What you need to know about automatic accrual
When setting up a business as a partnership, it’s important to put a plan in place for what will happen should one of the owners leave the business - either voluntarily or through death or serious illness.
The easiest way to do this is to write up a Partnership Agreement when the company is formed.
Although there’s no legal obligation to create a Partnership Agreement when you establish your company, it can save a lot of headaches down the line if you need to redistribute shares or equity, or when it comes to dealing with the rights of bereaved relatives.
There are many different ways to structure a Partnership Agreement, but one of the most common is to use an automatic accrual.
In this guide we’ll look at the benefits of a Partnership Agreement and why using an automatic accrual might be the best option for you.
What is an automatic accrual?
An automatic accrual agreement simply states that the outgoing business assets or interests that form part of the Partnership Agreement will be automatically passed to the remaining shareholders or partners in the event one leaves.
For example, if there are three partners in the business and one leaves, the remaining shares in the business will be redistributed to the remaining two shareholders with the partnership continuing as normal.
This would happen regardless of whether the business was a simple partnership, or a limited liability partnership (LLP).
Benefits of using an automatic accrual
The biggest advantage of using an automatic accrual is how simple it is and the clear procedure it lays out for what happens to the assets in the business in the event of a partner or shareholder leaving - for whatever reason.
If a partner exits the business, the partnership continues and the assets go to the remaining partners, simple.
Are there any downsides to automatic accrual?
A potential downside of automatic accrual arises when you consider any compensation to the outgoing partner’s family.
Under an automatic accrual agreement, the business assets would pass directly to the remaining partners in the company, and the outgoing partner’s beneficiaries wouldn’t be entitled to any reimbursement from the partnership.
With that in mind, depending on the nature of the relationship between the partners, you might want to write into the agreement that any beneficiaries should gain compensation for the outgoing interest in the company.
How to set up an automatic accrual agreement
To set up an automatic accrual agreement the partners should write up a Partnership Agreement upon formation of their company, stating that in the case of their death, or one of them leaving the business, the interest in the company goes directly to the remaining partner or partners.
It’s best to have this agreement drawn up by a solicitor and agreed by all partners at the beginning to avoid any disputes later.
As part of the agreement, to ensure the outgoing partner’s beneficiaries get some compensation in the business, each partner should also take out an own life protection policy.
This means that each partner would be responsible for buying and paying for their own life protection policy.
This policy should be taken at the value of their interest in the business (for example if the business makes £1,000,000 and the partner has a 50% interest in the company, their own life protection should be at £500,000).
It’s also best to place the protection into a trust as this can be better for tax purposes - which we’ll look at it more detail further down.
One thing to note, is that the business partner’s beneficiaries should be the recipients of the payout from the trust, not the partners.
The purpose of the own life protection is to provide some financial compensation to your beneficiaries for your share in the company.
It’s also worth considering writing into the Partnership Agreement that if the value of the business protection is below the real value of their stake in the company at the time they leave - or die - the remaining partners will fund the difference out of the company.
This kind of scenario could happen if an own life trust is taken out at the start of the company’s life - but that value has grown without updating the policy.
Understanding tax, business protection and automatic accrual
When it comes to paying out on a protection plan in the event of a partner’s death, it’s understandable you’d want to protect beneficiaries from paying tax unnecessarily.
This is why you should place your own life policy in a business trust.
By putting your own life protection policy in a trust and naming your estate as the beneficiary, you should avoid paying Inheritance Tax on the payout.
Every partner should ensure they’ve put their policy into a trust for this purpose.
It’s also possible that the value of the business interest that passes to the remaining partners could be covered by business property relief - although this is something you’d need to confirm when taking out the policy.
One thing to note, the payments on the own life policy themselves won’t be liable for any tax relief regardless of whether each partner pays for them individually or whether they take the money out of the business.
Protect your business with Rigby Financial
Protecting your business interests and the financial future of your family is a responsibility not to be taken lightly.
With the right Partnership Agreement and Business Protection in place, you can secure both regardless of what the future holds.
At Rigby Financial you can find the best policy to protect your business and provide for your family from the entire financial protection market.
One of our experts can work closely with you to understand the circumstances of your business and help you find the right policy to suit your needs.
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