A Brief Guide to Partnership Agreements
A partnership agreement is a legal document agreed to and signed by each of the members of a partnership that describes the rights, responsibilities, and obligations of each member of the partnership. The partnership agreement will often address all of the issues that may arise among the partners while they are operating the business as well as the eventual outcome of the company and each of its partners. A partnership can be formed between natural persons, corporations or other entities. A partnership can be formed between up to 100 persons in New York state.
Certain issues addressed by a partnership include the name of the partnership, the duration of the partnership, what happens if a partner dies, what happens if a partner wishes to leave the partnership or is forced out of the partnership , where the partnership’s principal place of business will be located, how decisions will be made and how profits and losses will be shared. There are many other issues that a partnership agreement can address, however, the above is a list of some of the most common issues.
All of the terms of the partnership agreement, and potential future outcomes must be negotiated and agreed upon before the partnership is formed. However, once the partnership is formed, it is of tremendous importance to review the partnership(s) at least every year to see if any changes or additional issues have arisen that should be addressed. Ignoring the potential issues of a future death of a partner can create some serious issues if not addressed.
When a Partner Dies
A partnership will almost always suffer some sort of setback or shake up after the death of a partner. Sometimes, however, the effects could be serious or fatal to the organization as a whole. Some businesses are routinely, significantly, affected by the sudden loss of a partner. For others, especially smaller partnerships, things are not so dire. Typical implications of a partner dying in a partnership include: Failure to Be Prepared – If the partnership failed to plan for such an event (which is common), partners may encounter a loss of capital into the partnership, or at least experience a winding down of the business operations. Ideally, the partnership will have discussed its options and reached an agreement on circumstances in which the business should be dissolved. Disruption in Business Operations – The agreed upon terms could be such that the remaining partners are not allowed to wind down operations until after a period of time, such as one or two years. What is most likely to occur, however, is a business disruption in the short term. A deal could have been made with another entity to absorb the business going forward, but in all likelihood the surviving partners are forced to run the day-to-day activities of the business just after suffering a loss. This could lead to not being able to operate the business efficiently and could damage client relationships. Financial Consequences – Loss of capital or a significant payout for a deceased partner’s shares can cripple a partnership. If the capital to be paid out is lost, it starts the partnership on a bad footing. Also, if a partner’s death meant that capital should be returned to the business, it will not be available. Having to unexpectedly arrange bank financing to meet those obligations can further stress the business. Value of the Business – Value changes and differences of opinions will be present when recovering and redistributing assets and capital from one partner’s death. That could possibly lead to one partner making a claim against the estate of the deceased partner (if, for example, there is a belief of unequal distribution of value). Those disputes are usually costly and only further diminish the ultimate return received by the partnership. Restrictive Covenants – Is a restrictive covenant prohibiting a former partner’s ability to compete, solicit clients, or participate in a similar business in the future enforceable? That and other legal implications could arise in the wake of a partner’s death, especially if the business is left in shambles. Unhappy or disappointed partners could be quick to jump ship. An exodus of partners will probably scare clients away and imperil the entire organization.
Death of a Partner Demands Legal Attention
Navigating the Death of a Partner in a Partnership Agreement
All partnership agreements must contain legal provisions that will dictate what happens upon the death of one of the partners. While most owners hope that their partnership agreement can be administered as written, there are a number of circumstances in which the agreement will not be administered as written.
Mandatory Provisions
Certain as if are mandatory and will govern in most, if not all, partnerships. For example, a provision requiring that the remaining partners purchase a deceased partner’s interest will be enforced as written unless it violates some law or public policy. Also, in many cases, an estate or heirs of a deceased partner will be required to be bought out upon the death of the partner for an amount set forth in the partnership agreement. As such, the number of continuing partners may be reduced by one with the partnership becoming a business entity with the deceased partner’s estate in possession of a decreased value. If the agreement does not provide for such an occurrence, the heirs of the deceased partner may be legally required to sell the deceased partner’s interest back to the partnership.
Voluntary Provisions
There are a few voluntary provisions that are often not included in partnership agreements. These provisions include advanced buyout terms that do not offer a statutory right of purchase to the estate of the deceased partner. Such provisions may overrule any legal mandate providing that the estate of a deceased partner has a right of first purchase. Also, if the partnership was an asset of a sole proprietor and a partner dies, the extent of the partner’s business will also be determined by the terms of the partnership agreement, if it exists.
Things to Do When Losing a Partner or Owner
Steps to Take After Death of a Partner
Once you have made the decision that the business will not continue or you have found another buyer, you and your partners will need to take some immediate steps to ensure that you are complying with the law, respect the wishes of the deceased partner (if any) and mitigate damages to the Company.
You will first need to notify anyone you do business with of the departure of the partner from the Company. This is both a good business practice and in many cases, a legal requirement under the partnership agreement. You may also have an obligation to notify third parties about the death in order to comply with the Internal Revenue Code.
You may also want to consider notifying your landlord, suppliers, key customers, banks and insurance agents. In addition, you should notify other parties such as creditors, vendors, customers, regulators and the incomng estate to let them know that the company will be experiencing a transition.
You and the remaining owners and/or management should sit down and review the language in the partnership agreement to determine what rights the remaining partners have, whether the terms of the agreement allow for the continuation of the business and what the purchase price of the deceased partner’s interest is. You will also need to determine whether the company should continue in its current business or whether it should take a new direction. Make a determination if the appointed person(s) shall be required to sell the business.
Business Valuation and Buyouts
Partnership agreements typically provide a framework for how to value the deceased partner’s interest in the business and either buy out that person’s share or convert it into their estate. A partnership agreement often determines how and under what circumstances business valuations will occur, as well as who will conduct the valuation. Some partnership agreements, in doing so, will also award up to two different types of value: book value and fair market value.
