It is essential to agree how the capital assets of a partnership, particularly freehold property, are to be valued in the event of a partner leaving or dying. This need has been emphasised by the Court of Appeal decision in Drake v Harvey (2011) EWCA CIV 838.
The case involved a farming business carried on by Francesca Drake, her parents and her brother. Unfortunately both Francesca’s parents ceased to be partners because they no longer had mental capacity and left the partnership as a result. Her brother died in March 2006.
On the administration of the brother’s estate a dispute arose about the value of the farmland used by the business. The estate contended that it was entitled to have the property revalued to reflect the current market value and to be paid its share of the capital assets on that basis. Francesca contended that the value of the land as set out in the last annual general account should apply. The land had been revalued in 1987 and included in the capital assets of the business which were valued in total at £360,000. The value of the land in 2011 was estimated to be £5.5m.
The Court agreed with the estate which left Francesca with the massive problem of having to fund the purchase of the shares of the other partners whilst continuing to run the business. She appealed successfully to the Court of Appeal.
The land had been shown in the partnership’s accounts at cost. The Partnership Agreement provided that on the death of a partner his/her Estate was entitled to be paid the amount standing to the credit of his/her Capital Account in the last annual account prior to the death. The agreement also provided that there would be no increase in capital without the consent of all the partners. The original Court decided that there was nothing in the dealings between the parties which indicated how the brother’s share was to be calculated in the circumstances and which would prevent the payment of a “fair value”. The Court of Appeal decided that there is no presumption in favour of a “fair value” when the Partnership Deed is silent as to the partners’ intentions.
The Court of Appeal had to decide between what they called “the Accounts Basis” and “the Fair Value Basis”. It decided that the basis of valuation had to be that which had been applied by the partners in agreeing the value of the land as recorded in the general accounts of the partnership.
It is common practice to include freehold property and other capital assets at cost in the annual accounts. It is also common practice to provide that an outgoing partner’s entitlement on leaving will be ascertained by reference to the last annual accounts prior to the leaving date. If you agree to this and you are the first to leave or die, you have to be aware that you or your estate will receive only the cost value of the assets and not the current market value. Of course, in a declining market, this may be to your advantage.
The lesson to be learnt is that when you start a business or join a partnership, it is important to agree how assets are to be valued on death or on leaving.
If you are happy to agree with a historic cost value basis, you need to be aware that, if you leave or die, you or your estate will not be entitled to share in the real value and that the continuing partners will have the benefit of any increase over and above the value of the land as recorded in the accounts.
If all the partners are happy to agree to the land being revalued either annually or on the death or retirement of a partner and for the current value to be included in the accounts, they have to be aware of the burden which will be placed on the continuing partners when they come to pay out the Capital Account of a retiring or deceased partner.
For further information on Partnership agreements, please contact Peter Moore in our Professional Practices team on 0844 391 5848.