A Guide to Understanding Partnership Redemption Agreements – What You Need to Know
A partnership redemption agreement is a legally binding contract between members of a business partnership that stipulates what will happen in the event that one of the partners dies or decides to withdraw from the company and receive payment for their shares of the company. The agreement essentially gives the remaining partners the first right of refusal to buy the shares of the withdrawing partner.
Such an agreement can be absolutely essential to the continuity of a business, as it gives the owners the ability to essentially "squeeze out" a partner who is no longer involved in the business without having to worry about selling those shares to an outsider if the remaining partners would rather avoid such a scenario.
For example , if you and your partner co-own a software development firm called SoftwareCo, and you have signed a partnership redemption agreement giving the other party first right of refusal to buy your shares in the company, if you were to pass away and your shares go to your spouse, your spouse would not have the ability to request remuneration for the shares if your partner does not so desire. They would instead be forced to sell those shares to your partner for the price agreed upon in the partnership redemption agreement.
This protects the company against your spouse being a potential distraction to the company as they would effectively have no shares or control of the company even if they otherwise did inherit your shares.
Essential Features of a Partnership Redemption Agreement
Understanding Partnership Redemption Agreements: Key Elements and Considerations
It is generally understood that a properly drafted partnership redemption agreement must address at least the following key components: While many states have statutes governing the permissible means of valuation, often, states allowing for partnership agreements or partnership redemption agreements dispel with formalities associated with valuation (i.e., such as requiring appraisal) and permit the partners to determine the method of valuation.
Payment Terms The basic details relative to payment of the purchase price for the withdrawing partner’s partnership interest generally include: (i) the manner and form of payment (i.e., lump sum, installments, security for payment, interest, etc.); (ii) the date for payment (i.e., upon withdrawal, within a certain period of time, etc.) and, if installment payments are permissible, whether timely payment of each installment is required.
Conditions Conditions typically addressed relative to the purchase of a partnership interest include the necessity of obtaining consent of any third parties, the passing of a specified time period, insurance requirements, satisfaction of open liabilities of any kind, deposit or retention of a percentage of the purchase price to secure completion of the transaction, and waiver of legal claims.
Important Considerations in Creating a Redemption Agreement
In drafting any partnership redemption plan, the parties must consider carefully the legal mechanics by which such a plan is implemented. An initial consideration in ensuring the enforceability of any partnership redemption agreement is whether such agreement is governed by statutory law applicable to partnerships or by common law applicable to contracts. Each State has its own statutory law provisions applicable to partnerships, some of which impose default provisions that are applied to partnerships in the absence of contrary express provisions in a partnership agreement. Under the Uniform Partnership Act adopted in most States, a partnership may be dissolved at any time by an express will of any partner without regard to the reason therefor.
Under the Uniform Partnership Act, any withdrawal of a partner is considered a "dissolution" and, if a partnership includes a provision for a partner’s retirement or resignation at a specified date or upon the happening of a specified event, then a "dissolution" is deemed to occur pursuant to that provision. The fact that a person is or has been a partner is not generally allowed to be a matter of public knowledge (e.g., under the Uniform Partnership Act, the name and address of each partner is required to be maintained at the principal office of the partnership, but that document is not open to the public, nor does it have to be published).
Most importantly, unless there is an express contrary provision in the partnership agreement, a partner has the power to dissolve the limited term of a partnership, not just to withdraw from the partnership. Accordingly, even if a partnership agreement grants a partner an annual right to request a redemption of its interest, without an express contrary provision in the partnership agreement, the redemption could be viewed as a dissolution. Dissolution is frequently not desired for tax and other reasons. The Uniform Partnership Act provides for the appointment of a liquidating trustee to wind up the affairs of the partnership. This process would clearly not apply if the partnership could be continued.
Similarly, the Tax Code provides that the terminable interest of a partner terminates when the partner’s interest may be acquired by the other remaining partners by the exercise of a purchase option, or otherwise, even if such purchase is not accomplished. Accordingly, a redemption plan should be designed to avoid treating the partner’s interest as having terminated. In addition, if the purchase price exceeds the partner’s outside basis at the time of redemption, the partnership must withhold tax at the time of the redemption. In such case, the agreement should provide for a "gross up" payment to the redeeming partner to account for such withholding. Similarly, if the redemption price is payable over time (e.g., two years), the partnership must withhold tax on the amount of the redemption price being paid in the first year (even though the partnership need not withhold tax in the second year until the redemption price is actually paid).
In drafting any partnership redemption plan, it is imperative to obtain the advice of tax and other advisors, including securities counsel, to ensure that the plan meets not only the parties’ needs but also applicable State and Federal laws that apply to the plan.
