What Is Dissolution?
The nuts and bolts of breaking up a partnership.
Many people do not understand the meaning of the term "dissolution" when attempting to terminate an operating partnership. A partnership dissolution does not mean the termination of the business. The UPA defines a dissolution of a partnership as "the change in relationship of the partners caused by any partner ceasing to be associated in the carrying on as distinguished from the winding up of a business." What this actually means is that the partnership continues until the winding up of partnership affairs is completed. Thus, the process starts with dissolution, followed by the winding up and termination of the partnership's legal existence.
How is Dissolution Brought About?
Dissolution may be caused in three ways: (1) by act of the parties; (2) by operation of law; or (3) by court order.
By Act of the Parties
The partnership agreement may state that a partnership will have a definite life or operate for the attainment of a specific purpose only and then automatically terminate. When the life is over or the goal has been accomplished, the partnership will terminate and dissolve.
By a Partner's Act Contrary to the Partnership Agreement
Even if the partnership agreement states that the firm shall operate for a fixed period of time, any partner may bring about a termination by her express intent to withdraw unless the partnership agreement states otherwise. A partner cannot be compelled to remain in a firm longer than she wishes to. However, a partner's early intentional withdrawal is not without legal problems and may make the terminating partner liable for damages for breach of contract.
Example: Tom Veblen was one of five partners operating as the ABCDV Partnership. The partnership agreement stated that the firm was to operate for five years and then terminate. In the third year, Veblen, tiring of the relationship, left the firm to form a sole proprietorship. His action of leaving, in violation of the partnership agreement, will subject him to possible liability for damages for breaching the agreement.
Observation: In computing damages and the net interest due the departing partner, the firm's goodwill is excluded.
Whether or not the partnership agreement has a definite term or purpose, partners may agree to terminate by express agreement of all of the partners. This frequently happens when a partner expresses a desire to retire and the remaining partners unanimously consent to the admission of a new partner to take the retiring partner's place.
Example: Tina Lugo was one of four partners operating as the MNOL Partnership. The partnership agreement stated that the firm was to operate for five years and then terminate. In the fourth year, Lugo advised the partnership that she wanted to retire for health reasons. The remaining partners agreed to permit Grant Rice, a younger person who could bring a fresh approach and additional capital into the partnership, to take Lugo's place.
The admission of an incoming partner dissolves the old partnership and creates a new one.
Expulsion of Partner
The expulsion of a partner in accordance with the terms of the partnership agreement will result in a dissolution unless the partnership agreement, or a separate agreement, states otherwise (see page 36 for a discussion of the continuation agreement). A partnership agreement is not unchangeable and a partnership may be dissolved at any time by the wrongful acts and expulsion of a partner at any time. The expelled partner is also liable for immediate and consequential damages.
Involuntary dismissal, in the form of an expulsion, must be done in good faith, and in accordance with the terms of the partnership agreement.
Example: Rufus Young was a partner in an architectural partnership operating as Old, Bold, New, and Young. An independent audit of the firm's books and records by the firm's accountant uncovered the fact that Young had been stealing thousands of dollars from the firm and charging them to fictitious accounts. The partnership agreement stated that the unauthorized or illegal acts of any partner shall constitute grounds for expulsion. Such expulsion shall be warranted after calling a meeting at which all partners, including the partner to be expelled, is to be called, evidence of the alleged acts presented, and a vote to expel taken. The expulsion must follow the guidelines set forth in the partnership agreement.
Observation: Expulsion of a partner generally, but not in all cases, causes a partnership to dissolve, and the remaining partners must draw up a new partnership agreement. If the partnership agreement makes no provision for expulsion or if the expulsion is made in bad faith, the expelled partner will be allowed to recover damages.
Warning: When a partnership terminates, its tax year is closed, thereby requiring the partners to include their share of the partnership's earnings for the short-period partnership tax year in their personal tax return. If the termination is not properly timed or is unforeseen, it may lead to having a partner including his share of the partnership income for the regular twelve-month period, as well as the income for the short tax year. This will cause a bunching up of the partner's income in one year thereby making the income subject to a tax rate higher than normal. Thus, unplanned tax problems could result from the expulsion of a partner.
