Always protect your partnership in times of crisis
Business protection insurance can mitigate the crisis caused by the death or critical illness of a key partner
The death or the diagnosis of a critical illness of a business partner could disrupt the smooth running of the business and put enormous financial strain on a firm at a time when it needs to be at its strongest.
Without proper arrangements in place, a relative of a deceased partner could indirectly influence the running of a firm. For example, they may have inherited the premises used by a firm. They may also demand the repayment of capital or undrawn profits due to the deceased partner, together with any personal loans made to the firm. The firm could also suffer substantial loss of profits in the absence of the deceased’s particular skills and contacts and, as a consequence, find it harder to service any loans it may have. Despite this, business protection for partnerships is, however, sometimes overlooked or thought to be unnecessary. With forward planning and a small amount of expenditure, the disruption caused by the death or diagnosis of a critical illness of a partner coupled with the financial strains which may be endured, can, at worse, be mitigated and, at best, totally avoided.
Business protection can be categorised under 3 headings: shareholder or partnership protection, key person protection and business loan protection. Shareholder or partnership protection regulates what will happen to a partner’s interest in the firm if he were to die or become critically ill. Additionally, the arrangement can provide the funds (usually through life assurance) required to purchase the deceased or critically ill partner’s interest in the firm. It also ensures that the funds that are provided by the life assurance policy are paid to the correct people. Key person protection protects against loss of profits caused by the death or diagnosis of a critical illness of a key employee or business partner. Business loan protection ensures that a loan is repaid on the death or diagnosis of a critical illness of a key member of the business.
Setting up Partnership Protection
The first stage is the partners’ agreement which is sometimes incorporated into the partnership agreement itself or entered into as a standalone agreement.
The most commonly used and generally the most tax efficient and flexible types of agreement are: double option agreements (also known as cross option agreements), single option agreements and an amalgamation of both single and double option agreements.
Double option agreements are normally used to regulate what will happen to a partner’s interest in the firm on death. Surviving partners have the option to purchase the deceased partner’s interest in the firm. Likewise, the estate of the deceased partner has the option to sell the deceased’s interest in the firm to the surviving partners. If either the surviving partners or the deceased’s estate chooses to exercise their option, the agreement becomes binding.
A single option agreement is normally used to cover the situation where one of the partners becomes critically ill. Only the partner that is critically ill has the option, within an agreed period, to sell his interest to the other partners. If he chooses to exercise his option, it would become binding on the other partners i.e. they would be forced to buy his interest in the firm. This agreement is favoured as it means that the partner who becomes critically ill cannot be forced out of the business, for example:
- He may wish to continue in the business.
- He may not wish to face the Capital Gains Tax liability on the disposal of his interest.
He may wish to retain his interest in the business in order to qualify for business property relief and so mitigate his potential Inheritance Tax liability, rather than having cash proceeds from the sale which would not qualify for such relief.
Single option agreements are rarely used as standalone agreements and will normally be amalgamated with a double option agreement. The agreement between the partners would normally also deal with aspects such as:
- Specifying the proportions in which the survivors buy the deceased’s interest.
- Obliging all parties to effect and maintain suitable life assurance policies, including critical illness cover where appropriate.
- Agreeing on how an interest in the firm is to be valued on sale.
- Outlining what will happen if the proceeds paid under the life assurance policy are greater or less than the value of the deceased or critically ill partner’s interest in the firm.
- Defining a critical illness (where appropriate), typically by reference to the life assurance policy wording.
- Agreeing the time limits in which the various options can be exercised.
Other types of agreement are available. Agreements that create an absolute obligation to sell the deceased or critically ill partner’s interest in the firm to be sold are generally avoided as property, subject to a binding contract for sale, does not qualify for business property relief.
Providing the funds is the next stage in completing the business protection arrangement. This is to ensure that there are sufficient funds available to meet the obligations created in the agreement. Normally this is done through life assurance policies. These provide a relatively inexpensive flexible method of providing the necessary funds.
There is a vast range of life assurance products available on the market. The basic choice will be between a term assurance policy and a whole of life policy.
A term assurance policy pays out an agreed amount of money on the occurrence of a specific event (e.g. death or diagnosis of a critical illness) within a set period. The term of the policy would normally be set to the date upon which that the partner intends to retire and relinquish all interest in the firm.