Common Circumstances for a Partnership Redemption Trigger
The circumstances of each partner’s departure will be different, but the redemption event is almost always triggered by an event outside of the control of the partnership. Certain events are rather common and most likely to be seen in any partnership agreement. For example, if a partner in the partnership dies, is required to retire due to age, or voluntarily withdraws from the partnership, the partnership will often buy him out. Generally speaking, a partner can also redeem his interest at the expiration of a fixed term partnership agreement or at dissolution.
At the same time, partners departing a partnership may do so in any number of ways. For instance, within a fixed term partnership agreement, non-renewal or expiration of a partnership agreement is often treated differently from mandatory withdrawal or retirement. In private companies, the market for the company cut-off from a partner’s rights in the company. See. e.g. Miller v. HCP, Inc., 191 S.W.2d 649 (Tex. App.- Houston [1st Dist.] 2006) (discussing whether a partner was entitled to a buyout pursuant to a partnership agreement). For public companies, as opposed to private companies, a partner may be subject to publicly traded stock restrictions. See. e.g. Mottaz v. Facet Bank & Trust Co., Nos. 08-1925, 08-1927, 2009 WL 565173 (8th Cir. Mar. 6, 2009) (discussing whether a bank officer was entitled to a buyout pursuant to a buy-sell agreement).
While not universally applicable, an example of a typical approach taken in a partnership agreement is to provide a partner’s redemption right, if any, upon certain events. Under one approach, the redemption of a partner’s interest is intended for the benefit of all partners upon certain specified events, including (but not limited to) a partner’s (a) death, (b) disability, (c) termination, resignation, withdrawal or retirement, (d) adjudication of incompetence or insanity, (e) conviction of a felony involving moral turpitude, (f) being named as a defendant in a criminal proceeding, or (g) determined to be in default. See a discussion of this approach in Clark v. Clark, 140 A.D.2d 493 (N.Y. App. Div. 1988). Under this approach, a partner’s agreement to contribute capital is a contingent obligation that each partner takes in light of the commitment of the other partners to continue in the partnership. Under this approach, each partner is entitled to such partner’s proportionate share of the return of his capital and any forfeited payment must be paid for the benefit of the remaining partners. Each of the events noted above could be considered an event of withdrawal, although some of the events may result in immediate withdrawal while other events may require a lengthy period of time to work through to see whether the partner in question is going to be able to return to the partnership. Accordingly, even if a partner is forced, such as during a bankruptcy proceeding, to turn over his ownership interest or the value of his interest, he will still be allowed to redeem his interest from the partnership.
The Pros and Cons of a Partnership Redemption Agreement
A partnership redemption agreement can be an ideal solution for buying out a partner, but practitioners should also understand the risks. A partnership can provide financial security and flexibility in structuring a buyout arrangement; the partnership can also provide liquidity for both the business and the partner, and a way to fairly assess the value of the departing partner’s interest. But the partnership form also has its own risks.
Liquidity is not always a given. In the event of a redemption at the request of a partner or the partnership, there may be liquidity constraints for the partnership which affect the value the partner receives. For example, if you only have cash on hand to fund 50% of the redemption price, that can limit both your ability to keep key people and an incoming partner.
With respect to an involuntary redemption, a redemption agreement can specify particular events that will trigger a mandatory redemption. If someone becomes disabled or dies, unless the partnership agreement states otherwise or the shareholders agree otherwise, the partnership is usually required to redeem their shares. But what if the departing partner is a key person and should be immediately replaced and doesn’t want to make such a transfer?
Or as Fluno states so well, if you have someone coming into your partnership who is a key person and a driving force and don’t want him to have to deal with a traumatic change at the business, it is better not to have to do a mandatory redemption for him.
You can typically avoid any liquidity concerns and avoid a mandatory obligation to redeem by prepaying for insurance and having the insurance proceeds go directly to the departing partner’s estate. But if a partner is closing that insurance and paying premiums, there may be objections from the partner and concerns over cash payments.
The partnership may require partners to purchase life insurance for the benefit of the partnership as a life insurance trust or custodian-controlled account. Partner C can control and own his own policy or have a family member be the beneficiary.
For a selling or incoming partner , it may be advantageous to be cash-rich and the purchase price to be in cash. But a selling partner may be pursuing the deal because of the ability to cash out and not be forced into the partnership for whatever complications may be involved, and an incoming partner may not be able to afford the entire payment at the outset and instead wants the payments to be spread out. This means using installment payments paid over time.
What do you do if a shareholder refused to sell his shares, or refuses to accept the proceeds? A disputes clause would allow for arbitration. Without an agreement to the contrary, you can use affordable and logical terms to return capital to the business.
Occasionally a key partnership will dissolve because of a deadlock or other circumstances. At the time of formation, you can specify how a partner can dissolve the partnership, whether a vote is needed, and what conditions must be met.
As Fluno further advises, "A partner with a spread-out buyout arrangement must have some say-so regarding the partnership being dissolved or sold." In the absence of such agreement, the partner could be unhappy with the dissolution and the price of the sale.
