Why Partnership And Shareholders Agreements Are Important

Julie Butler highlights the importance of partnership and shareholder agreements.

With the anti-avoidance legislation regarding the fashionable ‘mixed member’ partnerships being published in December 2013, there is much focus on ensuring that the correct legal documentation is in place.  

There have also been some well publicised cases of disputes where partnership agreements were not put in place (e.g. Ham v Ham [2013] EWCA Civ 1301). The dispute over what John Ham was entitled to when leaving the partnership occurred because of the poorly worded partnership agreement – the value being set was thus a matter of interpretation, rather than a clearly defined number or basis of calculation specified in the original documentation. One of the Appeal Court Judges expressed sadness that a lack of clarity in the agreement’s drafting had caused so much ‘anxiety and expense’ to the family.

The potential for dispute is not the only reason for a well drafted agreement. There is also the need to identify what is ‘personal’ property and what is ‘partnership’ property for the availability of 100% as opposed to 50% business property relief (BPR) for inheritance tax purposes. The tax facts are straightforward – for example, farmland made available to a partnership only achieves 50% BPR, whereas ‘partnership’ property achieves 100% BPR. The same applies to property made available to a company; only 50% BPR is available.

A number of partnerships and companies operate without a written partnership agreement, which has obvious dangers as it is important to set out the terms upon which the partners and shareholders agree to carry on business together. This should go beyond such matters as profit sharing; for example, to specify what should happen in the future if there is a dispute or a partner or shareholder leaves or dies. 

The importance of the drafting of the partnership agreement is therefore to lay down terms specifying what is to happen when the partnership ceases, or the property ceases to be partnership property. For example, if the property is sold, how will the sale proceeds be treated? Presumably the ‘property owning’ partner will have been credited with the value of the property in his capital account, which should be adjusted to take account of any profit or loss realised, by reference to the book value. On the partnership ceasing, the agreement may provide for the property appropriated to the property owning partner or towards his capital entitlement.

A set of partnership or company accounts signed by the parties may well be regarded as evidence of agreement between the partners on basic trading concerns, such as the division of the profits/dividends voted as shown in the annual profit and loss account. However, partnership accounts unsupported by a detailed written agreement cannot suffice by themselves, to provide the evidence of the detailed and intricate partnership agreement as to property ownership, and the need to ensure that the property is effectively beneficially owned by just one of the partners. Likewise, companies need strong guidance through a shareholders agreement.

The partnership and shareholders agreement should make it very clear what happens on death or serious illness. Does the person who inherits the share in the business become a partner or director? How is the share in the business valued to protect all parties? It is also important to see who inherits business interests.

All wills should be reviewed. Perhaps that might uncover a potential intestacy where there is no will. The consideration to pass business assets to the next generation using BPR or agricultural property relief (APR) on the first death should be given key consideration. Protection can be sought through a ‘deed of variation’ so that assets that do achieve APR or BPR can be passed down and those assets that do not can be passed to the surviving spouse, to take advantage of all the reliefs.

The deed of variation is the document where the beneficiaries can vary or alter the will within two years of death. This can be a very useful planning tool, but it can be made meaningless or less effective if there is no partnership or shareholders agreement protecting the value of the business owned.

Many family businesses have ‘blurred’ structures as many members of the family help and ‘lend a hand’ with the tasks needed.

The question of whether an operation was a sole trade or a partnership was looked at in the case of G Christodoulou [2013] TC02819. This can be important for all types of tax reliefs – from VAT status for the question of artificial separation, or inheritance, to see who was involved.

After considering the evidence of this case the tribunal concluded that, on balance, the restaurant was run as a partnership. Many would consider that the taxpayer did well to convince the tribunal that there was a separate legal entity for the restaurant. There was evidence pointing both ways so the conclusion had to be reached based on the balance of probabilities. Have all such blurred operations been reviewed recently?

Whilst the Christodoulou case was primarily a VAT case, it highlights the need for legal definition and documents. How often do stories of businesses or business ideas being stolen come to light – why not employ a legal agreement to prevent this?

The ’corporate partner’ is the jargon for a limited company acting as a partner in a partnership of individuals (a ‘mixed member’ partnership).  In recent years, under such structures profits have been diverted to the corporate entity to maximise the fiscal advantages of incorporation.  If the undrawn profits are left in the corporate entity then the tax savings compared to paying full personal rates are significant. 

Many would argue that this structure is adopted with strong commercial emphasis, to ensure profits are retained and long term business survival is assured.  However, legislation has been published specifically relating to the corporate partner, with the aim of preventing the manipulation of ‘excessive’ profit and loss allocations that may previously have been seen as advantageous.

In order, therefore, to ensure the long term survival of the corporate partner structure, the protection of a robust partnership agreement must be sought, indicating that the profit allocation is not excessive (i.e. exceeds a fair return on capital employed) and thus allowing the partnerships continued use of this commercial setup.  Focus must be on the return on capital invested, and the partnership agreement can clearly detail this so as to demonstrate the business entity can stand up to HMRC scrutiny.