Why you need a written agreement for your family farming business?
The majority of farms in the UK are run and farmed by family partnerships. This happens even where there is no intention to operate under a legal structure.
The law provides that when two or more people farm together and have the intention to make a profit, they automatically create a partnership. So if you and your spouse, parent, or a child farm together, you will have created a partnership. Therefore, , regardless of the fact whether you are running a husband and wife partnership business or family business, you need to have a deed of partnership.
Further, if you have not signed a written partnership agreement, your relationship as business partners and the functioning of the business will be governed by a default set of rules set out in the Partnership Act 1890, a law that is not particularly relevant today or that is likely to reflect the intentions of the parties.
The Partnership Act is rather a simple and outdated statute that offers very basic and often times disastrous rules on how partnerships operate. For instance, under the Act, if a fellow partner dies, they partnership automatically dissolves. This may bring about unpredictable tax or legal consequence.
Given that most people want the future value of the farm to accrue to the next generation and also to maximise how much inheritance tax relief they will get, not having a written partnership agreement can prove to be a financially crippling mistake.
One potential issue with not having a formal written partnership arrangement is that often it can be unclear whether the farmland and the buildings are partnership property or owned personally by one of the partners. This can lead to some serious tax implications.
On death, agricultural property is generally eligible for agricultural property relief (‘APR’) at 100%. However, the relief is based on the agricultural value of the property and not the market value which is usually 30% to 40% higher. APR is not available on land or farm property that is not being used for agricultural purposes.
Any partnership property in a farming partnership that is wholly or mainly trading may be eligible for 100% Business Property Relief (BPR). However, where the property is not partnership property, but rather it is owned by a partner personally and was being used in trade, it will receive 50% BPR.
In order to achieve the full BPR, the farmland and buildings will have to be partnership property. Some people mistakenly believe that by merely including the property in the annual accounts will be enough to demonstrate that the property is partnership property. However, without documentary evidence to support this, it is open to challenge by HMRC.
Previously, relying on the inclusion of the farm property on the balance sheet accounts would have sufficed to demonstrate that the property was partnership property. However, HMRC takes a more robust approach now. If it decides that the property was not part of the business, your claim to the BPR could be limited to 50% or your claim could be denied altogether, resulting in an inheritance tax charge at 40%.
So if you show the farm property as capital to the partnership, inheritance tax can be significantly reduced when the APR is not available on the entire estate and the BPR is claimed on the balance.
Dissolution of partnership on death
Forming a partnership is relatively simple and does not require a written agreement. In absence of a written agreement, the 1890 Act governs what happens.
Where there is no written agreement or if the written agreement is silent as to what should happen upon death of a fellow partner, the Act provides that the partnership is automatically dissolved and, from then on, the remaining partners can only act to wind up the business and sell the assets, regardless of whether there are several other partners who might wish to carry on the business.
In the absence of written agreement stating to the contrary, upon death of a partner, the personal representatives of a deceased partner can insist that the partnership is wound up and the assets be sold. The surviving partners will have no right to acquire the decreased partner’s share.
This can leave the existing partners and their personal representatives in a tough position while dealing with emotional beneficiaries to attempt to reach an agreement on a more suitable arrangement. Reaching an arrangement takes time, which can endanger the viability of the business and affect the critical contracts and cash flow.
Therefore, in depth consideration should be given as to what will happen when a partner dies. You need a well thought through plan. Specifically you should think and decide the following and ensure that whatever decision is reached, is put into a written agreement that covers:
- how partnership shares will transfer
- to whom will the partnership shares be transferred
- how shares are valued
- how and when will shares be paid for
In coming to a decision on these points, you need to keep the interest of the beneficiaries under consideration (who may differ for each partner) and also focus on how to reduce any impact of a deceased partner’s death on the business itself.
Profit and loss sharing
If no written partnership agreement has been entered into or in the absence of a specific provision stating otherwise, the law assumes that profits and losses of the business will be divided equally. Again, this may not be what the parties intend.
For instance, one partner may have contributed more capital to start the business or one partner may have more responsibility.
If the partners have not signed a written partnership agreement clearly stating out how profits and losses will be shared, being forced to share the profit and losses equally may create problems that can only be resolved with litigation.
New partners or retiring partners
Under the Partnership Act, a new partner can only be admitted if the appointment has unanimous consent from all the existing partners.
This may not be appropriate in all cases.
In order to improve on the default position of the Act, you should take time to consider what will happen in case of marriage, divorce, retirement, loss of mental capacity, and introduction of new partners. There should be clear provisions for what will happen to a partner’s share in those cases.
Similar to inclusion of new partners, removing a partner can also be very difficult in the absence of a written agreement. Under the Act, a partner cannot be expelled. The only option is to dissolve the partnership. Therefore, it will be worth your time to decide how a partner can be expelled, on which grounds, and the procedure that will ensue upon expulsion of a partner.
Control of the business
Being family member, you might assume that you will never come to a disagreement on major decisions relating to the farming business. However, in our experience conflict is systemic in every family business.
In the absence of a written agreement stating otherwise, the Partnership Act states that all decisions concerning a partnership business have to be made on the basis of the majority decision of the partners. This may not be what the parties intend or even practical in some cases.
Therefore, you should think about how control over concerns of the business will be exercised. Particularly, you should be thinking about which matters should be decided unanimously and which matters will not require voting and include this in a written partnership agreement.
Please note that the information provided on this page:
- Does not provide a complete or authoritative statement of the law;
- Does not constitute legal advice by Net Lawman;
- Does not create a contractual relationship;
- Does not form part of any other advice, whether paid or free.
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