Your Financial Architect’s guide to Partnership &
Shareholder Business Protection
Introduction
A partnership can be an effective method of pooling resources
and skills to the financial advantage of all concerned. However,
it brings with it responsibilities and the possibility of
financial burden, especially when one of the partners dies,
retires or becomes incapacitated. For a partner, his share
in the business is likely to be his greatest financial asset
so he needs to take steps to protect it, not only for the
benefit of his family but also for the benefit of the other
partners in order to help ensure the continuation of the business.
The directors of private limited companies are in a similar
position.
Business Protection Plans, based on a suitable legal arrangement,
can provide a simple and tax-efficient way to protect the
interests of partners and shareholders. This guide aims to
show how this may be achieved.
Business Protection Needs and Solutions
The business protection needs for partnerships are twofold:
1) ensuring that, when a partner leaves
through any cause, the remaining partners are able to continue
the business, whilst maintaining control, and without undue
financial strain.
2) ensuring that when a partner leaves the
business he or his family are adequately provided for.
These problems may arise when a partner dies, retires or
becomes incapacitated as the following sections demonstrate.
Death
When a partner dies, the deceased's share of the business
will normally form part of his estate for the benefit of his
family. Whilst some companies may have restrictions within
their memorandum and articles of association limiting share
ownership to certain individuals and determining who has the
initial right to acquire shares, it will be assumed that the
shares pass in the first instance to the family.
The family then has two alternatives:
i) A member of the family could take over
the deceased's position as partner or appoint someone to act
on their behalf.
ii) Realise the value of the share by selling
it.
Both these alternatives can present problems to the family
and those remaining in the business. Under alternative (i)
a member of the family may not want to become involved in
the business or may not have the right experience or qualifications
to do the job. The family could also have a problem? finding
someone who would be willing and able to act on their behalf
in the business. For those remaining in the business, alternative
(i) may not be attractive -they might, understandably, be
reluctant to invite a member of the family to become a partner
or a member of the Board, especially if that person does not
have the relevant experience. This would particularly apply
if the family had only a minority shareholding in a company
or if the deceased's shareholding had been split between a
number of beneficiaries on his death
Alternative (ii) would probably be preferred by both the
family the remaining partners if the family could sell the
share back to the business.
This, however, relies on the business having funds available
for the purchase. The business may have to resort to liquidating
some assets, borrowing the money or trying to find a replacement
partner itself to buy out the family's share. It is not certain
that any of these options will be open to the business, depending
on its circumstances. For example, if one of the partners
in a computer software development business died and was the
technical expert behind the success of the partnership, there
may be few assets, if any, to liquidate, he be may extremely
difficult, if not impossible, to replace and the bank may
not be willing to make a loan to the remaining partners if
they do not see the business as being viable without the technical
expert.
For the family, the sale of their share may present real
difficulties if the remaining partners are unable, or unwilling,
to buyout the share within a reasonable period of time. Shares
of partnerships and small private companies are not generally
readily saleable and even if the family did find a buyer,
they may not get the price they thought the share was worth,
especially if it is a minority share. Of course, if the family
did sell their share to a third party it would be likely to
lead to difficulties for the remaining business and possibly
a takeover or merger, depending on the size of the share held.
Ultimately, if the family and the business cannot resolve
the situation satisfactorily, it may lead to the business
being forced into liquidation, with both sides coming out
poorly.
Solutions
A carefully written Shareholder/Partnership agreement will
ensure that on the death of a partner a lump sum will be immediately
available to the remaining partners, enabling them to buy
back the share from the family, remain in control and ensure
the continuation of the business. Such a plan would consist
of Life Assurance Plans combined with a share purchase agreement.
Retirement
When a partner wishes to retire from the business, he will
need a retirement income. If this income is to be provided
by cashing in his share of the business, he and the remaining
partners will face many of the same problems that would occur
on the death of a partner as outlined above. Of course, having
been closely involved in the running of the business, the
retiring partner is more likely to have the interests of the
business in mind than the family of a deceased partner, but
the situation will still be difficult if the retiring partner
requires the cash sum and the remaining partners are not able
to buy out his share.
Some partners will want to retain some involvement in the
business even after they have retired, so may choose to leave
some or all of their share in the business or encash it in
stages over a number of years. This scenario is likely in
a family-run business or where the retiring partner is making
way for his son or daughter. In this situation, the partner
will require an independent source of retirement income.
