis as a policy in its own right.

Great care should be taken in selecting a suitable product and provider. When selecting the most suitable policy for partnership protection, partners should make sure that:

• sums assured are indexed

• cover increase and extension options are available

• the premium basis is guaranteed or reviewable

• there is availability of critical illness cover

• competitive premiums are secured

• taxation of policy proceeds is efficient

• the term and level of cover required is sufficient.

All businesses have key people whose particular skills, knowledge, leadership or experience contribute to their continued financial success. This is why it’s essential to have a well-defined partnership protection strategy in place to guard your company’s profitability.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.