A whole of life policy has no fixed term and will pay out on the occurrence of the event assured against (i.e. death or critical illness, although the latter may cease at a certain age). The cost of whole of life policies will be more expensive than term assurance but are sometimes favoured as they can be assigned to the retiring partner for his personal use e.g. he could transfer the policy to a family trust as part of an estate planning exercise, or used as part of his own personal investment portfolio.
Term assurance and whole of life policies will come with many extra options. When a term assurance policy is used, it is important that the policy should have an automatic term extension option. This will allow the term of the policy to be extended automatically (i.e. without needing to go through medical underwriting) if, for example, a partner delays his retirement. The valuation of each partner’s interest in the business is likely to increase over time. As such, whether or not a whole of life or term assurance policy is chosen, it should have an option to automatically increase the sum assured so that it mirrors any increase in the partner’s interest in the firm.
The final stage of the arrangement is setting up the policy. It is imperative that the funds generated by the life assurance policies are ultimately paid to each person that has a liability in terms of the agreement entered into between the partners. The funds should not be payable to the firm as this could increase the deceased or critically ill partner’s interest in the firm. Likewise the funds should not be paid to the critically ill partner or to the estate of the deceased partner.
Life of another policies is one of the more simple ways to set up the life assurance policies. It should really only be used where there are two partners (certainly no more than three) and there is no likelihood of any new partners being assumed. Each partner simply takes out a policy on the life of the other partner (“life of another policy”). On death or the diagnosis of a critical illness of one partner, the proceeds of the policy would be paid to the other partner.
As with life of another policies, joint life cover is really only appropriate when there are only two partners and there is no chance of new partners being assumed. Additionally, the partners should be of similar age and share equally in the business. In this situation only one policy is taken out. The policy is written on the lives of both partners with them both owning it. If either partner were to die, the proceeds would be automatically payable to the other partner. It is likely that the premium for the joint life policy would be less than the premium for two single life policies. This arrangement is not be suitable where the option agreement covers critical illness. For example if a partner were to become critically ill the funds would not be payable solely to the other partner but paid equally to both partners. The non – critically ill partner could then find himself in the position of having to purchase the critically ill partner’s interest in the business but only having half the necessary funds available to him.
Both life of another and joint life arrangements are inflexible. Even in situations where there are only two partners it is advantageous to place the policies into trust. Many life offices will provide style wording free of charge.
Each partner takes out a life assurance policy on his own life and writes it in trust from the outset using a flexible power of appointment trust. The initial beneficiaries are his co-partners but not himself. The current partners and future partners of the firm as well as the partner taking out the policy, are however potential beneficiaries of the trust i.e. the initial beneficiaries can be changed. This allows the beneficiaries of the policy to be changed to reflect changes in the ownership of the firm. By using a trust the proceeds of the policy can also be paid in different proportions to each of the partners. As the partner taking out the policy is a potential beneficiary, the policy can be transferred to him if he were to leave the firm.
On the death or diagnosis of a critical illness of a partner, the trustees pay the proceeds of the policy to the other partners allowing them to meet their obligations in terms of the option agreement.
Key Person Protection
This is protection taken out to protect against the loss of profits the business would suffer on the death or diagnosis of a critical illness of partner or employee. If the policy is taken out on the life of an employee it can be possible to obtain tax relief on the premiums. Unfortunately this tax relief would not be available if policy is taken out on the life of a partner.
It is likely that the key person within the firm will be a partner. In this situation it is common for the partner to simply take out a policy on his own life and place it into trust for the benefit of his other partners. On his death or diagnosis of a critical illness, the policy would pay the proceeds to the other partners who could then use the funds to compensate for the loss of profits the firm would suffer.
Business Loan Protection
There is unlikely to be such flexibility with this form of business protection. When a bank provides a loan it will normally insist that some form of life assurance is taken out. The firm’s ability to repay loans on the death of a partner or key employee should be considered under key person protection. Loans made to the firm by a partner which will become repayable on his death or diagnosis of a critical illness are normally covered under the partnership protection arrangement.
In the main it is prudent for partnerships to consider business protection. While any arrangement entered into should be kept under constant review and updated when necessary doing a little can often be worse than doing nothing at all. For example entering into an option agreement without setting up the appropriate mechanism to produce the necessary funds could create liabilities that cannot be met. Many life offices provide a wide range of technical support on this type of business protection which includes advice on tax issues. They will also provide, usually free of charge, a wide range of literature including style option agreements and trust wording.
Stephen Muir is a senior solicitor with Standard Life