Business protection - Partnership and membership protection

Why is there a need for partnership or membership protection?

A partnership

A partnership is defined in section 1 of the Partnership Act 1890 as ‘the relationship which subsists between persons carrying on business in common with a view of profit’. The definition excludes companies or associations registered under the companies acts. There is no longer any limit as to the number of partners a business can have.

Within a partnership, each partner has an interest in the business rather than the ownership of ordinary shares, as would be the case in a limited company structure. In the absence of a partnership agreement, section 33 of the Partnership Act 1890 states that the partnership is dissolved if one of the partners die. The valuation of that partner’s interest is based on their share of the assets of the business.

A limited liability partnership (LLP)

A LLP is a form of legal entity, which is a corporate body formed in accordance with the provisions of the Limited Liability Partnership Act 2000. Each member has an interest in the business, rather than ownership of ordinary shares.

If there’s no membership agreement, section 7 of the Act provides that where a member has died, their personal representatives may not interfere in the management of the business. However, they’re still entitled to receive whatever the member would have been entitled to.

Valuing the partnership or membership interest

The valuation of a partnership or membership interest can be difficult and so we strongly recommended that the partnership or LLP has a formal agreement which sets out how this value will be established and, in the case of the partnership, allows the business to continue in the names of the remaining partners.

Family interests

In the event of the death of a partner or member, the beneficiaries of the estate will usually be their family. They may have no experience of running a business and may not be able to contribute to it in any way. In these circumstances they’ll usually want to withdraw their share of the capital. Having partnership protection in place means the family can receive a fair value for that interest.

Partners’ or members’ interests

The surviving co-owners will continue to run the business with a sleeping partner or member taking a share of the profits. So they’ll be keen to pay the family their share of the business back as soon as possible. Partnership or membership protection means that the partners or members will have sufficient funds to do this.

To be effective, a partnership or membership protection arrangement should consist of three main elements:

1. An agreement setting out how the interest will be valued and the rights of each party.
2. Insurance cover to make sure the funds are available to buy out the interest.
3. A tax efficient structure.

Before reviewing the different types of business agreements in detail, the starting point for any effective partnership or membership protection arrangement should be to consider the individual partners’ or members’ own personal wills.

Why is a personal will relevant to partnership or membership protection?

It’s important to find out who will inherit the interest in the business.

The next step is to consider the timing of any potential purchase of that interest by the other partners or members. It’s in the interests of both the family and the other partners or members to have probate granted on the estate as soon as possible and buy the business interest. A valid, up-to date will can help to achieve this. However, the main reason for reviewing the partners’ or members’ wills before setting up a partnership or membership protection arrangement is to make sure each of the wills is tax efficient.

In particular it’s important to make sure full advantage is taken of any business property relief (BPR) that may be available for inheritance tax (IHT) purposes. BPR is a valuable relief which is available on transfers of business property. It’s subject to certain conditions being satisfied, both as to the type of business and the period the interest has been held. To qualify for BPR, the share in the business must have been owned for at least two years and it must be a trading business (not dealing in securities and land and buildings or making investments).

The rates of relief are shown below. No relief is generally given where a rent is charged for an asset owned personally but used for business purposes.

The bypass trust

A bypass trust is a discretionary trust established in the will of the partner or member. On the partner or member’s death, the value of the business interest would be left to the trustees of the bypass trust to hold in trust for the beneficiaries. No IHT charge will arise at that point if BPR is available. The partner or member can decide who the beneficiaries should be.

In practice, if a partnership or membership protection arrangement has been established in their lifetime, the other partners or members can buy out the interest in the business and the payment can then be placed into the bypass trust. The trustees can then invest the money and pay income, capital or even make loans to any of the beneficiaries including a surviving spouse or civil partner. The benefit of a bypass trust is that it avoids the proceeds of the sale enlarging the surviving spouse or civil partner’s estate on death, thereby potentially reducing the exposure to IHT.

However, it’s not just the individual’s will that needs to be considered. The business needs to have a ‘will’ to determine what happens on the death of the partners or members.

The partnership or membership agreement

A surprisingly large number of partnerships and LLPs have no partnership or membership agreement in place. This is a crucial document that not only sets out how the profits and capital of the business should be shared, it also states what should happen in the event of dissolution of the partnership or LLP, retirement, death or ill health of any of the partners or members.

Any existing partnership or membership agreement must be reviewed before recommending or arranging partnership or membership protection plans to make sure there’s no conflict. There are three main types of agreements that are generally used for partnership or membership protection purposes. These can either be incorporated into the main partnership or membership agreement or they can be contained in a separate deed.

