Partnerships dissolve. Sometime the decision is made to close the business. Sometimes there is a bankruptcy. Partner negligence, retirement, death, poor cash flow, and change in business practices are just some of the reasons for closing down.
Ethical Partnership Dissolution
In most dissolutions of a partnership, the business partners need to decide what will happen to the partnership itself. A partnership may be dissolved, but that may not end business operations. If the partnership’s business operations are to continue, the partnership must decide what to do with its customers or clients, particularly those primarily served by a partner leaving the business. An ethical partnership will notify its customers and clients of the change and whether and how the partnership is going to continue as a business under a new partnership agreement. Partners who are unable to agree on how to notify their customers and clients should look to the Uniform Partnership Act, Article 8, which outlines the general obligations and duties of partners when a partnership is dissolved.
A partner’s duties and obligation upon dissolution describe what the departing partner owes to the partnership and the other partners in duties of loyalty and care, which are the basic fiduciary duties of a partner prior to dissolution, as outlined in Section 409 of the Uniform Partnership Act. The one change upon dissolution is that “each partner’s duty not to compete ends when the partnership dissolves.” The Act states that “the dissolution of a partnership is the change in the relation of the partners caused by any partner ceasing to be associated in the carrying on as distinguished from the winding up of the business.”1 This may not terminate the partnership’s business operations, but the partner’s obligations under the dissolved partnership agreement will end, regardless of how the remaining partners create a new partnership.
The departure or removal of a partner or partners and the resulting creation of a new partnership may be tricky, because all original partners owe each other the duty of fairness and loyalty until the dissolution has been completed. All the partners, departing or otherwise, are required to behave in a fashion that does not hurt business operations and avoid putting their individual interests ahead of the interests of the soon-to-be-dissolved partnership. Once the partnership has been dissolved, the departing partners no longer have an obligation to their old business partners.
Fundamentals of Partnership Dissolution
The liquidation or dissolution process for partnerships is similar to the liquidation process for corporations. Over a period of time, the partnership’s non-cash assets are converted to cash, creditors are paid to the extent possible, and remaining funds, if any, are distributed to the partners. Partnership liquidations differ from corporate liquidations in some respects, however:
- General partners, as you may recall, have unlimited liability. Any general partner may be asked to contribute additional funds to the partnership if its assets are insufficient to satisfy creditors’ claims.
- If a general partner does not make good on his or her deficit capital balance, the remaining partners must absorb that deficit balance. Absorption of the partner’s deficit balance gives the absorbing partner legal recourse against the deficit partner.
Recording the Dissolution Process
As discussed above, the liquidation or dissolution of a partnership is synonymous with closing the business. This may occur due to mutual partner agreement to sell the business, the death of a partner, or bankruptcy. Before proceeding with liquidation, the partnership should complete the accounting cycle for its final operational period. This will require closing the books with only balance sheet accounts remaining. Once that process has been completed, four steps remain in the accounting for the liquidation, each requiring an accounting entry. They are:
- Step 1: Sell noncash assets for cash and recognize a gain or loss on realization. Realization is the sale of noncash assets for cash.
- Step 2: Allocate the gain or loss from realization to the partners based on their income ratios.
- Step 3: Pay partnership liabilities in cash.
- Step 4: Distribute any remaining cash to the partners on the basis of their capital balances.
These steps must be performed in sequence. Partnerships must pay creditors prior to distributing funds to partners. At liquidation, some partners may have a deficiency in their capital accounts, or a debit balance.
Let’s consider an example. Football Partnership is liquidated; its balance sheet after closing the books is shown in Figure 15.8.
The partners of Football Partnership agree to liquidate the partnership on the following terms:
- All the partnership assets will be sold to Hockey Partnership for $60,000 cash.
- The partnership will satisfy the liabilities.
- The income ratio will be 3:2:1 to partners Raven, Brown, and Eagle respectively. (Another way of saying this is 3/6:2/6:1/6.)
- The remaining cash will be distributed to the partners based on their capital account basis.
The journal entry to record the sale of assets to Hockey Partnership (Step 1) is as shown:
The journal entry to allocate the gain on realization among the partners’ capital accounts in the income ratio of 3:2:1 to Raven, Brown, and Eagle, respectively (Step 2), is as shown:
The journal entry for Football Partnership to pay off the liabilities (Step 3) is as shown:
The journal entry to distribute the remaining cash to the partners based on their capital account basis (Step 4) is as shown:
- 1 Uniform Law Commission. Uniform Partnership Act (1997) (Last Amended 2013). https://www.uniformlaws.org/viewdocument/final-act-with-comments-118?CommunityKey=52456941-7883-47a5-91b6-d2f086d0bb44&tab=librarydocuments