Buy Sell Agreement Partnershi by ncj94858


More Info
									      Life and Health Insurance 2010/11

      Chapter 13
      Partnership protection
      1 The need for partnership protection insurance
      When a partner in a business dies, ownership of their share passes to their
      estate. The beneficiaries will usually be his or her widow/er and/or children
      who may not understand the business or be able to contribute to it. Indeed,
      they may wish to withdraw their share of the capital. If they want to keep their
      shares, part of their financial future will be provided by the profits of a business
      over which they have no effective control.
      The surviving partners may have to continue the business with a sleeping
      partner who makes no contribution to the earning capacity of the business, but
      takes a share of the profits. Furthermore, the sleeping partner will have a share
      in a business in which he or she has no interest and will not be able to influence
      any future income stream.
      It may therefore be in everyone’s best interests for the surviving partners to
      buy out the beneficiaries’ interest in the partnership. The deceased’s family
      will receive a cash settlement, and the surviving partners are able to keep full
      control of the business and continue to run it as they wish. This can best be
      achieved if there is a proper agreement in force that ensures cash settlements
      are made to the right people at the right time.
      Ideally, all partnerships should have a written agreement to provide a
      framework for the business and to help avoid disputes. The agreement should
      cover what will happen on the death of a partner and give the surviving
      partners legal rights to buy their share and set out an agreed basis for valuing
      the share.
      Having the right to buy the share of a deceased partner is of little use if there
      is no ready cash available; it is often the case that the surviving partners have
      no capital resources other than those already tied up in the business. Life
      assurance is therefore a necessity (available for a modest cost) to provide cash
      on the death of a partner to enable the business to continue. This chapter looks
      at the different types of partnership protection plans available and goes on to
      examine the problems of retirement.

      2 Definition of a partnership
      A partnership is defined in Partnership Act 1890, s1 as ‘the relationship which
      exists between persons carrying on business in common with a view of profit,
      other than by way of membership of a body corporate’. It is therefore the
      carrying on of a business by two or more individuals without using a company.
      There is no longer any limit on the number of partners a partnership may have.
                    4: Business uses of protection – 13 Partnership protection

Each partner owns a share of the capital and goodwill of the partnership and
takes a share of the profits. In the absence of any agreement to the contrary, a
partnership is automatically dissolved on the death of a partner in accordance
with the terms of the Partnership Act 1890, s33.

3 Limited liability partnerships
A limited liability partnership (LLP) is halfway between a partnership and a
limited company. It is a body corporate which has a legal personality, separate
from the partners, and so can own property in its own right. It has to be
registered with the Registrar of Companies and, like a company, must have
a registered office. In most other respects it is like an ordinary partnership.
In particular, it is taxed as a partnership and the partners are self-employed
individuals, not employees of the LLP. The interest of a partner qualifies as
business property for IHT purposes, but the liability of the partners is limited
to the amount subscribed for the LLP.
The partners are not liable for the trade debts of the partnership in their own
personal capacity.
The methods of partnership protection explained below are as applicable to
LLPs as to ordinary partnerships.

4 Partnership protection plans
Because life assurance is a vital part of partnership protection, many life offices
offer partnership protection plans for use with their policies. Details vary from
office to office, but there are basically three types of plan:

•   Cross-option.
•   Automatic accrual.
•   Buy and sell.

These will now be dealt with in turn but the following points should be
considered before any plan is taken out:

•   Does it give rights for all parties to carry out the scheme?
•   Does it put the right amount of money in the right hands at the right time?
•   Does it ensure there will be no income tax on the proceeds?
•   Does it avoid any inheritance tax (IHT) liability?
•   Is the cost distributed fairly among the parties?

The cross-option method
This method, sometimes called the double option method, consists of an
option agreement between the partners backed up by policies under trust. The
      Life and Health Insurance 2010/11

      surviving partners have an option to require the deceased partner’s estate to
      sell, and the estate has a corresponding option to require the surviving partners
      to buy, within a specified period from the death. If either party exercises the
      option, the other party must comply. The period during which the option can
      be exercised would be, say, three months.
      The surviving partners will buy the deceased partner’s interest in the
      proportions to which they are already entitled to the balance of the partnership.
      If there are four partners each with a 25% interest in the business, then on the
      first death the survivors would each buy one-third of the deceased’s interest, so
      that the same ratio would be maintained between the survivors.
      Because the parties only have options to buy and sell, the agreement is not a
      binding contract for sale and so the interest of a deceased partner will still be
      eligible for business property relief for IHT purposes.
      The agreement will specify that each partner must effect and maintain a life
      policy to provide the sum required to purchase their interest, and will provide
      for the valuation of that interest on death. The policy will usually be under a
      special cross-option trust, with other partners also being trustees.
      While double options are generally used for life cover, they are less appropriate
      for critical illness cover (CIC). A partner who is eligible to make a claim under a
      critical illness policy may not wish to sell their partnership interest because:

      •   Their health is such that they can expect to continue working, eg after a
          mild heart attack.
      •   They do not want to be faced with a large capital gains tax (CGT) bill on
          selling their interest in the business.
      •   They do not want to convert a 100% IHT relievable asset into unrelievable

      To overcome these problems it is common to use a single option agreement
      alongside CIC, giving the critically ill partner the option to sell (a put option),
      but not providing their fellow partners with the option to buy (a call option).
      The option agreement can therefore become a long document, with different
      clauses applying on death or a claim under a critical illness policy.
      A single option agreement for CIC may not always be advisable, because a
      partner who thinks they can recover from their illness may not actually be able
      to do so. If they cannot recover fully, they may not be able to pull their weight
      in the business, and their partners may wish to be able to force them to leave. A
      double option agreement with different option periods could therefore be the
      most appropriate approach. The ailing partner could have an option to force a
      buy-out in the three or six months following diagnosis of the illness. The other
      partners could have an option to force a buy-out but only exercisable after a

