All About Partnership Agreements
Partnership agreements are contracts that govern the operation and management of business partnerships. Generally, these agreements set forth a distribution of profits and losses, as well as the various obligations, rights, and duties of each partner. By establishing a clear understanding of the terms of operation , these agreements are designed to reduce the chance of disputes arising between partners. The majority of partnership agreements will have the following clause types: Partnership agreements often contain sections on the process for one or more partners exiting the partnership, including dissolution. For those partnerships that have entered into an agreement, a formal dissolution clause is often included.
When to End a Partnership
A number of reasons might prompt a business partnership to dissolve or terminate its relationship. In some cases, the reason might be financial. Perhaps the business venture just didn’t generate the amount of profit anticipated after the first few years. Decision-makers may have perceived that often mentioned term, "the bottom line," became increasingly red and was likely to stay that way. The prediction about future finances may have been that unless capital was increased, there was no reasonable hope that it could be salvaged.
Another possibility is that differences of opinion about the direction in which the company should go led to persistent disagreements. Even one partner may have asked for a divorce. Disagreements can also affect a partnership’s ability to continue because they sometimes lead to loss of focus on essential day-to-day survival tasks.
A third common reason is that business conditions have changed so much that the partnership no longer makes sense. For example, the advent of new technology can have that effect. A small computer company formed in 1980 focused on the development of floppy discs. Regulation changes in 1990 made floppy discs obsolete. Its two partners had a very difficult time deciding whether they wanted to rebuild their business in a different niche or dissolve their partnership. They decided to end it. Sometimes a merger with a larger firm can trigger the same decision by the smaller firm’s owners.
Legal Responsibility Followings Dissolution of a Partnership
When it comes to the law, a contract is a contract. Even in the case of breaking up a business, there are legal implications to consider when you dissolve a partnership agreement. The general rule of thumb is that the first step is to have the partnership agreement drafted with a lawyer, who can include guidance on dissolution and the legal obligations of each partner in the case of termination.
Using the law as your base, your goal is to avoid personal liability after the company is dissolved. If some kind of error occurs, you may still be liable for any taxes, debts or other liabilities that were not covered appropriately during the proceedings. That’s even if there was never enough money to cover liabilities in the first place. It’s important to manage obligations and liabilities carefully when dissolving a business partnership in order to avoid personal liability.
If it’s a partnership corporation or limited liability corporation, it’s easier to avoid liability. Closely-held business entities typically protect partners from liability in such cases. You may not be personally liable for company debts if you’ve split the assets appropriately before dissolution.
But if it is a simple general partnership, you need to be careful. In a general partnership, a partner may be personally liable for any debts or obligations the company incurs. Even if you didn’t contribute personally to a company’s debt, you could still be liable in such a case. Partnerships outside of corporations do not offer that separation of liability.
How to Legally Terminate a Partnership
Terminate Your Partnership Based on the Terms
In the same way that you must start the dissolution process in accordance with the terms of your partnership agreement, you also need to end the partnership in accordance with the agreement. If one partner plans to buy out the other, they need to do so based on the specific terms outlined in the partnership. If the partnership is set up to dissolve in the event of a specific event such as the death of one partner, you must also follow those rules. If the dissolution stems from a legal basis such as a loss of license or illegal behavior, you need to prove this up and show that the partnership is irrevocably impacted.
Notify the IRS
The first tax-related step you need to take to successfully dissolve your partnership is to contact the IRS. You are required to tell the IRS about the dissolution if the partnership was taxed as either a corporation or a limited liability company (LLC). You also need to let the IRS know if you’ve dissolved a partnership that is taxed as a corporation or an LLC by filing Form 8832. If the partnership is taxed as a corporation, you need to file a final corporate return, which is generally Form 1120s if the organization was an S corporation or Form 1120 if you are filing for a C corporation. You’ll also need to take care of any final employment taxes, including: If you give each of your partners a Schedule K-1 that indicates their distributive share of partnership income, loss and credits, you will be able to report the partnership’s final year of income on the partners’ personal income tax returns. The only time you will have to issue a Form 1065 is on the last day of the tax year for the partnership. You’ll also need to check the box on this form to indicate that it’s the final return.
Give Notice to Creditor
The next step in dissolving your partnership will be notifying all creditors that the partnership is dissolving. If you have all of the partnership’s assets tied up in the business in a way that prevents payment and encumbers the partnership with debt, you may still need to give notice before proceeding. This notification lets all parties know that they are entitled to collect all debts incurred before the money runs out. If there is no cash left in the partnership and no way of liquidating the assets without causing more harm than benefit, you may not need to give prior notice.