1. Automatic accrual.
2. Buy and sell agreement.
3. Cross-option agreement.

The differences between each type of agreement are discussed in the sections that follow. Regardless of the type of agreement, they should all include the following main points:

• Names and addresses of the partners or members entering into the agreement.
• Details of the business.
• An undertaking to make sure there’s always enough cover.
• An agreement to review level of cover regularly.
• Details of how and who will value the business.
• A fall-back should there be a shortfall in plan proceeds to meet the cost of the share of the business, that is, how will any balance be paid?

It’s important to be aware of the differences between the agreements in order to decide on the one most suitable for your clients’ needs.

Automatic accrual

This type of agreement is only available to partnerships and LLPs and it doesn’t involve an actual sale or purchase of the share of the business. Instead, an agreement is entered into whereby the partnership is allowed to continue on the death of a partner and the share in the business automatically passes to the remaining partners.

In the case of an LLP, the member’s interest automatically passes to the surviving members. The estate doesn’t receive any payment for their interest in the partnership or LLP.

Instead, the individual partners all have responsibility to take adequate life cover in their own names for the value of their share in the partnership or LLP, by way of compensation for their families. Each plan would normally be placed in trust for the benefit of family members so that the proceeds would be outside the estate for IHT purposes.

If all partners or members do this then no IHT liability should arise on the premiums paid where they’re shown to be a part of a bona fide commercial agreement. If the proceeds of a plan are less than the value of the deceased partner’s or member’s share of the business, the agreement would normally require the surviving partners or members to make up the shortfall.

If BPR applies to the value of the deceased’s interest, no IHT will be payable on the transfer to the remaining partners or members.

Buy and sell agreement

The partners or members enter into an agreement whereby, on the death of any one of them, the remaining partners or members must buy the interest in the business and the estate must sell. The purchase of the interest in the business will normally be made by the survivors in proportion to their existing interest but an alternative split can be put in place.

To finance this, generally each partner or member will have an obligation to take out life cover on his own life and write it in trust for the benefit of fellow partners or members. Or, they may be required to take out ‘life of another’ plans on the lives of their fellow partners or members. The merits of each of these options will be covered in detail later in this article.

The major drawback of this buy and sell agreement and the reason it’s seldom used is the potential charge to IHT due to the loss of BPR for qualifying business assets. The buy and sell agreement is treated as a binding contract for sale at the time of the partner’s death. So under the IHT Act 1984 s 113, the partner or member’s interest in the business is not deemed to be business property and so doesn’t qualify for the relief.

Cross-option agreement

This agreement is similar to the buy and sell agreement, but the surviving partners or members have the option to buy and the deceased’s executors have the option to sell. The option period would normally extend to three months from the date of death. If one party wishes to exercise their option, the other party must comply. So, for example, if the surviving partners or members wish to buy the deceased’s interest in the business, their executors have no option but to sell. This arrangement is often known as a double option agreement.

Its major advantage over the buy and sell agreement is that as it only gives the option to buy/sell and is not a binding agreement to sell on the death of a partner or member, business property relief will be available for qualifying business assets. Life cover is set up in the same way as for the buy and sell agreement.

What if critical illness is included?

Critical illness cover for partnership or membership protection can be as important as life cover.

Critical illness can often result in a partner or member withdrawing from the business. Any of the agreements we’ve outlined can accommodate a transfer or sale if someone gets a critical illness.

However, in the case of the cross-option agreement, it would be usual to incorporate a single option on critical illness. The single option allows only the partner who is ill the right to exercise the option. This means that they can’t then be forced out if they feel they’d be able to return to the business once they’ve recovered.

If they fail to return to work after a period of time, it’s also possible to then give the remaining partners the option to purchase.

A single option can also be appropriate in the case of a terminal illness, as it means that the affected
partner or member can’t be forced out of the business. Although they can opt to sell their share if they wish, they can choose to keep it until death, as their share in the business may attract BPR for IHT purposes and no capital gains tax would generally arise on the sale.

Which agreement is best?

This depends on the individual circumstances. Automatic accrual is simple and so it’s a popular choice for partnerships, in particular small firms where the main asset is goodwill. Although the buy and sell agreement is also simple, the loss of BPR can be costly. The cross-option agreement is generally believed to be the most tax efficient. You should always seek separate legal advice.

Valuing the business

All of the above agreements will usually specify how, when and by whom the business should be valued. The client’s accountant will usually be involved in finding the most appropriate method of valuation to use. Partnerships in particular can be difficult to value as much of the value will relate to goodwill.

Common ways to value partnerships and LLPs are:

Average partnership profits

The objective is to reach a figure for the maintainable profits for the business. This usually involves reviewing the accounts for the last three or four years, together with projections of future profits. Any unusual items would normally be excluded from this calculation.

This figure is then multiplied by a suitable factor to give the value of the business. It’s not uncommon to use a factor of between three and six for this purpose.

Goodwill

An agreement can be reached among the partners or members after taking professional advice on a method to value the goodwill of the business.