                 4: Business uses of protection – 13 Partnership protection

suitable period has elapsed since diagnosis (eg one or two years); by that time
the final situation should have been clarified so as to enable a sensible decision
to be made.
When a partner dies or becomes the subject of a critical illness claim, the
trustees will claim the money from the life office and pay the proceeds to the
surviving partners. They will then use that money to buy out the share of the
deceased or critically ill partner.
Specimen agreements are usually offered by life offices on the basis that they
are suggested drafts for use by the partnership’s solicitors, because they will
have to be consistent with any existing partnership agreements.
The trust used generally only allows the other partners to benefit. It is possible
for the settlor to be a potential beneficiary in case he or she ever needed to
recover the policy. This could happen if, for example, the partnership broke
up or went out of business for any reason while the policy was still in force. If
that happened, then each partner could be appointed the sole beneficiary of the
policy on his or her life. The policies could then be continued and used for any
other purpose, with the other partners retiring as trustees.
Normally, including the settlor as a potential beneficiary under the trust
would make the transaction a gift with reservation, but that would not
apply in this case as the whole arrangement would be a bona fide commercial
arrangement. Partner X is only putting his or her policy in trust for Y and Z
because they are putting theirs in trust for him or her as part of a commercial
arrangement. There is no donative intent. As it is not a gift, it cannot be a
gift with reservation. However, the rules for pre-owned assets tax (POAT)
(see section 7), now mean that to name the settlor as a potential beneficiary
could mean that a tax liability arises in certain limited circumstances. In
any event, a partner’s spouse and family should not be included as potential
beneficiaries, because this would create a gift with reservation by destroying the
commerciality of the arrangement.
Any new partners joining the firm would normally be automatically included as
beneficiaries of the existing policies.
Any new partner would, of course, have to sign a supplemental agreement and
effect and maintain a policy on his or her own life under trust for the existing
partners. Possible future changes in the name of the business can be coped with
by the use of the words ‘and their successors in business’.
The sum assured under each policy should be the amount required to meet the
value of the life assured’s share of the partnership on death.
The life policy used should be a term assurance to the expected retirement date
of the partner. When a partner dies, the trustees will claim the money from the
life office and pay it out proportionately to each surviving partner to enable

      Life and Health Insurance 2010/11

      them to purchase their part of the deceased’s share from the estate, under the
      option in the agreement.

      Illustration of cost
      Example 13.1 is an illustration of the cost of a cross-option plan, showing how
      the scheme can work.

         Example 13.1
         The Hans Christian Andersen Partnership Capital £400,000
          The partners
          Mr Hans                            Age 50                  Share 50%
          Mr Christian                       Age 40                  Share 30%
          Mr Andersen                        Age 30                  Share 20%
          Normal retirement age              Age 65

          The policies
          Level term assurance      Mr Hans           Mr Christian     Mr Andersen
          Policy term in years         15                 25                35
          Sum assured               £200,000           £120,000          £80,000
          On trust for            Mr Christian &       Mr Hans &       Mr Hans &
                                  Mr Andersen         Mr Andersen      Mr Christian
          Annual premium              £736               £248             £115
          Total premiums                                                 £1,099

      The tax situation
      Because each policy is qualifying or has no surrender value, there will be no
      income tax liability on the proceeds. Neither will there be CGT, because the
      proceeds are payable to the original beneficial owners – the other partners.
      If all the partners take part in the arrangement, there will be no IHT either at
      outset or when further premiums are paid. This is because it can be claimed
      that the arrangement is a bona fide business transaction for full consideration
      with no gratuitous intent (Inheritance Tax Act 1984 (IHTA 1984) s10), full
      consideration being the fact that all the partners are participating. There will
      be no IHT on the policy on death, since no transfer of value has occurred.
      There will be no IHT on the partnership share on death, because 100% business
      property relief applies. If the settlor is excluded as a potential beneficiary, there
      will be no potential POAT liability.

                 4: Business uses of protection – 13 Partnership protection

Distribution of cost
In most partnerships, the ages of the partners are not equal. However,
premiums under life assurance policies are, of course, largely based on age and
therefore the older partners will be paying higher premiums but will be less
likely to benefit, since they are more likely to die. There will be some inequality
of cost but, because term assurances are being used, the amounts may well
be minimal. It should be remembered that in any partnership arrangement
there will always be some element of give and take, although it is possible for
the differential in cost to be adjusted according to an agreed formula. Any
adjustments can then be made by way of cash payments between the partners.
These will normally be small enough to be exempt from IHT under the small
gifts or annual exemptions. Alternatively, it could be claimed that they were
exempt as a bona fide commercial arrangement.

   Example 13.2
   An example of a distribution of cost formula applied to a three-man
   partnership of A, B and C.
   The cost A should pay is the sum of the following:
                   Sum assured on A × B’s premium
                 Total sum assured − sum assured on B
                                Sum assured on A × C’s premium
                              Total sum assured − sum assured on C
   The same principle can be applied to B and C.
   Having worked out the costs that each partner should bear, it is then a
   simple matter to ascertain what payments need to be made between the
   partners to achieve equity. This can be illustrated using the Hans Christian
   Andersen Partnership referred to earlier in example 13.1.
   The cost Hans should pay is the sum of:
               Hans’s sum assured × Christian’s premium
              Total sum assured − Christian’s sum assured
                           Hans’s sum assured × Andersen’s premium
                          Total sum assured − Andersen’s sum assured
                     200,000 × 248      200,000 × 115
                   400,000 − 120,000   400,000 − 80,000
                              49,600,000   23,000,000
                               280,000      320,000

                                  177.14 + 71.87



To top