What is an Agreement to Dissolve a Partnership?
A partnership dissolution agreement is a written document, signed by all partners, that serves to formally end a business relationship. The agreement may include details on how the partnership assets (i.e. money, property, and stock) are to be distributed after the termination date. A partnership dissolution agreement may also outline the responsibilities of the partners in regard to their partnership dissolution obligations and liabilities.
When a partnership is dissolved, everything and everyone in the partnership is released from any obligations under the agreement. A dissolution may be equitable, such as a voluntary termination because one partner survives while another does not . An involuntary business dissolution may occur because of bankruptcy, a prolonged incapacity, criminal activity, or abandonment. Partnering agreements may specify any number of conditions that will result in the need for dissolution. However, it is always up to the partners to agree to bring the business agreement to an end.
A partner may try to dissolve a partnership at any time but the remaining partners may be able to file for a business dissolution if there is a specific circumstance detailed in the agreement or state law that applies to the situation. To execute a legally binding partnership agreement, all partners must sign the document, which then becomes a legally binding agreement.
Essential Components of an Agreement to Dissolve a Partnership
A partnership dissolution agreement outlines the details and timeline of the dissolution process. Essential components outline the distribution of partnership assets, the division of liabilities, and the obligations of the partners throughout the dissolution. The dissolution process may be rapid, such as in cases where no compensation is given to one or more partners, or take up to a year or longer based on the size of the partnership and the complexity of the issues to be resolved. Key elements of a partnership dissolution agreement include: Both in and out of court valuations are used to determine the value of the partnership. If available, an appraisal by a qualified third party is often preferred and is the easiest means by which to establish the value of the partnership and its assets, however, appraisals may be costly and time consuming. Should the partnership have an employee program such as a 401(k), well-trained staff are able to calculate the value of those assets, while deeds provided by a qualified attorney may be used to transfer real property. Almost all partnership dissolution agreements include asset distribution details. Depending on the terms of the partnership agreements and state laws, trusts may also be divided as part of the dissolution. Debts and accounts payable are also needed to determine the fair distribution of liabilities. Throughout the negotiations, involvement of legal counsel is vital to ensure that the dissolution procedure is handled fairly and in accordance with state laws. Sharing of documents and other records is required as part of the dissolution procedure as once the agreement is signed, it will be sent to the court to finalize the dissolution. After filing, a court hearing is scheduled, after which a dissolution order is issued by the court.
Common Reasons for the Dissolution of Partnerships
Partnership dissolution can occur for a number of reasons, including the following:
Agreement Among the Partners: The most common reason for dissolving a partnership is that the partners mutually agree to bring it to an end, as provided for in the partnership agreement. This could also occur as the result of a decision by one partner to retire, be successfully buy out by another partner or be terminated because he or she is no longer performing his or her duties, in accordance with the partnership agreement. Dissolution by Operation of Law: A partnership can be dissolved without any action of its partners, such as when it becomes illegal for the partnership to continue or when all of its partners die or otherwise can no longer carry on business. Again, in this case, a partnership agreement usually provides for how the fully or partially dissolved partnership is to be managed or liquidated. The court can also intervene to manage the partnership’s affairs, subject to the conditions of the partnership agreement. Dissolution by Court Decree: A court can also order the dissolution of a partnership, such as when a partner can no longer carry on the business or has engaged in conduct that prejudices the business. A court can also order the dissolution of a partnership when the business cannot operate profitably, the partnership can only be carried out at a loss or the agreement to form the partnership has expired. The court can also determine how the remaining partners will divide the interests and property of the partnership.
Legal Implications of Dissolving a Partnership
In the process of dissolving a partnership – ending a business relationship with one or more people – legal and tax issues arise that must be resolved. For example, if the partnership is a limited liability entity, all the provisions for winding down must be checked to verify that they are being honored, including requirements for notifying creditors and state partnership filings. A winding-down period, during which creditors can file claims, may also be necessary.
If the partnership does not conduct a formal asset audit, the general and limited partners need to ascertain the value of all assets and either divide them up among themselves or sell them. They also must take care of all outstanding bills, especially when it is a limited liability entity, to ensure creditors do not file claims after the business is closed. Like a closely held corporation, a partnership will be required to file an information return for the year that the partnership is legally dissolved under Internal Revenue Code Section 6046(b). If the partnership has employees, Wage & Tax Statements (Form W-2) should be issued as usual for the final year.
For income tax purposes, the partnership must recognize capital gains or losses on the sale or distribution of individual capital assets, including accounts receivable and inventory. Also, payments made to each partner must be reported on Schedule K-1 (Form 1065). The partnership also must continue to file these forms to wind up operations.
Steps for Drafting an Agreement to Dissolve a Partnership
There are a number of steps involved in drafting the Dissolution Agreement for your partnership. I list them below and give a few comments and examples on each step.