Net assets

As with companies, the net assets are not always a helpful guide to the firm’s value, but they should be taken into account.

Whichever valuation method is used, it’s important to review it regularly to make sure there’s adequate cover.

Writing the plans

How should the cover be written?

Once an appropriate agreement has been drafted and a valuation determined, the next step is to consider how best to write the cover.

In the case of automatic accrual, the plans will be written on an own life basis and placed into trust for family members.

However, where the proceeds are needed to be paid to the other partners or members in the business to allow them to buy the interest, there are two options available – own life in trust or life of another.

Trusts

Should cover be written on a life of another basis or on own life under business trust?

Writing a plan as life of another is the simplest option as it doesn’t involve trusts or equalisation of premiums. Premium equalisation is covered in more detail later in this article. However, if there are a number of partners or members it can mean there are lots of different plans in place.

If, for example, there are four partners then each partner would need to take out a plan on the life of each of their fellow partners, resulting in twelve plans being written. There could also be problems in proving insurable interest.

While at first it may seem complicated to take out a plan of which the partner or member is the applicant and the person covered, and then place it in trust for the benefit of their fellow partners or members, it does have some major advantages.

The first is that fewer plans are needed. For example, if there are four partners then each partner would need to take out one plan only on their own life. So only four plans and four trusts would be needed.

This option also allows flexibility to include partners or members at the time of death, not just at the outset.

So new partners or members can benefit, subject of course to them effecting cover in trust on the same basis. Where a partner or member leaves the business, then typically the trustees can assign the plan back to the leaving partner or member and they can continue to pay the premiums themselves.

Another reason why the trust route may be the preferred option is if critical illness is included in the plan. If the person covered suffers a critical illness they may decide to stay on within the business. If the plan is set up on a life of another basis, the proceeds will be paid to the owners of the plan, that is, the other partner(s)/member(s). The partner or member who has suffered the critical illness will have no control over the proceeds.

However, if they’ve set up the plan on an own life under trust basis, as settlor and trustee they would have a degree of control over the proceeds. For example, the money could be invested within the trust and could then be used to buy their interest at a later date when the need arises.

Are there any disadvantages with the own life in trust option?

There are two main drawbacks of the own life in trust option. The first is that to make sure the transaction is commercial, premiums need to be ‘equalised’ so that each partner or member pays a commercial amount relative to the benefit they may receive (IHT Act 1984 s10).

If premiums are not equalised, then the difference in premiums paid (caused by the partners’ or members’ differences in age, health and size of stake in the business) could be deemed transfers of value for IHT purposes. This may not matter if the difference is small, because of annual IHT exemptions.

However, the position in the event of a claim can be more dramatic. In this case, the arrangement wouldn’t be completely commercial or in other words would involve gifts. This then raises the possibility of an IHT charge on the proceeds under the gift with reservation legislation.

For a three-man partnership the formula shown below would be used to work out partner A’s equalised share of premiums to be paid. The same principle would be applied for partners B and C and then the three partners would arrange between themselves to settle the differences in premiums actually paid.

The other disadvantage of using the own life in trust route is that advisers need to be aware of the potential impact of the pre-owned asset tax charge (POAT) which came into effect on 6 April 2005.

This is a charge to income tax which applies where a person can benefit from an asset they used to own. The new charge is designed to counter IHT planning arrangements that bypass the gift with reservation of benefit provisions, yet still allow the settlor to benefit from the asset given away. The tax charge applies to the annual benefit they enjoy.

The method of valuing the annual benefit varies depending on the type of asset. However, no tax charge will arise where the annual benefit is £5,000 or less. If it’s more than £5,000, the full amount is added to the individual’s other income for the tax year and is subject to tax at their marginal rate.

Unfortunately, using business trusts for partnership or membership protection falls foul of the POAT provisions since they include the settlor as a potential beneficiary (by virtue of them being a partner or member in the business). The trust isn’t caught by the gift with reservation of benefit provisions as it’s
part of a commercial arrangement but a POAT charge may apply as there’s no similar exclusion under the legislation.

Having said that, in many cases any annual benefit would be within the limit of £5,000. Since the trust asset is a protection policy, the annual benefit will be calculated as 2% (this is the official rate of interest, which may be subject to change) of the ‘open market value’ of the policy. While the person covered is in good health the open market value would be negligible, so the charge should not apply.

Where it may become an issue for the settlor is if they suffer from a critical or terminal illness and the funds sit in the trust for any length of time (for example, if they decide not to sell their business interest). In that case, the value of the trust fund will be considerably higher and so 2% may exceed the limit.

Any potential tax charges can be avoided if the settlor is removed as a potential beneficiary from the trust.

We generally recommend that the settlor should only be removed as a beneficiary when a payment is to be made to allow flexibility within the trust to assign the plan back to them should they leave the business.