It is not uncommon for a partnership agreement to stipulate
that each partner will effect a personal pension, sometimes
also stating a required minimum contribution. This 'encourages'
each partner to make sensible and adequate provision for his
own retirement rather than for the partnership to feel obliged
to make payment at a later date.
Solutions
Again, where the partners intend to cash-in their share on
retirement, a suitable Shareholder/Partnership agreement will
help ensure all goes smoothly and the business will continue.
Individual pension arrangements would normally be the recommended
product solution where the partner plans to retire but leave
his share in the business or when directed to take out such
a plan in the underlying agreement.
Disability
Not only do partnerships have to plan for a partner's retirement
or death, they also have to consider what would happen if
a partner becomes disabled.
The long-term disability or critical illness of a partner
could lead to severe financial problems for both the business
and the partner concerned; the partner would not be contributing
to the daily running of the partnership, but would still be
drawing his income in the short term. In the long run, the
partner may never be able to return to work so would require
another source of income to maintain his standard of living.
If the partnership has a partnership agreement it would normally
specify what would happen if a partner becomes incapacitated.
Quite often, he will be treated as prematurely 'retiring'.
Given this, the partnership will face many of the same difficulties
as when a partner retires at the normal age, but without the
benefit of knowing the 'retirement date' in advance.
To overcome this potential problem, a clause can be written
into the partnership agreement stipulating that each partner
effects and maintains a plan to provide income protection.
Solutions
Again, a suitable Shareholder/Partnership agreement will
help ensure all goes smoothly and the business will continue.
Appropriate Income Protection plans would normally be effected
to provide the continuing income.
Calculating the Amount of Cover
The amount of cover required under a life plan effected to
buy out a partner's share on death or retirement will obviously
be the value of that share as follows:
Partnerships
The value of a partner's share will consist of:
 the capital value of the partner's share in the
business plus the value of his share in any other assets,
such as property
the value of the partner's share of the business
goodwill if this is included in the partnership accounts
the estimated value of any undistributed profits
at the date of death or retirement as appropriate.
'Goodwill' can be described as 'the value of a business reputation
and the likelihood that the customers will continue to be
attracted, notwithstanding a change in proprietorship'. In
some partnerships (eg accountancies), goodwill, in the form
of the firm's reputation and client list, will be far more
valuable than any tangible assets.
The valuation of the components of a partner's share would
normally be undertaken by the partnership's accountant, or
other professional adviser, in conjunction with the partners
and with reference to the method of valuation as set out in
any partnership deed.
Private Companies
The valuation of the shares of a private company may be relatively
straightforward, such as in the case of a recently formed
company, or it may be more complicated, depending on the type
of company and the complexity of its operations.
The valuation should be undertaken by a professional adviser,
accountant or solicitor, with reference to the memorandum
and articles of association. If the company has any report
and accounts (see 'Guidance on Financial Underwriting' below),
this will be a useful guide to a company's value.
Note
Periodic reviews of the amounts of cover should be undertaken
to ensure that the cover provided under the various plans
still meets the share protection requirements. Share purchase
arrangements for partnerships should be reviewed whenever
a partner leaves or a new partner joins the business.
Arranging the cover
The Legal Framework
There are a number of possible Shareholder/Partnership plans
that can be used and the particular one that is recommended
will depend upon the individual circumstances of the business
or partnership.
The suitability of a Shareholder/Partnership plan should
be assessed with reference to the following criteria.
Money must be in the right hands
- those who will need the cash must have it available - and
at the right time.
Equitability - the cost of providing
the capital should be distributed fairly amongst the partners.
Flexibility - the plan must be
sufficiently flexible to take into account future changes
in the constitution of the partnership.
Tax efficiency - the plan should
be designed to avoid or, where that is not possible, to minimise
the effects of inheritance tax (IHT), capital gains tax (CGT),
corporation tax and income tax.
A Shareholder/Partnership plan consists of:
a written Shareholder/Partnership agreement
a series of suitable insurance plans
The Shareholder/Partnership agreement provides detail on
what will happen to each partner's share on death, retirement,
etc and the insurance plans provide the money to carry out
the provisions of the agreement. To ensure the Share Protection
Plan is effective, it is vital that the insurance plans are
underpinned by a Shareholder/Partnership agreement.