- The Ending – the event that causes a partnership to end must be stated. We often sectionalize our Dissolution Agreements into parts called Recitals. This is where we will often state the reason for dissolution. For example:
- Hitting upon the real cause of the problem – Sometimes a few well-placed questions will identify the root cause of a breakdown. A bitter partner may refuse to extract accounts receivable from a client or he may be delayed in returning customer files, even though his partner wishes them to be returned promptly. If the day of the Dissolution Agreement just happens to be the same day that his wife files for divorce, there may be some connection between dissolution and divorce.
- Spelling it out – If a partner is a lawyer, for example, he will want clients to remain with the firm even after its dissolution. Because a partnership may exist by default, meaning that a Dissolution Agreement may never have been signed, ending the partnership has the potential to sever every employment relationship and end each and every sub-contractor agreement. We like to include paragraphs like the following that protect our clients.
- Duplicating the work of others – if you are parting company with an accountant, you will need to divide accounts needing to be transferred, divided or sold . An accountant may have signed a letter of engagement with your client. This letter may need to be rewritten to reflect that the accountant is no longer your partner, but continues to represent the client. You will also have to divide insurance, and you will certainly need to divide the phone book.
- Determining how to split the assets – unless all partners agree to divide their assets equally, one may be favored over another. For example, the accountant may have developed an extremely valuable accounting program, and the attorney wants his share of it. The attorney will have to know how to value it and how to divide it. If he has been able to sell it to the firm for $ 1 million, he may simply take $ 500,000 from the attorney and let him keep his software.
- Getting it in writing – opens the door to liability. Once you have the Dissolution Agreement written, you can go about closing the business. However, without an Agreement in writing, California may very well presume that the partnership continues to exist, and you may be responsible for the acts of your partner, even though you had nothing to do with the decision-making process. In addition, failure to document the Agreement may lead to misunderstanding by your creditors and others who routinely deal with the firm. For example, banks and insurance companies may insist on knowing whether the firm exists or has closed.
Mistakes to Avoid in Agreements to Dissolve a Partnership
Common pitfalls occur when partners dissolve a partnership. While partners (and their attorneys) are focused on how the partnership, itself, will be dissolved, they may neglect to discuss whether there is a Buy-Sell Agreement in place or need to sell the business to pay debt. An otherwise simple transaction can turn into nightmare if left undiscussed, particularly when there is real estate involved.
We outlined some common pitfalls.
Mistake 1: Letting the partnership control assets, liabilities, and/or distribution of funds after dissolution of the partnership. The partners need to discuss and document how once the partnership is dissolved and the business is liquidated, distributions will be made. Without addressing this in advance, there could potentially be an exclusion of a partner from distribution of cash until all liabilities and debts of the partnership are satisfied.
Mistake 2: Failure to address how the dissolution will affect other contracts and debts. Even if no real estate is owned, lenders may require the property to be sold in order to satisfy a a debt. In that case, you don’t want the partners squabbling about how and when real estate should be sold or need the sale to occur before dissolution of the partnership.
Mistake 3: Real estate held personally. Many clients develop a partnership for the purpose of acquiring real estate. If an individual holds title to the property but intends to transfer it to the partnership, that individual needs to address how the property will be held and, if necessary, transfer the property so that the partnership is the legal owner before dissolution.
Mistakes 4: Messy documentation. A verbal agreement is not enough or may get turned upside down if partners fail to discuss the details. Similarly, a handshake agreement is not sufficient or could be similar to a verbal agreement in that it can become he-said-she-said-fighting over what was said and agreed to. We suggest that documentation be prepared and copies given to each partner.
Mistake 5: No recognition of the practical realities of dissolving the partnership. You could end up with bitter partners if the dissolution of the partnership was not carefully discussed. We suggest consultation with an attorney who specializes in business law and partnership agreements, and spend time discussing options and the impact of your agreement or dissolution. Clear and concise communication about the disposition of assets, liabilities, and debts, and the distribution of funds will go a long way towards avoiding a costly and ugly dispute.
How Mediation Can Assist in Dissolving a Partnership
Mediation involves the intervention of a neutral third party to help both parties to a dispute amicably resolve their differences. In the context of a partnership dissolution, aligning the best interests of all parties involved is crucial. In these cases, the process of mediation often helps partners resolve their disputes internally, as opposed to delaying the dissolution process or escalating the level of conflict. If all partners are willing to share their perspectives about the dissolution, a mediator can be a very useful third party service provider to involve .
Different from arbitration, which results in an impartial ruling of what each party must do, mediation provides an opportunity for everyone with an interest in the outcome to have an integral role in the arrangement, and therefore is much more likely to result in a fair outcome that is agreeable to all concerned. It does not matter whether the business is small or large, just like the actions of a couple in a divorce, a partnership dissolution requires expert facilitation to make the transition orderly and to minimize pain.