Extract: “Challenges of life insurance marketing – business applications” by Rizwan Ahmed Farid, 2010
A man’s home is his castle and his business, his kingdom. Besides fires, accidents, thefts, burglaries, forgeries, strikes, riots, civil war, malicious damage, subversive activities, terrorism, and earthquakes etc, this KINGDOM is constantly exposed to the perils of premature death, disability, illness, retirement, and insolvency of its owners. These human hazards result in major changes in the continuity, solvency, ownership, control and earnings of the business.
The death of a partner is one crucial problem which, if not provided for, can potentially wipe away the success, goodwill and assets that have built up in the partnership over the years due to expended labour and skill. It could result in a severe below to the business which would greatly affect the future of the surviving partners. It is ironic that a form of business that demands extremely close personal relationships founded on trust, confidence and the cooperative spirit of members, can suddenly be destroyed through factors beyond their choice or control.
The reason for buying Partnership Insurance is the same as for buying personal insurance, i.e. PROTECTION. Through insurance, partners & entrepreneurs ensure the continuity of their business thus also providing continued security to their families. The fortune of the partners’ business and their families are contiguous where the fate of both often rise and fall together.
Some knowledge of the fundamental nature of a partnership is prerequisite to understanding the problems involved in formulating a satisfactory plan to ensure the continuation of the partnership in the event of death of a partner.
Definition of a partnership
A partnership may be viewed as a business marriage. For better or worse, richer or poor, two or more persons pool their assets and liabilities towards a common objective – profit. [2]
Section 4 of the Partnership Act, 1932 contains the following concise definition:
“Partnership is the relation between persons who have agreed to share the profits of a business carried on by all or any of them for all.”
Bates, an outstanding authority on partnership law, says:
“A partnership is the contract relation subsisting between persons who have combined their property, labour, or skill in an enterprise or business as principals for the purpose of joint profit”.
Mechem, another authority on partnership law states:
“Partnership may be tentatively defined as a legal relation, based upon the express or implied agreement of two or more competent persons whereby they unite their property, labour, or skill in carrying some lawful business as principals for their joint profits.”
Liability of partners for acts of the firm
Every partner is liable, jointly with all the other partners and also severally, for all acts of the firm done while he is a partner (Sec. 25 the Partnership Act, 1932).
Liability of partners for acts of the firm
Where under a contract between the partners the firm is not dissolved by the death of a partner, the estate of a deceased partner is not liable for any act of the firm done after his death (Sec. 35 the Partnership Act, 1932).
Rights of outgoing partners in certain cases to share subsequent profits
Where any member of a firm dies or otherwise ceases to be a partner, and the surviving or continuing partners carry on the business of the firm with the property of the firm without any final settlement of accounts as between them and the outgoing partner and his estate, then in the absence of a contract to the contrary, the outgoing partner or his estate is entitled at the option of himself or his representatives to such share of the profits made since he ceased to be a partner as may be attributable to the use of his share of the property of the firm or to the interest at the rate of six percent per annum on the amount of his share in the property of the firm.
Provided that whereby contract between the partners an option is given to the surviving or continuing partners to purchase the interest of a deceased or outgoing partner, and that option is duly exercised, the estate of the deceased partner, or the outgoing partner of his estate, as the case may be, is not entitled to any further or other share of profits; but if any partner assuming to act in exercise of the option does not in all material respects comply with terms thereof, he is liable to account under the forgoing provision of this section (Sec.37 of the Act).
Dissolution on the happening of certain contingencies
Subject to contract between the partners, a firm is dissolved:
- If constituted for a fixed term, by the expiry of that term.
- If constituted to carry out one or more adventures or undertakings, by the completion thereof.
- By the death of a partner; and,
- By the adjudication of a partner as an insolvent.
(Sec. 42 of the Act)
Sale of goodwill after dissolution
In settling the accounts of a firm after dissolution, the goodwill shall, subject to contract between the partners, be included in the assets, and it may be sold either separately or along with other property of the firm (Sec.55 of the Act).
The formal working agreement called the deed or articles of partnership will include provisions for withdrawal of a partner, the specific ownership, profit shares and allocation of duties of each partner. Since a dissident partner can disrupt the business by electing to withdraw, the articles of partnership should provide for withdrawal of a partner by choice, or by reason of death, disability or retirement. The intention is to ensure that a withdrawing partner will cause the least amount of disruption to the business routine.
Some marked differences between Professional and Commercial Partnerships
Professional or personal service partnerships are formed by advocates, architects, accountants, actuaries, physicians and consulting engineers, etc. They differ in some material respects from ordinary commercial partnerships.
