How a Partner's Death Affects Your Partnership

A business partnership is built on a personal relationship. Unlike a company, which survives changes in its directors and shareholders, a partnership is the partners. That is why the death of one of them sets a legal process in motion whether anyone wants it to or not.

The default rule, in every Australian state and territory, is that a partner's death dissolves the partnership. But that default is also the most avoidable part of the whole story, because the legislation that creates it operates subject to any agreement between the partners. Whether the business survives, who buys the deceased partner's share, how it is valued and what the Australian Taxation Office (ATO) needs to be told are all things that can be settled in advance. This article walks through the mechanism from start to finish: what the law does on its own, what a partnership agreement can do instead, how the tax treatment follows the paperwork, and where a buy-sell agreement funded by life insurance fits in.

Who Is Involved When a Partner Dies

Five groups have a direct stake in a partnership immediately after a partner dies, and their interests do not always line up:

• Surviving partners: They keep running the business day to day, but from the moment of death they are, in law, winding up a dissolved partnership unless an agreement says otherwise. They remain personally liable for the firm's debts.
• The deceased partner's estate: The executor or administrator steps into the deceased partner's shoes. The estate is owed the value of the deceased partner's share of the business, and it may also be liable for the deceased partner's share of the firm's debts.
• Staff, creditors and suppliers: Employees keep their entitlements, and lenders, landlords and suppliers keep their claims against the firm. Because a partnership is not a separate legal entity in most states, those claims are pursued against the partners personally.
• The ATO and the Australian Business Register: The composition of the partnership has changed, so the partnership's registration, tax file number (TFN), Australian business number (ABN) and GST registration all need to be reviewed, and the ATO notified within 28 days.
• An insurer: If the partners put a buy-sell arrangement in place, a life insurer may hold the policy that funds the purchase of the deceased partner's share from the estate.

The tensions are easy to see. The surviving partners want the business to continue quickly and cheaply. The estate wants a fair price for the share, and may need the money to pay the deceased partner's debts or to distribute to beneficiaries. The ATO wants to know what happened and when. A written agreement is the document that reconciles these interests before a crisis makes reconciliation much harder.

The Default Position: Death Dissolves the Partnership

The starting point is s 33 of the Partnership Act 1892 (NSW), and the equivalent provision in every other state and territory. Section 33(1) provides that, subject to any agreement between the partners, every partnership is dissolved as regards all the partners by the death or bankruptcy of any partner.

Three consequences follow automatically when there is no agreement to the contrary.

First, the partnership ends at the moment of death. The business can still be traded while it is wound up, but the legal footing changes. Under s 38 of the NSW Act, the authority of each surviving partner to bind the firm continues only so far as is necessary to wind up the affairs of the partnership and to complete transactions begun but unfinished at the time of the dissolution, and not otherwise.

Second, the deceased partner's share becomes a debt owed by the surviving partners. Under s 43 of the NSW Act, the amount due to the representatives of a deceased partner in respect of their share is a debt accruing at the date of the dissolution or death. In other words, the estate is entitled to the value of the share as at the date of death, calculated according to the rules in the Act, which default to equal shares in capital and profits under s 24 unless the partners agreed otherwise.

Third, liability continues on both sides. Under s 9 of the NSW Act, every partner is jointly liable for the debts and obligations of the firm incurred while they were a partner, and after death the deceased partner's estate is also severally liable for those debts so far as they remain unsatisfied, subject to the prior payment of the deceased partner's separate debts. For the surviving partners this means personal exposure for staff entitlements, lease obligations, supplier debts and tax liabilities if the business cannot meet them from its own assets.

If the partnership is wound up rather than continued, s 44 sets the order of distribution. Losses come out of profits first, then out of capital, and finally out of the partners' own pockets in the proportions in which they shared profits. The firm's assets go first to paying the firm's debts to people who are not partners, and only then is anything left for the partners or the deceased partner's estate.

What a Partnership Agreement Can Change

The words subject to any agreement between the partners at the start of s 33 are the whole game. A properly drafted partnership agreement displaces the statutory default and decides in advance what happens on death. The clauses that matter are:

• A continuity clause: This states that the death of a partner does not dissolve the partnership and that the business continues with the surviving partners.
• A valuation mechanism: The agreement should fix how the deceased partner's share is valued, whether by a formula, a multiple of earnings, or a fair market value assessment by an agreed valuer. Without this, the estate and the survivors negotiate over a number, and that negotiation can destroy the relationship.
• A buyout mechanism: Who buys the share, at what price, and on what payment terms. This may be a sale to the surviving partners, or a transfer to a replacement partner nominated by the estate.
• An executor clause: In a two-person partnership, continuity usually requires the agreement to allow the deceased partner's executor, trustee or beneficiary to join the partnership, so that there is never a period where only one partner remains.
• A profits clause: The agreement should say what happens to profits earned after the death but before the buyout is completed, so the estate does not end up arguing over them later.

It is also worth knowing what the statutory defaults are, because they apply to anything the agreement does not cover. Under s 24 of the NSW Act, in the absence of agreement, all partners share equally in the capital and profits of the business and must contribute equally to its losses, no partner is entitled to remuneration for running the business, and no new partner can be introduced without the consent of all existing partners. An agreement that says nothing about death therefore leaves the estate with an equal share of the profits, and it leaves the survivors unable to bring in a replacement without the estate's consent.

One option is to do nothing: the surviving partners may simply decide to close the business, sell its assets, pay its debts and distribute the balance. That is a legitimate choice, but it is rarely what the partners intended when they built the business together, and it exposes the survivors to the full personal liability described above while the winding up runs its course.

