UK farms are frequently operated on the basis of a partnership structure, with family members joining the partnership as they become part of the business. However, commonly, either the agreement on which they rely is out of date or no partnership agreement is in place, with family members relying on the strength of their relationship and simply noting the partnership in the annual accounts of the business. So why is it important to have an up-to-date partnership agreement?
- Partnership property
From an inheritance tax (IHT) perspective, there are major implications if it is not clear whether the land, buildings and farmhouses from which the farming business operates are partnership property or owned personally outside the partnership.
On death, agricultural property generally is eligible for agricultural property relief (APR) at 100%, but this is only on the agricultural value of the property, not its open market value which is usually higher, often by 30-40% (or significantly higher if the land has development value). APR is also not available on land or farm buildings which are not used for agricultural purposes. Many farmers are diversifying to maximise their income and this can result in a loss of valuable IHT reliefs.
On the death of a partner, if a partnership business is wholly or mainly trading, their share of the business (including the value of property from which the business trades) will be eligible for up to 100% business property relief (BPR), subject to the two year qualifying period. However, land and buildings owned individually by a partner outside a partnership will, at best, only be eligible for 50% BPR.
Historically, relying on the inclusion of property on the balance sheet of the accounts would have been enough to demonstrate that it was an asset of the business. However, HMRC are taking a more robust approach if the accounts are not clear and there is either no partnership agreement or any mention of such asset in the partnership agreement. If HMRC decide that an asset is not a part of the business, they could limit BPR claims to 50% or deny the claim completely, resulting in an IHT charge at 40%.
Therefore introducing such property as capital to a partnership can significantly reduce IHT, when APR is not available on the entire estate and BPR is being claimed on the balance. It is therefore vital to ensure that there is an up-to-date partnership agreement to demonstrate to HMRC that the property is a business asset.
- Automatic dissolution on death
Where there is no partnership agreement, or the partnership agreement does not make express provision for what should happen on death, the Partnership Act 1890 (Act) will govern what happens next. The Act states that the partnership is automatically dissolved on the death of any partner and from then on the remaining partners should act only to wind up the business and sell the assets, even if there are several other partners who wish to carry on the business. A dissolution also occurs automatically, if there are only two partners and one of them dies.
If a dissolution does arise on death, the personal representatives of the deceased partner (PRs) can insist that the partnership is wound up and the assets sold. The surviving partners have no inherent right to acquire the deceased partner’s share. This then leaves both the PRs and the surviving partners in a difficult position, having to deal with highly emotional beneficiaries to try to reach agreement on a more suitable arrangement. Reaching such agreement can take some time. Meanwhile, the viability of the business is endangered, employees may leave due to the uncertainty and there can be negative effects on critical contracts, cash flow and goodwill.
Detailed consideration should be given in advance as to what will happen to the partnership share after the death of a partner. A well thought-through plan will deal with what will need to happen on a practical level, how the partnership share will transfer and to who, how any valuation will be carried out, and when and how that share will be paid for. The plan needs to consider the interests of the beneficiaries and also how to reduce the impact of the death on the business. Where appropriate, consideration should be given as to how to reduce the impact on cash flow to enable the continuing partners to continue the business. The details of the plan will depend on the individual circumstances, including the financial position of the remaining partners, the on-going viability of the business and the tax regime, and, perhaps most importantly, the personalities of any individuals involved.
- Conflict with terms of a will
It is also not uncommon for a deceased partner to have drawn up a Will, but not at the same time reviewed the partnership agreement. It is important to ensure that both the partnership agreement and the Will, and if relevant the terms of any trust, reflect and correspond with the succession plan. Although a partner can purport to dispose of their partnership share in their Will, if the partnership agreement also contains provisions about what happens to a deceased partner’s interest in the business and partnership assets, but different provisions are made for what should happen on death, the terms of the partnership agreement will override the provisions of the Will.
The Will may also include a gift of specific property which has been transferred into the partnership and the gift could subsequently fail if the partnership agreement does not include a special provision for a partner or their PRs to withdraw land from their capital account.
- Other issues to cover in the partnership agreement
a. Incoming/outgoing partners
Other than death, there are other possibilities that should be considered for inclusion in the partnership agreement, including, marriage, divorce, retirement, loss of mental capacity, introduction of new partners and birth of children. In each case, the partners should consider whether the partnership agreement should provide for what happens to a partner’s share in the partnership and whether any terms need updating. In particular, under the Act a new partner can only be admitted with unanimous consent of the existing partners, which may not be appropriate in all cases. Care should also be taken as to the applicability of the terms of the partnership agreement to a new partner and any tax consequences of their admission. Relying on the Act to remove a partner is also extremely difficult and therefore the partnership agreement should provide for the unlikely scenario of having to expel a partner.
b. Profit and loss
The partnership agreement should specify the split of profit and loss, particularly as the Act provides that these should be shared equally, which may not always be appropriate.
c. Time devotion
The Act is silent on how much time partners are required to devote to partnership businesses and therefore, for clarity we would always recommend that the partnership agreement specifies the amount of time partners are required to devote to a partnership business, whether outside interests are permitted and if so how to deal with profits deriving from such interests.
d. Decision making and disputes
Whilst family members are unlikely to think they will ever disagree on major decisions relating to the business, as the Act generally requires decisions to be made by simple majority voting of all the partners, the partners should consider whether any decisions should be decided unanimously or if a particular partner should have a casting vote and if so, include this in the partnership agreement. The partners should also consider what should happen in the event of a dispute and whether a specific dispute resolution procedure should be specified in the partnership agreement.
The Thompson Smith and Puxon Agriculture, Corporate and Commercial and Wills and Estates teams can work together to help you to establish a succession plan and partnership agreement tailor-made for your business, to help ensure that control of the business is transferred according to your wishes, whilst also providing on-going financial security for you and your family. Please get in touch with one of the team members for further information.