Addressing the financial issues of a partnership when one of the partner’s dies is often a concern for those planning for their family. At the death of one partner, a partnership is dissolved if there is no agreement beforehand. The partnership no longer exists and the surviving partners do not have a legal authority to act for the partner who has died. One exception is the purpose of finishing up business affairs for the partnership.
It is important then to have a plan in place before any living partners die. When one partner dies and there is no plan in place to distribute or dispose of the business interest, the options are then limited to reorganization or liquidation of the partnership.
Reorganizing a Partnership
The reorganization process is designed to extend the life of a company when financially troubled or when the death of a partner in a partnership leaves the business with limited options in regards to making financial decisions for the business. This can lead to several financial problems within the business.
- Estate Settlement Costs – Questions pertaining to the liquidity of the deceased partner’s estate in settling estate taxes and administrative costs are raised. Can the deceased partner’s estate sufficiently pay for these costs without liquidating the partnership?
- Heirs as Active Partners – Is there an heir that is qualified and willing to take an active role in the day to day management of the business? Are the surviving partners in agreement with remaining in business with the deceased partner’s family?
- Heirs as Inactive Partners – If the deceased partner’s family is not going to take an active role in running the business, are there funds available for the surviving partners to support them? Are the surviving partners willing to take on this role?
- Sell to Outsiders – If the deceased partners part of the business is sold to outsiders, are the surviving partners willing to work with those selected by the deceased partner’s family?
- Sell to Heirs – Are the heirs of the deceased partner willing and able to buy the business? Are they able to start another business from scratch?
- Buy from Heirs – Are the heirs willing to sell to the remaining partner’s? If so, will they be able to agree on a selling price? How will this funding affect the business?
These are just a few of the questions raised when a partner dies. Preplanning for death in a partnership is a necessary step in financial planning for both the remaining partners and the heirs.
Liquidation of a Partnership
Liquidation is the process of dissolving a partnership and distributing the assets. A partnership can not only be liquidated due to the death of one of the partners but also when the partnership goes bankrupt or if one of the partners chooses to dissolve and liquidate their partnership in order to begin a new business venture. Liquidation of a partnership can often leave a business making considerably less money due to time constraints.
Many times, after the death of a partner, reorganization of the business fails to leave surviving partners and heirs with unplanned liquidation. This can result in unfortunate results for both the heirs and the surviving partners.
- Survivor Income – Often, a deceased partner’s dependents will not have a replacement income that was previously received from the partnership.
- Job Loss – When a partnership is lost, it is difficult for the surviving partners to start from scratch in developing a new business.
Even worse, if a partnership is liquidated and there are not enough funds raised to pay off the liabilities, the surviving partners are liable for their share of the deficit. In addition, they may be liable for the entire amount of the deficit if the estate of the deceased partner is insolvent.
Life Insurance as a Potential Solution
Advanced financial planning allows a partnership to reorganize or allow for a planned liquidation avoiding disastrous problems for the surviving partners and their heirs. Using life insurance as a potential solution allows for a seamless transition for all involved.
One solution is for the surviving partners to acquire the deceased partner’s share of the business at the fair market value. This is done through a binding cross purchase buy-sell plan that is funded with life insurance. The surviving partners will then have the cash available to purchase the deceased partner’s interest on a previously agreed-upon price that is fair to all parties involved.
An insured cross purchase buy-sell plan, when planned in advance, can accomplish:
- The prevention of a forced liquidation or an undesirable reorganization
- An agreed upon price of the partnership interest that surviving partners are committed to buying and the deceased partner’s estate is committed to sell
- At a partner’s death, funds to complete the sale are available without delay
- A fixed value of the partnership interest for federal estate tax purposes
- A fair cash price for the partnership interest is guaranteed for the deceased partner’s heirs
- The deceased partner’s estate can be settled quickly and promptly with the available cash
- No interruption in family income
Funding a Buy-Sell Plan
There are several ways that partners of a business can fund a cross purchase buy-sell plan in order to avoid forced liquidation or reorganization.
- Cash Method – If able, partners could amass sufficient cash to buy the partners business interest at a partner’s death. This method can take several years to save the necessary funds.
- Installment Method – If the cash is not available, the purchase price could be paid in installments which can be a significant drain on business income. However, the deceased partner’s family would be dependent on future business performance without any ability to make decisions.
- Loan Method – If there is enough equity in the business to obtain a loan, then over time the loan plus interest must be paid back resulting in an overall higher price to be paid for the deceased partner’s interest.
Insured Method – The best method that guarantees there is cash available immediately to complete the sale assuming that the value of the business has been accurately estimated.