WHEN A PARTNER IN A PARTNERSHIP DIES

ACCORDING to the Malaysian Partnership Act, a partnership is defined as a relationship that subsists between persons carrying on business in common with a view of profit.

The Malaysian Partnership Act states that all partners in the firm are jointly liable for all contractual and other debts and the liabilities including tax and judgment debts, which are incurred while each is a partner. In the case of any legal action taken, third party may sue all the partners individually or the partnership; or in reverse, the partnership or all the partners may jointly as plaintiffs sue a third party. In another word, a general partner not only exposes his personal assets to partnership creditor's claims, but is also responsible for other partners' action on behalf of the partnership in the normal course of business.

Unless provided otherwise by an agreement, when a partner dies, the partnership is legally terminated irrespective of the surviving partners' plan.  The surviving partners must collect all outstanding bills from debtors, settle all the liabilities, wind up the business, liquidate the assets and divide the proceeds among the partners according to the proportionate interest of partnership.  During this period, the surviving partners act as trustee for the partnership.  They are required to act fairly, promptly and with accountability. If there are new contracts that turn bad, the surviving partner will be held liable personally. If the new contracts make profit, it must be shared with the deceased partner's estate.

Lee and Kumar have a partnership business in accounting practice for the last 15 years.  The business has grown so well due to the relentless effort of the two partners.  The partnership has two offices - one in Damansara managed by Lee and another in Penang run by Kumar.  They have a verbal understanding that if either one of them were to die first, the surviving partner will buy over the deceased's share at an agreed price.  They have even bought life insurance on each other to fund the purchase.  However, there is no legal document that bears witness to such an agreement.

Lee's financial advisor had earlier highlighted the importance of having a written buy-sell agreement to avoid any future disputes.  Lee did not take heed of that advice purely on the basis of the trust he has built with his partner.

Two years later, Lee dies in a plane crash.  Kumar receives the life insurance proceeds but does not use the money to buy over the deceased's interest.  He winds up the business and registers a new practice.  What Lee's heirs get is only the minimum liquidation value of the partnership.

Action Plans To Consider

 When a partner in the partnership dies, the heirs have the following alternatives to dispose of the business interest:-

 Forced liquidation of the business

Forced liquidation is the worst alternative to both the surviving partners and the deceased partner's estate.  It will invariably result in serious shrinkage of the business value.  In addition, if the liabilities are more than the business assets, the surviving partners and the deceased partner's estate will be fully liable.

  The heirs sell the deseased partner's interest to the new partner to form new partnership with the surviving  partners

For this alternative to be viable, there must be a prospective buyer who is willing to enter into a partnership - one that has just lost a key partner.  The new partner must also possess the personality and working experience acceptable to the surviving partners.  If a wrong partner were to be admitted, the partnership may get into trouble and eventually end up with dissolution.

 The deceased partner's heirs form a new partnership with the surviving partners

In this arrangement, the heirs may not possess the necessary skills, knowledge and experience to receive an income as much as the amount received by the deceased partner.  The surviving partners would face the uncertainty of personality and cooperation of the heir.  If the partnership is a professional firm that requires a registered professional to act as partner like the case study, this alternative will not be possible.

 The deceased partner's heirs buy over the surviving partners' interest

For this alternative to be viable, the deceased partner's heirs must possess sufficient fund to buy over the business interest and necessary know-how to operate the business successfully.  However, this is very unlikely to happen.

 The heirs sell off the deceased Partners interest to the surviving partners

This is the most viable alternative for both the surviving partners and the deceased partners heirs. The surviving partners will be able to continue with the business without any interruption.  The deceased partner's heirs will get the fair value of their interest in the partnership.  However, there are two issues that must be resolved.  First, an unanimous agreement on the price of the business interest.  There will certainly be a conflict when the heirs go for the best price possible while the surviving partners will offer the lowest possible.  Second, the ability of surviving partners to finance the purchase.  In most of the case, the purchase of the business interest will require quite a substantial amount of cash.  If the surviving partners do not have the sufficient fund, this alternative would also not be possible.

1. Enter into a buy-sell agreement. Since the alternative of the heirs selling off the deceased partner's interests is the most advantageous option to both parties, proper solutions need to be devised to address the two obstacles, namely agreement on price and financing method.
 

The partners can enter into a buy-sell agreement to address the problem of partnership interest disposal. Buy-sell agreement is an agreement among the partners outlining the respective rights and obligations of the partners with respect to the disposition and acquisition of the interest of any deceased or disabled partners.

The agreement ensures that the surviving partners must buy the interest of the deceased partner from the heirs and the deceased partner's heirs must sell the interest of the deceased partner's to the surviving partner. In the agreement, the price of partnership is specified or based on a formula agreed mutually among partners. Such a pricing establishment would be more acceptable among the partners because it was made when the partners do not know on which side of transaction they would be. If he survives, he is going to be the buyer. If he dies, he is going to be a seller.

 
2. Identify suitable financing plan method to fund the buy-sell agreement. A buy-sell agreement without ensuring proper funding for the partners to honour the promises is as good as a car without fuel. The partners have the following alternatives to fund their buy-sell agreement:

  Using cash from own savings. This funding option would only be viable if the surviving partners have adequate cash or assets at the time of purchase.
 

  Using borrowed money.  This funding option would only be viable if loans can be secured at reasonably low interest and future business income can absorb loan repayments.

  Using instalment payments from own income.  This funding option would only be viable if the estate accepts the duration and extra interest charged to the instalments.  It is important that the heirs are aware that the buyers may fail to complete the payments in the situation of death, disability, adverse business conditions and bankruptcy.

  Using the life insurance proceeds.  This funding option would only be viable if the partners in the agreement are insurable and can afford the premium.

 3. Choose the most suitable arrangement of buy-sell agreement. If the partnership chooses to have a buy-sell agreement, the partners will have the following options on the various forms of buy-sell agreement.  Due to the different nature and financial background of each company, the partners should consult their estate planner to identify the most suitable financing method for their agreement

  Cross-purchase plan

Under this alternative, each partner buys life insurance on the lives of the partners enough for him to buy over the business interests.  For example John and Richard are partners holding 30 per cent and 70 per cent respectively.  John buys a policy on Richard's life for the amount equivalent to 70 per cent of the agreed partnership's value.  At the same time, Richard buys a policy on John's life for the amount equivalent to 30 per cent of the agreed partnership's value.  If Richard dies, John will be able to use the life insurance proceed to purchase Richard's business interest.

  Entity plan

Under this alternative, the partnership buys life insurance on the life of each partner equivalent to the interest percentage of the agreed partnership's value.  Upon the death of any partner, the partnership will use the life insurance proceed to purchase the deceased partner's interest.  Each surviving partner's interest percentage may be adjusted to reflect the proportionate increase in their share.

  Trustee cross-purchase plan

Under this alternative, a trustee is appointed in a buy-sell agreement to buy life insurance on the life of each partner.  Upon the death of any partner, the Trustee will receive the life insurance proceeds and redistribute them to the respective partners for them to purchase the deceased partner's interest.

In a partnership whereby there are quite a number of partners, it is more viable to use trustee cross-purchase plan than cross-purchase plan because it reduces the number of policies used.

For example, in a partnership of 15 partners, a cross-purchase plan would require 210 policies (i.e.15 x 14). A trustee cross-purchase plan would  require only 15 policies.

From TheSTAR BizWeek dated Saturday 20 December 2003

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