Structure of a Partnership
A Partnership comprises of two or more self-employed people operating together in a trade or profession. In the event of the death of one of the partners, their next of kin will then be entitled to his or her share of the partnership. This can consist of any capital that the partner had invested in the business and the deceased partner’s share of undrawn profits. In addition they may be entitled to a payment for a share of the goodwill of the business if it has been recognised by the partners as an asset of the partnership.
The Partnership Agreement
Before entering into a Partnership Insurance arrangement, any pre-existing Partnership Agreement should be consulted as this will generally define how the partnership is to be continued by the surviving partners and how the share of capital of the deceased, if any, will be payable to the next of kin.
If no Partnership Agreement exists, the ‘survival’ of the partnership depends on the Partnership Act of 1890, which states that in the event of the death of a partner, the partnership is dissolved and any sum due to the deceased is payable to the next of kin.
In either case the surviving partners face the prospect of having to find a substantial capital lump sum on the death of a fellow partner. If advance provision is not made, the surviving partners may be faced with the need to borrow capital, to fund the repayment to the deceased partner’s estate.
Setting up Partnership Insurance
The approach to arranging the life assurance cover and to quantifying the amount of insurance required will depend on what payments need to be made by the surviving partners. The capital injection and any undrawn profits are relatively straightforward to calculate. The most important factor to be decided is whether or not there will be financial payment in respect of goodwill.
Goodwill can be very difficult to value; it is common for it to be taken as a multiple of the fee income of the firm. Professional advice from the accountant to the partnership is recommended for calculating goodwill.
Where the surviving partners are making a payment in respect of goodwill the Partnership Insurance is normally set up as an ‘Own Life in Trust Arrangement’. If the surviving partners are making no payment in respect of goodwill, there is normally an arrangement of ‘Self Insurance’. There is a third approach known as “Life of Another” which may be useful in certain circumstances. Each of these approaches is discussed below.
Own Life in Trust Arrangement
The steps in setting up an ‘Own Life in Trust Arrangement’ are as follows.
- Each partner effects a life assurance policy on his own life, for a sum assured equivalent to the estimated full market value of his or her partnership share. The premiums are generally paid by the partnership from that partner’s share of profits. There is no tax benefit to either the partnership or the partners in respect of the premiums.
- Each policy is arranged under Trust, so that on death the proceeds are payable directly to the trustees for the benefit of the surviving partners.
- A legal agreement is put in place between the partners. This can be either a Buy/Sell Agreement or a Double Option Agreement.
- A Buy/Sell Agreement obligates the surviving partners to buy the deceased’s share of the partnership at a fair open market value and obligates that next of kin’s personal representatives to sell the share of the partnership back to the surviving partners.
- A Double Option Agreement is a flexible form of the Buy/Sell Rather than a legally binding obligation, it gives the surviving partners an option to buy out the next of kin. It also gives the next of kin the option to sell their share of the partnership to the surviving partners. In either case it is the exercise of the option that creates a binding contract.
- To ensure that there is no Inheritance Tax liability in the hands of the surviving partners certain Revenue Guidelines must be met. These include the need to show that the policies are clearly effected as part of a commercial arms length arrangement and are part of a reciprocal arrangement between the partners. Any surplus not used by the surviving partners to purchase the deceased partner’s share will be liable to Inheritance tax.
- This uses a different approach to compensating the next of kin for the goodwill element. Rather than the other partners compensating the next of kin each partner takes out a policy on their own life the proceeds of which are paid to their next of kin. This is known as “Self Insurance” and may be specified in the Partnership Agreement.
- Each partner takes out a life assurance policy on his / her own life for a specified amount. The amount of cover is set to provide compensation for the “goodwill” element of their share of the Partnership.
- Normal Inheritance Tax rules apply i.e. if the funds go to the spouse of the deceased there will be no liability.
- This method of arranging cover can be tax deductible for the individual partners, depending on the type of policy taken out.
Life of Another
- Under ‘Life of Another’ each partner takes out a policy on the other partner’s lives. This is generally only feasible where there are a small number of partners and the partnership composition is unlikely to change.
On the death of one of the partners each of the others receive the proceeds of their policy which can be used to buy out the next of kin.
Partnership Insurance ensures the future security of the partnership by ensuring funds are available to compensate the deceased partner’s next of kin for his or her share of the partnership.
Goodwill may be defined by the anticipated value of the partnership’s name, tradition and contacts.