The Tax Mechanics: Reconstituted or New Partnership

The ATO's position follows the general law: when a partner dies, the partnership is dissolved and a new partnership is formed. But the ATO draws a distinction between a technical dissolution, where the business simply continues with a changed membership, and a genuine winding up. That distinction decides whether the partnership keeps its TFN and ABN.

According to the ATO's guidance on changing the makeup of a partnership, if the changes in composition amount only to a technical dissolution, the partnership may be able to continue as a reconstituted partnership. The ATO will generally treat a changed partnership as a reconstituted continuing entity where:

• at least one partner is common to the partnership before and after the reconstitution;
• the partnership agreement contains an express or implied continuity clause;
• there is no break in the continuity of the enterprise, meaning the partnership's assets remain with the continuing partnership and the nature of the business, the customer base and the business name do not change; and
• there is no period where there is only one partner, which in a two-person partnership means a direct transfer of the deceased partner's interest to the incoming partner.

A reconstituted partnership keeps its existing TFN and ABN and lodges a single partnership tax return for the full income year. A new partnership, by contrast, needs a new TFN and a new ABN, and both the old and the new partnerships must lodge separate tax returns covering their respective parts of the income year.

Timing matters. To apply for continued use of the partnership's TFN, a partner or authorised contact must inform the ATO within 28 days of the change of registration. The same 28-day window applies to updating the partnership's registered details with the Australian Business Register, which is a legal requirement whenever your business details change.

There are also tax consequences beyond registration, including capital gains tax when the estate disposes of the deceased partner's interest and the treatment of the deceased partner's share of income up to the date of death. Those positions depend on the circumstances of the estate, and a tax adviser should map them out before the buyout documents are signed.

Buy-Sell Agreements: Funding the Transition

A partnership agreement decides what happens on death. A buy-sell agreement decides who pays for it. The two are usually signed together and cross-referenced.

The typical structure is a cross-purchase arrangement. Each partner takes out a life insurance policy on the other partner's life, and the surviving partner is the owner and beneficiary of the policy. When one partner dies, the survivor receives the insurance payout and uses it to buy the deceased partner's share from the estate, at the price and on the terms set out in the buy-sell agreement. The estate gets cash quickly, the survivor gets the whole business, and neither side is left negotiating a sale with a grieving family.

The agreement usually fixes the valuation method in advance, so the insurance cover can be set at the right level and reviewed as the business grows. It should also cover the trigger events that sit alongside death, such as total and permanent disability, and what happens if a policy lapses or a partner becomes uninsurable.

A buy-sell agreement is not a substitute for the continuity clause in the partnership agreement. It funds the transfer, but the partnership agreement is still what allows the partnership to continue at law, and it is what the ATO looks to when deciding whether the change amounts to a technical dissolution. The two documents work as a pair: one says the business continues, the other provides the money to make that happen.

The Cases That Catch People Out

Three situations consistently cause trouble, because they sit outside the tidy scenario where everything was documented in advance.

The first is a partner who dies without a will, or with an estate that takes months to administer. The executor cannot transfer the share until they have authority to act, and if no one has authority, the buyout stalls and the surviving partner is left running a business that is, in law, dissolved. A partnership agreement can reduce the damage by saying what happens if probate is delayed, but the practical fix is for every partner to have a current will.

The second is the business that simply carries on without any final settlement of accounts. Under s 42 of the NSW Act, where surviving partners keep trading with the firm's capital or assets without settling with the estate, the estate can elect to receive either the share of the profits attributable to the use of the deceased partner's share of the assets, or interest at six per cent per annum on the value of that share. That election is a live claim that can surface years later, when the estate or its beneficiaries finally demand an accounting.

The third is a dispute over valuation. If the agreement is silent, or the formula is stale, the survivors and the estate will argue over what the share is worth, and the argument can drag the business through litigation at exactly the moment it needs stable management. Agreeing the method, and the identity of the valuer, while both partners are alive is the cheapest form of dispute resolution available.

Where a Lawyer Helps

There are two moments when a commercial lawyer earns their keep in this area, and they are very different jobs.

The first is planning, while everyone is alive and healthy. A lawyer drafts the partnership agreement and the buy-sell agreement as a matched pair: continuity clauses, valuation mechanics, executor provisions and insurance ownership all need to be consistent, and the tax treatment of the buyout needs to be checked with an accountant or tax adviser before the documents are signed. This is also the moment to fix the gaps, such as a partner without a will or a policy owned by the wrong person.

The second is the aftermath. When a partner dies, the surviving partners need to know immediately whether they can keep trading, what they owe the estate, and what the ATO expects within 28 days. The estate's executor needs advice on their duties, the valuation, and the tax position of the sale. If the partners never signed anything, or the agreement is ambiguous, a lawyer's first job is to work out what the default rules produce and whether the parties can still negotiate a sensible outcome rather than litigate one.

Plan for the Trigger Before It Happens

The mechanism has one feature that deserves emphasis: every path away from dissolution starts with an agreement signed while all the partners were alive. The statute dissolves the partnership on death, subject to any agreement between the partners. After the death there is no longer any such agreement to be made, because one of the parties to it is gone. The continuity clause, the valuation formula and the insurance policy must all exist before the trigger event, or the estate and the survivors are left with the statutory defaults, personal liability and a valuation dispute to sort out in the middle of a bereavement.

For most small partnerships the cost of the paperwork is modest compared with the price of getting this wrong. A partnership agreement and a buy-sell agreement, reviewed as the business grows, turn a partner's death from an event that ends the business into an event the business was built to survive. Artificer Legal's commercial lawyers can help you draft those documents, or advise surviving partners and estates after the event. A consultation to work out where your partnership stands is a sensible first step.