If the buyout arrangement fails and causes the dissolution of the partnership and liquidating distributions are not in satisfaction of their buyout obligations, the partnership can end up losing capital in contravention of IRS rules, Fluno reminds.
To protect everyone’s interests, you may want to form a restricted partnership with a limited partnership component that can be governed by LLC rules. Before a partner becomes a partner, you can specify what happens if the entity or business pressures them to dissolve the partnership or cease doing business. In the event the entity or business just shuts down, the partner receives distributive shares.
Negotiating Partnership Redemption Agreement Terms – Things to Keep In Mind
Negotiating the terms of a partnership redemption agreement is a crucial step in achieving a fair and equitable outcome for all parties involved. Successful negotiation requires a careful and strategic approach, as the terms of the agreement can impact both the departing partner and the remaining partners for years to come. Here are some effective strategies for achieving a mutually beneficial outcome.
Do Your Due Diligence
Before entering into negotiations, it is important to have a clear understanding of the underlying issues prompting the action. This includes not only the specific event leading to the potential redemption, but a review of the health of the company and the financial position of all partners. You will want to take into consideration accounting practices, valuation methods, and how your company fits into the market as a whole. If your company is strong, or if you are aware that the outgoing partner may have ulterior motives, it may be worth initiating a buy out away from litigation. Additionally, becoming familiar with other agreements governing the company can help avoid tendentious tacts designed to gain the upper hand during negotiations.
Keep the Exiting Partner Informed
Educated guesses on what the opposition will and won’t support can lead to a poorly drafted agreement and cause delays in closing a deal. Firms familiar with previous experiences with ownership transitions can often anticipate what a partner may request based on what is fair in our current climate. For example, existing law firms can suggest what is considered fair when it comes to further compensation for a selling partner. They are also up to date on changing employment laws and what they consider fair. Talking with a knowledgeable firm can ensure that your agreement is on the cutting edge, and is consistent with current practice.
Choose Your Battles
It’s easy to get caught up in the moment and allow emotions to dictate your strategy. Don’t allow this to be your downfall. A smart negotiator knows that not every issue is worth fighting for, and a little give and take can help the process reach a swift and satisfactory conclusion. If a current dispute has colored the argument to the point where the parties can’t discuss it without a lawyer present, it may be time to pursue mediation, divorce counsel, or a third party jurist. It is essential to preserve your professional relationships while resolving the issue.
Consider the Big Picture
Understanding the overall tax implications of a buyout, it is possible to use tax minimization strategies to provide anywhere from thousands to millions in tax savings. For instance, having a buyout occur at the beginning of a calendar year may allow you to carry back any net operating losses. Alternatively, using payment over time or an annuity may help you avoid a large tax burden in any given year. The best way to assure your financial future is to consult a qualified financial planner, business attorney, or accountant about your options. Nothing is more frustrating than being dinged for thousands in taxes after the fact.
Partnership Redemption Agreements: A Practical Look with Real World Scenarios
To illustrate the types of situations where a buy-out or purchase from the partnership can take place pursuant to a redemption agreement, the following are examples of successful redemption agreements.
An accounting firm had a combined retirement and disability agreement that provided for a full buy-out from the partnership on retirement at age 62 with mandatory retirement at that age. If a partner became disabled, his or her buy-out from the partnership was based on a formula in the agreement. The buy-out was payable in increasing annual installments over a 10-year period. All capital accounts were fully repaid and dividend income deferred on unliquidated amounts. An additional term of the redemption agreement provided for the deferral of any income that would be payable on the unpaid amounts until the following January since buying partners did not want to pay income tax on amounts that would have to be repaid in the current year. The agreement satisfied the requirements of Section 736 of the Internal Revenue Code. The payment terms for the retirement and disability occasions were similar.
A law firm had a redemptive buy-in agreement providing for a subsidized buy-in (i.e., discount) for new admitted partners. The admitted partner’s share of partnership capital which was attributable to attorney time in the practice of law for the prior 36 months was discounted by 20%. In addition , the new partner would continue to receive credit for his or her 20% ownership of the demonstrable office premises over the first two years of attendance. The cash obligation to the new partner was the present value of his or her deal over the next five years. A discount of 6% was applied.
A large corporate workplace solutions firm had a buy-out purchase agreement for minority partners where part of the purchase price consisted of the partner’s unliquidated capital. Annual payments were made to the buy-out partner which included interest at a fair rate where the partnership would assume the risk of the capital contribution being repaid; the longer it took to make the buy-out, the less actual cash would be returned to the buyer. This was both to compensate the partnership and to provide an advantage to the partnership in obtaining additional employees.
A medical practice that had a significant account receivable and revenue stream from one physician had a buy-sell agreement to buy-out the spouse of the physician on his death. Since the spouse was not involved in the practice, a redemption agreement to repay capital, distribute equity, credit the spouse for investment into the office space, etc. was determined to be in the best interest of the practice as it would be a distraction for partners to deal with the spouse personally.