Most entrepreneurs place much of their effort into meeting the daily demands of running their own business and then neglect to plan for what will happen to the business when they are no longer there to run it. And such a business could possess assets that represent a substantial slice of their estate.
Continuity of business interests is of paramount importance. Planning should ensure that it can continue uninterrupted. Beneficiaries of an estate are likely to receive far less if a business is sold on the basis of fixed assets, stock and a debtors book rather than as a going concern.
Various factors will need to be taken into consideration in the event of the death of a partner. Would a surviving partner welcome a wife and children as partners? Unless they have been involved in the business from the start, this is unlikely.
In many small to medium businesses, the modus operandi is seldom committed to paper. Partners tend to work on trust and when one dies, and there is no written agreement, disputes may arise over details.
Under common law a partnership must be dissolved in the event of the death of one partner, and a new partnership may be formed for the business to continue.
A partnership agreement can be very simple and needs only three key components.
The first is that the surviving partner has the right of first refusal and can take over the business. Secondly, a time limit must be set for this to take place, so that winding up of the estate is not delayed while the surviving partner makes up his mind and, possibly, has to raise the necessary finance. Three months after death is generally considered adequate for this purpose. Thirdly, it is essential to have a regular determination of the value of a business. This can take the form of an addendum to the partnership agreement, which is signed by both partners as soon as the annual financial accounts are available.
For the third step, they need to sit down with their auditor and discuss the value of underlying assets and goodwill. Agreement must be reached on the basis of a willing seller and a willing buyer. When the business is largely dependent on the input and skills of an individual as opposed to trade, it is important to agree upon the intellectual capital.
Partners may make provision for the survivor to fund the taking over of the other’s share of the business by taking out life assurance on each other’s lives and by paying each other’s premiums. The reason for this approach is that, for purposes of estate duty, life assurance is added back into the estate except where policies are taken out as part of a partnership agreement and the partners pay each other’s premiums. It is important to remember this and, even if the business pays the premiums, they must adjust their salary packages to reflect payment as individuals.
In that way there is no duty on the proceeds of such insurance. Otherwise they are effectively taxed twice, as a policy added to the estate and subject to duty and as an asset being used by the partner to buy the business. There is a limit to the amount of cover that can be taken, and this may be loaded for reasons such as health problems and the age of a partner.
If a business grows rapidly, the value of the insurance will need to be increased. Eventually a limit will be reached on the amount of the premium that can be justified, and it will be necessary to make provision in the agreement to cover any shortfall. It is important in such instances, however, to ensure that the surviving partner is able to settle the shortfall in a reasonable period without, for example, being forced to go to an institution for a loan which would put a drain on cash flow.
Every effort should be made to make it easier for him to take over the business. He should be allowed, for example, to settle the shortfall over a period of, say, five years. It may also happen that one partner brings in 70 to 80 percent of the intellectual capital. To attract a suitably qualified replacement would need substantial funding, and for this purpose “key man” insurance should be considered. Disability insurance should also be considered. The agreement should specify the stage at which a disabled person should bow out, and also allow for a continued income from the business.
Sole proprietors should also consider succession planning. His will should indicate who should be approached first to take over the business and how the executor should deal with the situation. It could be useful to give or sell the successor a small share in the business beforehand.
It is important to design any such agreement to suit the specific needs of a business. Then it should be updated regularly. This will ensure not only that your heirs receive the full value of the business assets, but also that they are not involved in disputes, confusion and resentment when you are no longer there for them.