Distribute Assets and Dissolve the Business
Once you’ve given notice to creditors and settled any outstanding debt, you can begin distributing assets amongst your partners. You will also need to legally dissolve the business, which you can do by sending a bill of sale to your secretary of state. This lets them know that the business has been dissolved and is no longer in operation.
Dissolving a Partnership Negotiations
Your partnership agreement is generally going to be the contract that governs your relationship with your former business partners. One of its most important functions is to provide the process by which you can terminate the business and wind down its affairs.
The dissolution terms in your agreement may include how the partnership must notify its creditors, how the books must be balanced, and the manner in which the remaining assets must be allocated. These terms are binding on all parties to the partnership and should be followed closely to avoid problems later. In fact, if the agreement is not followed, any parties injured by the failure of the business to follow its terms can sue over the losses.
In addition to the terms of the agreement, and of the law of partnerships, you must also negotiate with your partners on the terms of this dissolution. Issues to address include the division of any assets that remain after the debts of the business are satisfied , how any unfinished business will be allocated, and any future non-compete agreements that your business may want to enter into.
This phase of a business dissolution often depends on the sort of relationship you were able to maintain with your co-owners. If you were able to work together amicably and ended up with a friendly split, then negotiation should go smoothly. If, on the other hand, you were barely able to stay in the business together at a civil level, it can quickly devolve into arguments and fights that cannot be resolved.
If it appears that the parties are unable to come to a compromise on the various issues involved, litigation may soon follow. That is why it is critical to keep an open line of communication with your partners to avoid problems arising later. It also helps to be flexible in your negotiations; if you can be willing to give something up in order to keep the peace, your co-owners may do the same.
Addressing Tax Issues
Any partnership that dissolves must carefully consider its tax situation. Like many business considerations, it may not be your first thought when closing a partnership. But there are critical tax considerations to understand to avoid unpleasant surprises.
Dissolving partnerships are pass-through entities. This means the partnership does not pay tax. Instead, the partnership income (and losses) gets passed through to the partners, much like it does on an ongoing basis. So even when dissolved, partnership income or loss gets passed through to the partners on a K-1.
The tricky part is determining how to allocate partnership income or loss on the final returns. Allowing partners to allocate income or a loss among itself, itself normally takes into account the ownership percentages. But there is no requirement for partners to split income and loss equally if it benefits them in their tax situation to do otherwise. In the case of a dissolved partnership, if partners were splitting losses equally before the dissolution, the split generally remains the same afterward.
If the partnership has appreciated assets or debt at the time of dissolution, these could also have tax implications. When a partnership distributes appreciated property to partners, the partnership must recognize a gain in the amount of the appreciated fair market value of property received in excess of the partnership’s tax basis of appreciation property that was distributed.
Partnership Termination Errors to Avoid
When dissolving a partnership, it’s critical to avoid mistakes that can lead to severe financial and legal consequences. One common error that many partners make is failing to update all contracts and agreements. As a business partnership operates, it often enters into new contracts with clients, vendors, and other businesses. If you don’t amend your contracts to incorporate the changes from the dissolution process or if you fail to remove the other partner from existing contracts, it can lead to misunderstandings and legal disputes down the line. Make sure all current contracts are reviewed and updated appropriately. Likewise, you need to communicate with clients, vendors, and employees during the dissolution process. Be transparent and open about what’s happening to avoid confusion and frustration. If you don’t have the support of clients, vendors, and employees, it can be hard to execute a successful dissolution. That’s why communicating with all stakeholders is vital. It’s important to sell or appropriately distribute all partnership property to avoid personal liability for partnership debts. Even if you and the other partners decide to distribute an asset among yourselves, be sure to properly document the transfer. Be clear about who gets what and why. For instance, if your business has a truck, it may be appropriate to divide it up among three partners using a formula based on the value of the truck. Another option is to sell the asset to an outsider and then divide the proceeds among partners. No matter how you choose to do it, you need to be crystal clear about your approach.
Seeking Professional Guidance
Before moving ahead with the dissolution, you should consult with a couple of trusted professionals. They should be able to advise you on various aspects of the dissolution process, from the industry regulations that must be met to the accounting requirements after the business is voided.
Not every partnership can or will be dissolved amicably. If your partner refuses to sign or claims you owe money or other considerations, you may have to "have the court dissolve the business," says Business News Daily’s Adam C. Uzialko.
Some business owners will initially follow through with the dissolution process and then simply not complete the final step of filing the paperwork , which makes the dissolution invalid and may leave the owner on the hook for the business’ debts, Uzialko adds.
"Similarly," Uzialko notes, "if the articles of dissolution are incorrectly filed or required fees are not paid, the business will continue to exist as a legal entity until the dissolution can be correctly processed."
A freezing or other mechanism can temporarily stop a partner from making business decisions even while they exist as the legal entity. Contacting an experienced business attorney can help you continue with the process.