The creation of a general partnership does not require any kind of legal formalities. States do not require the filing of forms and written partnership agreements are not necessary either. All that is required is two partners engaging in a business together.
If a partnership was begun without formalities and without a written partnership agreement, then when it ends, the law of the state in which the partnership operates will govern the termination by default. If there is a formal partnership agreement, it may contain provisions that guide the termination process.
How is Partnership Termination Accomplished?
The law regarding partnerships varies from state to state. Nonetheless, in many states, in the absence of an agreement that provides otherwise, a partnership dissolves when any of the following events happen:
- One of the partners dies;
- One of the partners resigns or otherwise withdraws from the partnership;
- One of the partners becomes mentally or physically incapacitated;
- One of the partners retires;
- One or more partners expel another partner;
- The partnership business files for bankruptcy;
- The partners agree to dissolve the partnership;
- The partnership business is illegal;
- One partner buys out all the other partners. If this happens, the partnership ends but the business can continue as a sole proprietorship.
In some states, when a partner dies or withdraws from a partnership, the partnership does not automatically dissolve. Rather, the state’s partnership law allows the remaining partners to buy out the interest of the deceased or withdrawing partner without dissolving the partnership. But if they do not buy out the interest, then the partnership dissolves.
It is best business practice for partners to agree ahead of time what they will do if one or more partners dies or withdraws. This is done by formalizing the partnership agreement in writing at the inception of the partnership and including provisions for its termination. A buy-sell agreement, or buyout agreement, can be included as part of the partnership agreement in case the events that can lead to a buyout arise.
What if I Have a Dispute Involving Partnership Termination?
When one or more of the partners disagree about a decision to terminate the partnership, it can lead to a dispute. If the partners have a partnership agreement, they can consult it and it should include conditions and procedures for termination, including resolution of conflicts. A similar situation occurs when the remaining partners contest the withdrawal of a partner from a contract or business deal.
Property distribution can be another source of conflicts in many partnerships. Again, how the distribution should be done depends on whether the partnership is general or limited. For general partnerships, the partners are typically entitled to equal distribution of partnership property. For limited partnerships, the property should be distributed in proportion to each partner’s individual contributions to the partnership.
When a partnership dissolves, it means the individuals involved are no longer engaged in business together, however the partnership continues until its affairs can be wound up. Terminating or winding up a partnership would involve selling the partnership’s assets, paying its debts, and distributing any money or property that remains to the partners or their heirs.
In most states, when dissolution takes place, each partner has an equal right to participate in the winding up process and should receive an equal share in the distribution of its assets. If dissolution occurs because of the death of a partner, the surviving partners ordinarily have full power to control and dispose of the assets. The partners may, however, choose to agree that one or more of them will have exclusive authority to dispose of the assets upon dissolution.
When a partnership is dissolved, the partners cannot just take the partnership’s money and property. Instead, the partnership’s assets have to be sold or otherwise disposed of. Then an accounting must be made. The assets that remain must be used to pay all outstanding partnership debts, including those owed to the partners.
Outside creditors have priority over the partners. Anything that is left after all outside creditors are paid in full can be distributed to the partners. If the partnership is not left with sufficient funds to pay its debts, the individual partners will have to make up the difference and pay creditors from their own funds. It is good practice to publish a notice of the partnership’s dissolution to notify creditors and file a statement of dissolution form with the state Secretary of State or similar official.
A partnership is a legal entity that may own property and operate a business, but it does not pay taxes itself like a corporation. Instead, a partnership passes its income through to its partners for tax purposes. All of the profits, losses, deductions, and tax credits of the business are passed through the partnership to the partners’ individual tax returns. However, partnerships are required to file annual information returns with the IRS on Form 1065, U.S. Return of Partnership Income.
For tax purposes, a partnership continues until its termination phase is complete. A partnership’s tax year ends on the date on which it terminates. If a partnership terminates before the end of what would otherwise be its tax year, then it would want to file IRS Form 1065 for the shortened period.
For tax purposes, there are two types of partnership terminations, real and technical:
- Real Termination: The real termination of a partnership for tax purposes takes place when the partnership stops doing business. This happens when all of its operations are truly discontinued and no part of the business is carried on by any of its partners. When this happens, the partnership has to dissolve and cease being a partnership for state law purposes. Its assets must be liquidated, so its debts can be paid.
- Any assets that remain are distributed to the partners. There are likely to be tax consequences for the partners who may have to recognize a taxable gain on any money or property distributed to them. Or, each partner will share in a loss that may reduce their taxable income. Of course, capital gain is only recognized if the amount of money distributed exceeds the partner’s basis, i.e. total investment, in their partnership interest before the distribution.
- Technical Termination: In a technical termination, the partnership continues but an interest of at least 50% of the total interest in the partnership’s capital and profits is sold or exchanged within a 12-month period. Technical terminations are merely technical because the partnership continues for state law purposes; the partnership is not dissolved. The partnership ends for tax purposes, but a new partnership for tax purposes begins again immediately.
- The new partnership automatically takes over all the old partnership’s assets and liabilities; these are immediately distributed to the partners in the old partnership. The new partnership even keeps the old partnership’s employer identification number for tax filing purposes. Technical terminations usually do not result in the partners recognizing any gain or loss that affects taxation. It can, however, have other technical tax consequences, e.g. the loss of favorable real estate depreciation and tax accounting methods.
Do I Need a Lawyer for Assistance with Partnership Termination?
Partnership termination is a complex area of business law. Also, there can be much variation in termination procedures, depending on the type of partnership as well as individual state laws. You may wish to consult a corporate lawyer if you need help with partnership termination or other related business matters.
A qualified business lawyer in your area will be able to recommend options for partnership termination, and can help avoid costly, time-consuming conflicts. If your partnership needs to wind up its business, it would probably be wise to involve an experienced business lawyer who can inform everyone involved of the legal procedures required for termination and help resolve problems before they escalate. You are most likely to get the best possible outcome with a business lawyer to help guide you.