The Shareholder/Partnership agreement will generally form
part of the partnership agreement in respect of partnerships
and the articles of association in respect of private limited
companies.
Common Types of Shareholder/Partnership agreement
Clearly given the number of businesses in existence, one
can expect to encounter many types of agreement, formal and
informal, often specifically dovetailed to what may be the
relatively unusual circumstances of a particular concern.
However in practice there are three agreements commonly encountered.
These are as follows:
Buy and Sell
Double Option (sometimes also referred to as a Cross
Option)
Automatic Accrual
Buy and Sell Agreements
This method consists of two elements, namely the plan and
an underlying legal agreement. Each partner is party to a
Buy and Sell agreement. Under the agreement, each partner
agrees to two things:
That on his death, his executor/s will sell his
share of the business to the surviving partners.
On the death of a partner the surviving partners
will buy the deceased's share.
The capital to purchase the share is provided from
the proceeds of a life plan. The sum assured should be equivalent
to each partner's share of the business.
The plans are set up on a 'own life' basis under
a business trust for the benefit of the remaining partners.
Buy and Sell agreements provide 'the money in the right hands'
and can be equitable (see 'Sharing the Cost' section), flexible
as regards to beneficiaries and, because of their compulsory
nature, certain in effect. However, the taxation disadvantages
of Buy and Sell agreements make them an unattractive option
in most cases. This is because IHT business property relief
is not available where the business interest is subject to
what is known as a binding contract for sale. A Buy and Sell
agreement is regarded as a binding contract for sale. Given
that in many circumstances IHT business property relief is
available at a rate of 100% it can be a costly advantage to
sacrifice. The problem with the availability of relief has,
in most cases, seen Buy and Sell agreements replaced by Double
Option agreements.
Double (or Cross) Option Agreements
A Double Option agreement is incorporated into the partnership,
under which the following is agreed:
The surviving partners have an option to buy the
deceased's share of the business within a specified period
of time.
During that period, the estate has a duty not to
sell the share to any other party. In addition, they have
an option to insist on purchase by the surviving partners.
If one party exercises their option, the other party must
comply. Only if neither party chooses to exercise their respective
option will the share of the business remain with the family.
Again, the capital to purchase the share is provided from
the proceeds of a life plan. Each partner effects an 'own
life' plan set up under a business trust for the benefit of
the remaining partners which ensures 'the money is in the
right hands'. The sum assured should be equivalent to each
partner's share of the business. The cost of providing the
capital through life plans can be made equitable (see 'Sharing
the Costs' section later).
Double Option arrangements are also flexible enough to cope
with new partners. The new partner would complete a supplemental
Double Option agreement and effect a life plan on his own
life under trust for the benefit of the other partners. Also,
if the correct trust form has been used, the new partner will
automatically become a beneficiary of the plans effected by
the existing partners.
The Double Option agreement method of share protection is
very tax efficient in respect of plan premiums and proceeds.
In addition, the problem with IHT business property relief
encountered with Buy and Sell agreements does not arise, as
the 'optional' nature of the agreement means it is not a binding
contract for sale.
Double Option agreements are the most commonly used and accepted
method of setting up partnership or shareholder share protection
arrangements.
Whilst many existing Double Options are appropriate for covering
the death of a partner, until relatively recently most have
not specifically catered for the critical illness of a partner.
If such cover was simply dealt with under the terms of a 'standard'
Double Option agreement the following issues could arise:
reaching a satisfactory conclusion relies on the
total agreement of all parties at a time when the ill partner's
personal interest may not be compatible with his partners'
view of the best interests of the business
the critically ill partner could be forced to give
up their share in the business by the continuing partners
even though he may be able to continue working in the future.
there may be severe capital gains tax implications
if either retirement relief and/or business asset taper relief
are unavailable or are insufficient to reduce the chargeable
gain on the ill partners disposal of his business share to
the continuing partners.
To cater for the critical illness cover it is increasingly
common to see either incorporated within the Double Option
agreement or as a separate standalone document a Single Option
agreement giving the critically ill partner the option to
sell his shareholding with no reciprocal option for his fellow
partners to buy.
Suitable insurance plans.
The most appropriate type of policy/ies will depend on the
individual circumstances of each partnership or Company. Therefore
advice from an appropriately qualified Independent Financial
Adviser should be obtained.
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