Generally professional partnerships are formed for the same reasons as commercial partnership, i.e. expense savings, help with workload, better use of expensive equipment, wider experience, and greater prestige. For example, physicians may find that a partnership practice will benefit each partner by freeing up several nights a week from night calls. Further they may be able to handle more parents than in a separate practice. In a partnership, they can make effective use of medical equipment, technicians, computers, paramedical and secretarial help to handle the increased patients load. Access to equipment and organization at this extent may not be economical for a sole practitioner.
The factors that distinguish a “professional” partnership from a “commercial” partnership have little to do with the professional qualifications of partners. Partners in a professional firm may not necessarily have a higher level of college or university education compared to their commercial counterparts. They may also not be ethically more superior – as ethical behaviour is determined by individual as well as collective conduct.
In a commercial partnership goodwill and capital in the form of tangible property such as land, buildings, fixtures, machinery, raw material, and merchandise represent the major assets of the business. By contrast, a professional or personal service partnership would only need a small amount of capital in the form of tangible property. Legally, little or no goodwill is attributable to a partner’s interest after death.
Professional partnerships may further be distinguished from commercial partnerships by the fact that the former generally use the cash method of accounting in keeping their books. Such firms usually have substantial outstanding amounts of unrealized receivables but these are not visible on their books of account because of the accounting method used.
Commercial partnerships differ from professional partnerships in the character of their assets. While a pharmacist’s skill and competency are important, an attractive store and adequate stock of medicines have even more essential to the generation of income. On the other hand the location of a physician’s or surgeon’s clinic would be of little significance to the earnings of a partnership, in light of his well established reputation and skill. In a professional partnership, therefore, the most valuable assets are the professional skills of the partners.
There is another way that professional partnerships differ from commercial partnerships. A pharmacist can sell his store, or his interest in it, to a non-pharmacist. The non-pharmacist would then hire other pharmacists to fill out prescriptions and dispense medication. The physician however is limited in his ability to sell the practice or his interest in it to persons other than qualified physicians by the ethics and practices of his/her profession. The above noted differences between professional and commercial partnerships result in fewer sale of business/ interest options available to professional partners.
To summarize, the distinguishing features of a professional partnership over a commercial partnership are:
- The major assets are professional skills and earning power of the partners.
- Usually the sale of the partnership is restricted to another qualified practitioner.
- Tangible property may form a small amount of total assets.
- Unrealized accounts receivables do not appear on the balance sheet of the firm because transactions are recorded on a cash basis.
The Contingency of Death of a Partner
As noted earlier, partners in their written partnership agreement may set forth the events which will terminate their business relationship. Often they forget or are unaware that, the death of a partner automatically dissolves the partnership business if not provided for specifically with the partnership agreement (under Section42 of the Partnership Act 1932).
On dissolution a partnership must either be liquidated or reorganized.
Reorganization
In reorganization the surviving partners may choose to re-build the partnership with the deceased partner’s heirs or with an outsider.
The possibility of reorganizing a partnership with the heirs of the deceased partner may be subject to many legal and economic obstacles. Legally, the heirs may find that they cannot enter into a new partnership unless a succession certificate is acquired – a procedure which may involve a considerable amount of time and money. The question of guardianship of minor heirs will also create an obstacle for the formation of a new arrangement. It is likely that the surviving partners may find that the heirs are neither capable nor personally compatible partners.
Alternatively, the heirs of the deceased partner may wish to sell their interest in the firm to an outsider who may not be acceptable to the surviving partners. They would be forced to accept this stranger to avoid liquidation and to ensure the continuation of the business. Reorganization with an outsider would also be subject to the same obstacles of obtaining the necessary succession certificate and possibly guardianship in the case of minors, as when reorganizing with the deceased’s heirs.
A third option, in the event that the heirs are inclined to continue the business and have the funds to pay a fair price to obtain the interests of the surviving partners, is that the surviving partners sell out the business to the heirs of the deceased partner. However, the time and money involved in obtaining the succession certifications and guardianship in the case of minors makes this option cumbersome. Also, court approval may be required for a minor’s investment in business (Guardians and Wards Act). Furthermore, the surviving partners would find themselves with cash but with no business of their own.
The fourth solution for reorganization of the business is that the surviving partners purchase the interest of the heirs of the deceased partner. Again, the obstacles of obtaining succession certificates and guardianship of minor heirs (since all heirs must join in and approve the sale) can make this a time consuming and frustrating process. Complications may arise if some of the heirs pressure the partners for a sale price that is beyond the fair market value. On the other hand the surviving partners may face difficulties in raising sufficient money to fund the purchase of the interest of the deceased partner.