Book vs. Fair Market Value
Book value looks at the value of the business according to the business’ books. This is a straightforward accounting process. Fair market value accounts for what a third party company would be willing to pay for that interest in the business . The following are some examples of circumstances associated with business value: Sometimes the book value is higher than the fair market value, in which case the partnership agreement can provide options for the business in both cases, mitigating both tax liability and financial loss.
Tax Implication Oversight
Each circumstance can affect taxable income within the partnership agreement, hence why it’s vital to gain the proper advice so as to mitigate liability. Typically, a corporation’s stock is bought back following an insurance settlement, whereas in an LLC, it may be possible to buy the assets and stock back with the respective cash from there. It’s also important to note that the tax treatment for either situation can also differ based on the structure and nature of the business itself.
Keeping the Partnership Together
Making Sure the Partnership Continues to Function after a Partner’s Death
Ideally, the death of a partner in a partnership agreement shouldn’t disrupt the operations of the partnership. A well-drafted partnership agreement will contain a buy-sell provision that will govern the circumstances under which the surviving partners purchase the deceased partner’s interest from her estate.
It is important for the terms of the buy-sell provision to be clearly set forth in the partnership agreement. The buy-sell provision should specify what payment is to be made to the deceased partner’s estate. Oftentimes, the amount to be paid to the estate for the deceased partner’s partnership interest is governed by a formula that is set forth in the agreement. It may be based on an appraisal of the deceased partner’s interest in the partnership. The payment terms should also specify the timing and manner of payment.
In addition, a properly drafted buy-sell provision will provide one or more options for the purchase of the deceased partner’s interest. For instance, the surviving partners may have the first right to purchase the partnership interest of the deceased partner. If the surviving partners do not exercise their right to purchase the deceased partner’s interest, the partnership then has the right to purchase the deceased partner’s interest. Finally, if neither the surviving partners nor the partnership elect to purchase the deceased partner’s interest, the deceased partner’s beneficiaries or estate have the right to purchase his interest in the partnership. Regardless of when or how the remaining partners and partnership elect to purchase the deceased partner’s interest, it is important that the agreement clearly specify the purchase price terms.
In certain circumstances, the partnership agreement may allow for payments to be made over time. In such cases, it is essential, as I have found, that the agreement clearly specify when and how the payments are to be made. In addition, the agreement should clarify what happens to the amount to be paid if the surviving partners, partnership, or estate die prior to the funeral of the deceased partner. Further, a properly drafted agreement will also address what happens if the funds are not available from the bank.
As is evident, despite the importance of the partnership agreement, things do not always go as planned. Quite often, years after the execution of the partnership agreement, like in the case of my client, changes in banking practices will necessitate a review of the partnership agreement, specifically the buy-sell provision. In fact, a simple change in bank practices caused an entire restructuring of the buy-sell provision in my client’s partnership agreement. My client’s bank no longer had insurance policies available to fund the buy-sell provision of the partnership agreement. As a result, parties affected by seemingly minor changes may need to meet and resolve the issues regarding the partnership agreement and the buy-sell provision.
At times, a partnership may need to bring in another partner following the death of a partner. In this situation, the partners may need to negotiate with the bank to secure a new insurance policy or line of credit in order to finance the purchase of the new partner’s share of the partnership.
Planning Ahead to Guarantee Security
Anticipating the death of a life partner is a necessary and uncomfortable aspect of life. Partners may find it easier to address this issue by creating a plan that addresses the anticipated legal issues that will arise in the event of proof of death.
The partnership agreement should include a dissolution process in the event of the death of any life partner. In the absence of specific language addressing the death of a partner, partners may be subject to the rules and regulations concerning a partnership’s dissolution set forth by the particular state’s Partnership Act. Under some partnership acts, where there is no valid fiduciary relationship between partners, partners are not required to trust or rely on the fiduciary duties of their partners. See the Alaska partnership act attached here.
If a partnership agreement does not address the death of a life partner, and the partners are not subject to a fiduciary relationship under the relevant partnership act, it is possible for the surviving partner(s) to dissolve the partnership without compensation to the deceased partner’s estate.
If you wish to limit your surviving partner’s ability to dissolve the partnership where there is a death of a life partner, you could implement a partnership agreement that clearly lays out a specific time limit for the dissolution of a partnership. By including a time limit in the partnership agreement, you are ensuring the other life partner did not use the time limit to the detriment of the deceased partner’s estate . See Mich. Comp. Laws Ann § 449.170 (West). Even if a state’s partnership act does include a fiduciary duty for partners, it may not, as in Alaska’s partnership act, specifically include liability for harm arising from a breach of a duty of loyalty within the scope of the fiduciary duty of partners.
Once you have drafted a partnership agreement which addresses the death of a life partner, it is important to have another partner review the agreement to ensure the language is sufficiently clear. The partnership agreement should contain an explicit statement providing instructions to partners regarding the dissolution of the partnership upon the death of a partner. An explicit instruction will prevent the other life partner from dissolving the partnership without compensation or imposition of any fiduciary duty.
An additional preventive step is to review every five years, or at the beginning of a new partnership term, the partnership agreement and related documents (e.g., will) to ensure that the documents are up to standard with the law that applies at the time.
If you do expect to dissolve the partnership upon the death of a life partner, you must keep a current valid copy of your partnership agreement later than six (6) months after execution. Failure to do so may be deemed lack of accord in the partnership. Participating in the dissolution of a partnership pursuant to a partnership agreement falls well within the scope of "realized expectations."