What happens if my business partner suddenly buys a Porsche with company money and then disappears with the partnership's chequebook? (or Why you need a documented Partnership Agreement)
General Partnerships have Unlimited Liabilities
When people make the decision to go into business together, one important yet often overlooked consideration is how best to establish and document the legal relationship between them.
While one of the key benefits of a general business partnership is that it allows the Partners to pool their respective skills and resources (skilled labour, financial resources, business relationships, equipment, etc.) they also need to address how to manage the risks of unlimited personal liability, for the other partners' actions.
All Partnerships should have a documented Partnership Agreement in place.
The often overlooked risk of an undocumented business partnership is the business Partners face an additional ongoing risk of exposure to liability for countless wrongdoings of their business co-partners.
- Because a general business partnership is not a legal entity, its partners assume personal liability for all partnership debts and wrongdoings including misappropriation of partnership funds.
This liability will arise regardless of whether the Partner may have had no involvement in or knowledge of the wrongdoing of the other.
An unfortunate reality of partnerships is that relationships between the partners may break down over time, which can result in unintended and potentially devastating financial outcomes for the partners as a result of their unlimited liability for partnership debts.
A frequently occurring example is debts to third parties that go unpaid after a breakdown of the business relationship between the partners.
Those debts remain owing after the dissolution of the partnership, and in some cases may accrue significant interest and penalties.
If the debt remains unpaid, Court proceedings may be commenced against one or more of the partners personally.
What happens if my business partner dies and I need to pay out their family?
In an undocumented partnership, when a business partner dies, their share of the business profit and debt becomes the responsibility of the surviving business Partner.
The family of the recently deceased Partner will no doubt seek to sell off the business assets and liquidate the business to extract its value. Without a prior written Business Partnership Agreement in place, there will be no instructions to follow at this very stressful time of business interruption - for the remaining partners and the grieving family of the deceased partner.
So how do business partners prepare for this eventuality?
- Get a legally documented Partnership Agreement in place that outlines the agreed liabilities of each partner and the ownership of the partnership's assets.
For example: If one business partner suffers a stroke and can no longer work, do they have the right to continue to draw an income from the partnership for the rest of their life? If one business partner died, what happens to the business profits, debts and asset debt liabilities?
- Get a legally documented Buy and Sell Agreement in place that creates the automatic procedures to be followed upon the death (and/or disability) of a business Partner and the agreed ownership transfer, the sale price to be paid by the surviving partner, and debt arrangements to follow.
- Set up the funding arrangements required to achieve the ownership purchase and transfer from the deceased partner's estate, and debt payout.
There are three main ways business Partners can fund the transfer of a share of a partnership.
Option 1: Self-insure and simply pay cash when this event occurs to buy out the surviving partner.
With this option, the surviving owners use cash at the death of a co-owner to fund the buy-sell agreement.
But there are several drawbacks to this self-insurance approach.
- At the time of the death, funds may not be available for payment.
- A personal Savings Plan can accumulate funds over time, but what happens if the funds are needed earlier than planned?
- Will a savings plan be depleted if there are unforeseen circumstances and the business needs a cash injection?
- Accumulation of cash may cause an accumulated earnings tax problem.
- Accumulating large amounts of unused cash within a partnership exposes those funds to Bankruptcy Trustees and Family Law Court claims.
Option 2: Wait and try and borrow the funds to complete the ownership transfer when needed.
With this option, the surviving owner attempts to borrow funds, usually from a bank, at the death of their Business Co-partner to fund the buy and sell agreement.
This wait-and-see approach also has high risks.
You cannot guarantee that the surviving owner will be eligible for finance at a future date (especially upon the sudden death of a business partner )The death of an owner usually causes disruptions to a business that results in a decline in sales that further complicates asking a bank for money with a decreasing cash flow).
- The death of an owner may remove underlying security assets that may have been used by a bank securing earlier funding.
- The surviving partner may now find themselves having to sign for funds, now exposing personal assets that up to now, have not been required with multiple business partners.
- Surviving Business Partners pay dollar-for-dollar plus interest on any new loans required to fund the ownership transfer agreement, buying out the deceased outstanding share of the business in this interest which will impact the valuation of the business remaining.
- The surviving partner may have to borrow money from the deceased business partner's family to complete the transaction, effectively putting them ‘in business’ with another who may not have patience and share a similar approach to running a business.
Option 3: Use a Life Insurance policy to provide the funding needed at the time required.
Purchasing a life insurance policy is usually a cost-effective funding option, to complete a buy-and-sell agreement in the future.
A Total and Permanent Disability (TPD) policy will also extend the buy and sell agreements capacity in case one of the owners is disabled and can no longer work in the partnerships, but continues to live.
Typically, the policy is taken out on the life of each Business Partnership Owner so that when one owner dies or becomes disabled, the surviving partner will now have money provided by the policy to buy out the family of the deceased (or disabled) partner exiting the business.
Using life insurance as a funding mechanism provides the following benefits.
- Immediately available upon the death of a business partner. the death benefit proceeds are usually income tax free.
- The premiums of such a policy are usually lower than the cost of repaying loan interest for the same amount would be.
- The cost of the insurance policy is mere pennies to the amount of the payout to the family.
- Having such a life insurance policy in place allows partners to sleep better and work undistracted, allowing them to put their full attention to growing a business rather than wondering what will happen to their share of the business upon the unexpected death or disability of their Business Partner.
Whichever option works best for you, it helps to get all the facts together before you make your decision.
Getting your Legal Partnership Agreement in place and then getting your Legal Buy and Sell Agreement in place, with the right funding strategy, significantly reduces the risks to all business partners and usually results in an uptick in business focus, confidence, and clarity.
How we can help
A Legally drafted Partnership Agreement is essential to all members of a partnership.
- Sapience can provide legally drafted Partnership Agreements, legally drafted Buy and Sell Agreements and Life and Disability Insurance strategies and policies to complete your partnership's business planning.
Contact us for a confidential chat about your needs.