Liquidation
This is an elaborate and costly process involving the winding up of business, selling of assets, paying of debts, and distributing of the residual amount, if any. If for any reason liquidation results in a forced sale, losses could range from fifty to ninety percent due to:
- Goodwill being entirely wiped-out
- Accounts receivable becoming impossible to collect
- Inventory, machinery and fixtures being sold for a fraction of their market value.
- Creditors pressing for immediate settlement of their accounts.
Often the result is disastrous to the personal estates of all partners. Hence, an arrangement to handle the disposition of a partner’s interest has value both to the outgoing partner as well as to the continuing partners. So long as the business has value as a going concern, proper planning for the event of death of a partner helps avoid the costs and hazards of liquidation or reorganization.
While a partnership can function without a formal agreement, it functions best when all the rights and duties of partners are spelled out in writing. The ease with which a partnership can be created has a corresponding drawback that the partnership can just as easily be dissolved. The partnership agreement should specify the rights of the partnership and surviving partners. It should clearly specify that the surviving partners will offer to purchase the interest of the outgoing partner. The agreement should cover withdrawal from partnership, whether voluntary or by reason of death, disability or retirement.
The problem that death creates in a partnership is clearly indicated above, i.e. there is dissolution of the partnership at death and the surviving partners are faced with liquidation of the business imposed by law unless some alternative solution can be worked out. Keeping in view the complex situation of any partnership the partners’ objectives would be:
- For the business to continue without any legal hindrance from the heirs or legal representatives of the deceased partner.
- For their heirs to get the full value of the deceased’s interest in cash.
- For the surviving partners to continue to own the business.
A buy-sell agreement funded by Partnership Insurance therefore seems a logical solution. Partnership insurance offers a simple but valuable solution to the multifarious problems caused by the death of a partner for partners as well as their families. It helps to keep the business as a going concern whereas otherwise death or disability of a partner may:
- Affect the business’ credit.
- Adversely affect the control of the business.
- Diminish the business’s monetary value and profits, or
- Dissolve the business.
The Buy sell Agreement would be funded by the Partnership Insurance as follows:
A written contract is drawn up among partners individually, or between the firm and its partners collectively, for SALE AND PURCHASE of the interest of any deceased partner. The contract either stipulates the price to be paid (this is kept up-to-date by periodic appraisals) or a formula that will be used to arrive at a fair value for the deceased partner’s interest.
Upon death of a partner, the insurance proceeds are paid to surviving partners or the firm as the case may be. The insurance money is then paid to the legal representative of the deceased partner, who will then transfer the deceased partner’s interest to the surviving partners or the firm as the case may be.
Thus, through partnership insurance, the surviving partners will continue to own the business while the heirs of the deceased partner will receive the fair and full cash value of the deceased partner’s interest in the partnership.
ADVANTAGES OF PARTNERSHIP INSURANCE
Advantages to all partners while living
- It is good business investment. The cost of partnership insurance may be less than interest charges on a loan of the principal sum.
- It provides a guaranteed market and price for a partner’s interest at death.
- The gradually increasing cash values of the policies provide liquid reserves, which may be used in emergency for stabilizing the business and/or to provide cash for exceptional opportunities.
- It creates peace of mind to know that in the event of death of a partner the surviving partners will own the business and the heirs of the deceased will receive a full and fair value of the deceased’s interest in cash.
- Special provisions may also be made to provide benefits to a partner in the event of total and permanent disability.
- It promotes goodwill of employees, financial institutions, and creditors by ensuring stability of the business.
Advantages to surviving partners
- It prevents loss of business momentum. It guarantees that needed funds will be available immediately in the event of death of any insured partner for any necessary payment, such as cash with which to buy out the deceased’s partner’s interest.
- Full ownership is guaranteed to the survivors at an agreed price. It eliminates any danger of dissension and stalemates with the heirs as everything is specified within the agreement and has been settled in advance.
- It prevents undesirable management changes, reorganization or forced liquidation
- It underwrites their business future, and their families standing in the community.
- It insures continuation of the business.
- It prevents loss of credit and good will.
- It is effective and economical.
- A retiring partner may continue his insurance for his personal use.
Advantages to heirs
- It guarantees an immediate market (often the only market) at a fair and full cash value for their inherited interest. The heirs have the assurance of immediate settlement of the deceased’s account and cash payment.
- It protects the family against losses due to liquidation.
- It removes their assets from the hazards of shrinkage or loss (if the firm is a speculative business enterprise).
- It frees their personal estates from all liability from business creditors.
[1] This article was first published in the “Insurance Journal: April – June 90 Issue.”
[2] All section cited in this article are from the Partnership Act, 1932.
