Make the most of farming partnership agreements

The financial and legal implications of partnership agreements are often inextricably linked. Jeremy Heal of solicitor Howes Percival and Danny Clifford of accountant Ensors answer questions which often arise on family farms.

Do you understand your partnership agreement and is it up to date?

A partnership is like a marriage; it starts with optimism but can end in bitterness. A partnership agreement is effectively a commercial pre-nup and it’s worth taking time to understand it.

While it’s important for agreements to be well drafted in the first place, they can be reviewed, as long as all partners agree with any changes.

For good reasons, the hardest but most important clauses to understand are those which relate to retirement of a partner. “Retirement” technically includes death and covers a partner leaving for any reason, so every partner will ultimately retire in one way or another.

Many aspects such as changes in land values or profit shares can radically change the effect of these clauses. If the value goes up, perhaps if planning permission is granted or becomes likely, you may not think of looking at the partnership agreement to see what the implications are but it is important to do so in case revisions need to be made.

These retirement provisions hold a balance between the interests of partners who leave and those who remain in the partnership. At the outset, most people won’t know which they want to favour as they don’t know what the future holds, so the clauses have to be very carefully drafted.

What happens if there is no written agreement?

In these cases, the Partnership Act 1890 applies. This is more than 120 years old and is out of date – its effects are unexpected and can be disastrous.

For example, any partner can dissolve the partnership at any time without notice – it can happen on the spur of the moment in a family row.

In that case, the business has to cease; all the partnership assets have to be sold on the open market; the creditors must be paid off, and what’s left is divided equally between the partners.

Fortunately partnerships have very little compulsory regulation, so a partnership agreement can include virtually any provision the partners want, for example management, voting, retirement, dissolution, profits and losses.

The essential point is that you must have a written agreement if you want to avoid the real problems which the Partnership Act can impose.

What happens if a partner dies, retires or leaves for another reason?

Their share in the partnership income stops immediately. All their other interests in the partnership are instantly converted into a debt due to them, and the amount of that debt is calculated in accordance with the partnership agreement. Incidentally, that debt does not qualify for any inheritance tax relief if a partner retires and then dies shortly afterwards.

The partnership agreement will often provide for the debt to be paid out over a period of years, to prevent the other partners having to find a large lump sum in cash on top of the other problems caused by the loss of a partner. Considering at the outset how the partners want issues such as this to be handled can save a lot of time, heartache and professional fees.

Is a partnership agreement as important as a will? Which takes priority?

The partnership agreement takes priority. Your will can only dispose of what you are entitled to at the moment before your death. The partnership agreement defines what you are entitled to, so the will can only take effect on the money due to you from the partnership, which has become a debt due from the other partners to your estate. This is another reason why you must get the partnership agreement right.

If land is currently held privately outside of the accounts, what is the tax position?

If the land is not in the balance sheet but is used by the partnership, you will only get 50% business property relief from inheritance tax. Effectively therefore it may be that half of the value of the property is taxable at 40% – an effective 20% tax rate across the whole value. Some people do not realise this until too late.

Can tax be saved by placing the property into the balance sheet?

Putting property into the balance sheet of a partnership is a short-hand way of saying that you are making it partnership property, though there is much more to it than simply including an extra set of numbers within the accounts.

The main advantage to land appearing in the balance sheet is that it will normally qualify for 100% business property relief for inheritance tax. This means that provided you’ve been a partner for two years and some other conditions are satisfied there will be no inheritance tax on your death on your interest in the land, decreasing the effective 20% tax mentioned previously, to zero.

What about the effect on other taxes if land is in the balance sheet?

From a pure tax saving point of view there are advantages and few disadvantages – for example the position for rollover relief from capital gains tax is unaffected. Land in the balance sheet will also qualify for rollover relief from capital gains tax. Thus if you sell a very valuable area of land, eg for development, you will be able to roll the proceeds over into more farmland or buildings (or some other assets), avoiding what would have been a huge tax bill.

Strictly speaking, rollover relief defers the tax; but if you defer it until you die and you had rolled the gain over by investing all the proceeds in more farmland, the tax could disappear completely.

There are, however, non-tax issues such as your loss of control over the land which need to be taken into account – the decision should not be taken lightly.

What else is affected if land is put into the partnership balance sheet?

If you put land into the balance sheet, it becomes a partnership asset, normally on the date when the accounts are signed. This means that it is not your land any more – you hold it on trust for the partners. You can’t sell it or take it back out of the partnership without your partners’ agreement. It is primarily available to pay partnership creditors.

Also if the land rises in value, that extra value may benefit not you but the other partners. If you haven’t addressed this properly in the partnership agreement, you may find that the land is shown in the accounts at some historic value (maybe at cost), and if you retire or die you are not (or your estate is not) entitled to share in the increase in value.

A recent case in the Court of Appeal highlighted this. It involved a family farming partnership where the land was worth several million pounds more than the value shown in the accounts. The son sadly died young and the two parents lost mental capacity shortly afterwards, leaving the daughter as the sole surviving partner.

After years of unhappy litigation, the daughter succeeded in taking the bulk of the land value. She claimed that the estates of her brother and her parents should only be paid out on the (low) land value in the accounts, and won.

It is hard to believe that any family relationship can survive litigation like this and it could have been avoided by a clear provision in the partnership agreement setting out whether the land should be valued at market or book value.

How does entrepreneur’s relief work?

This very valuable relief is designed to give business owners a 10% capital gains tax rate on the sale of a business, instead of the normal 28% rate and it’s potentially worth up to £1.8m. Each individual currently has a £10m lifetime allowance of gains made in a trading business.

The catch is that it normally won’t apply to the sale of individual business assets used in a farming partnership, such as a field with planning permission. Assets must be used in a trading business to qualify and the business must cease or there must be a disposal of a significant part of the business.

What matters most is to plan at least a year before any sale, and to ensure your business is structured to comply with the very detailed rules.

• Got a partnership question? Jeremy Heal and Danny Clifford will be checking our forums from time to time over the next week and responding to your questions. Go to our forum to take part in the discussion

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