The value of a well-drafted partnership agreement becomes apparent when there is a dispute, or when a partner leaves, retires or dies.
A partnership agreement can be thought of as an insurance policy in case things don’t go as expected, especially where there is a dispute or partnership breakdown, says Andrew Holden, head of rural at law firm Napthens.
Where there is no written partnership agreement, the Partnership Act 1890 sets out what happens. This includes the dissolution of the partnership on the death of any of the parties involved.
“This can mean all debts would need to be settled, borrowings returned to banks, and the residue distributed between the remaining partners,” Mr Holden says.
However, in most circumstances, as long as the parties agree, a new partnership agrees to take over all debts and assets of the old partnership and there is no sale or distribution.
“A written partnership agreement can also help reduce the chances of a dispute, and provide the mechanisms for how a dispute is to be settled,” Mr Holden says.
Lenders increasingly want to see a well-drafted partnership agreement before they agree to new lending.
They also generally like to see a new partnership agreement when a new partner is admitted, to make sure that person is also liable for the existing partnership debts.
However, Mr Holden says many farming families still operate partnerships without an agreement, or with a poorly drafted document.
The basics of a good partnership agreement include:
- Provision for the partnership to continue when a partner retires, dies or otherwise leaves.
- A list of partnership assets.
- How profits will be shared – both income and capital.
- How an outgoing partner’s share in the assets is handled. It is common for remaining partners to have an option to buy that share but the terms must be considered. Should this be at book value, market value or any alternative method of valuation? Also, the agreement should say whether payment for the share is to be made as a lump sum or instalments, and over what period. Partners may want to state who should conduct any valuation and whether their decision is binding.
- How to deal with a voting deadlock.
- How to remove a partner who may have lost capacity.
- How new partners can be brought in – they do not automatically have to have a capital interest in the partnership.
- Setting out business spending limits for junior or other new partners.
Personal or business assets
Wayne Horrex, manager at accountant Ensors, stresses that it is important to be clear which are personal and which are business assets belonging to the partnership. This can be set out in a partnership agreement.
“It is often assumed that including the property in the annual accounts demonstrates that this is partnership property, but without documentary evidence to support this it can be challenged by HMRC,” he says.
“This is important for inheritance tax reliefs. Where a farming partnership is wholly or mainly trading, then partnership property will be eligible for full Business Property Relief (BPR).”
However, only 50% BPR is available where property is owned personally by the partners and used in the farming trade of the partnership. Agricultural Property Relief applies only to assets used for agricultural purposes and covers only the agricultural value, which may not be the market value, he points out.
It is also important that wills and other documents dovetail with the partnership agreement.
Mr Horrex says: “If land and property is included as partnership property it can no longer be gifted in a will. However, an interest in the partnership can be left in a will.”
Partnership documentation should be reviewed regularly and, at the very least, on the purchase of new land or significant assets, or the introduction of new partners, he advises.
Rise in litigation
Julie Robinson, head of rural at law firm Roythornes, points out that unless a partnership agreement is comprehensive, then the Partnership Act will give the lead on any matter on which a written agreement is silent.
The rise in land values has led to increased litigation on partnership terms between family members in recent years, says Ms Robinson.
Lack of clarity over the method of valuation is a relatively common problem, as in the Ham v Ham case (see panel below).
Ms Robinson says agreements should also consider the unexpected, such as the death of a member of the younger farming generation before their parents or other older partners.
The Partnership Act 1890
The act states that two or more people farming together, with the intention of making a profit, automatically are in a partnership.
Where there is no written agreement, the Partnership Act 1890 dictates the terms, which can have undesirable consequences for farming businesses of today.
The act states how partnerships should operate and says that:
- Profits and losses are to be divided equally among the partners.
- Death or bankruptcy of a partner triggers dissolution of the partnership.
- The retirement of a partner will trigger dissolution if the arrangement is a partnership at will (rather than for a fixed term).
- When a partnership is dissolved, the remaining partners have no right to buy the outgoing partner’s share but the partnership must be wound up and the assets sold. Each partner is entitled to their share of the capital, once debts and liabilities have been paid.
- Any partner can dissolve the partnership by giving notice to the other partners at any time, with immediate effect.
- One partner cannot be expelled from the partnership by another.
- Every partner has equal voting rights.
Ham case highlights valuation issue
A well-known case, Ham v Ham (2013), highlights how important it is for partnership agreements to be clear about how partnership shares are to be valued when a partner leaves for any reason, including the death of a partner.
In this case, a son wanted to leave the farming partnership he had entered into several years earlier with his parents.
Their partnership agreement said that the remaining partners would buy out the leaving partner.
The son felt he should be paid out according to the full market value of the farm but his parents said his share should be based on the (much lower) book value of the assets.
The parents won at the initial hearing but the son won on appeal, entitling him to claim the market value on his share of the assets.
Because the agreement was not clear on how the share should be valued, the family went though a stressful, expensive and lengthy court case.