Example: Roy Mulligan is a partner in a partnership whose natural tax year ends on April 30, 19XX. For the partnership tax year ending on April 30, 19XX, Roy's share of the partnership's taxable income is $40,000. On November 30, 19XX, the partnership expels John Seacroft, another partner. This causes the partnership's tax year to end on this date. As of November 30, 19XX, Roy's share of the partnership's income is $25,000. Thus, for the tax year ending December 31, 19XX, Roy must include the $40,000 from the partnership tax year ending April 30, 19XX, plus his share of the partnership's income ($25,000) for the short tax year from May 1, 19XX through November 30, 19XX. Roy's total reportable income for 19XX will be $65,000.
Observation: As we will see later on in this chapter, a continuation agreement can be used to allow the partnership to continue after a partner leaves, thus avoiding the unforeseen tax consequences just discussed.
What happens when the partnership agreement makes no provision for expelling a partner? In a recent 1996 New York State case, a law firm's partnership agreement surprisingly enough made no provision for expelling a partner. Unhappy with the work of one of its active partners, the firm voted to dissolve and reform itself without the old partner. The expelled partner brought an action for damages based on the firms' bad faith and for failure to include the value of goodwill in their distribution to him. Not only was the expelled partner awarded his interest plus damages but also his share of the suggested goodwill of the partnership despite the fact that the partnership agreement stated that the goodwill of the partnership shall have no value. The best way to avoid this problem is to have the partnership agreement specifically state that goodwill is to be excluded when distributing assets. Failure to insert such a provision will require that the remaining partners each come up with cash to pay the departing partner.
How to give notice of expulsion: After a duly called meeting of all of the partners who have voted to expel, the expelled partner should be given a written notice of the decision to expel that includes the date of the withdrawal and a statement that the expelled partner will not have the right after this date to participate in future partnership profits. This provision is always found in the partnership agreement.
What this means to you: It would be wise to insert into the partnership agreement a statement indicating that "any decision to expel a partner in accordance with the terms of this partnership agreement is final and shall not be reviewable by any court of law or arbitrator." This clause in the partnership agreement will minimize the possibility of a lawsuit by the expelled partner thereby keeping possible litigation costs to a minimum.
Partnership at Will
A partner may terminate without incurring liability to the other partners if no time or particular undertaking is specified in the partnership agreement.
Example: Ralph Howell and Linda Everest formed a dental partnership and orally agreed to continue the business for an indefinite period of time to see "how things work out." After six months, Linda expressed her intention to dissolve the partnership as soon as reasonably possible. The partnership is treated as one at will and may be dissolved at any time without subjecting either party to liability.
The most effective way of notifying the other partners in a partnership at will of a partner's intent to withdraw is by a written statement to each partner signed by the terminating partner giving notice that he is withdrawing either immediately upon receipt of the notice of termination or at a certain date.
As noted previously, an assignment by a partner of her interest in the firm does not of itself dissolve the partnership, nor does it entitle the assignee to interfere in the management of the firm. In case of dissolution, the assignee is only entitled to receive the assignor's interest.
By Operation of Law
When the Partnership Activity Is Unlawful
A partnership is dissolved by operation of law when it becomes illegal to continue with the partnership business.
Example: Rona Nugent, Lex Botel, and Yuri Harding operated a gambling casino in a state allowing such enterprises. A newly elected state government was able to pass a new law prohibiting gambling within the state. The partnership would automatically be dissolved by the law prohibiting gambling within the state.
When a Partner Dies
The death of a partner automatically dissolves a partnership unless the partnership agreement states otherwise. The UPA specifically lists death as one of the causes of partnership dissolution. Upon the death of a partner, her personal legal representative (an executor or administrator) stands in the deceased partner's place. The representative has the right to require that the surviving partner or partners wind up the affairs of the partnership within a reasonable period of time and to pay over to the estate the deceased partner's share of the firm's assets after payment of all firm debts.
Observation: When a partnership is dissolved by the death of a partner, the estate of the deceased partner is liable to the same extent as the deceased partner.
Bankruptcy of a Partner
The bankruptcy of any partner will dissolve the partnership. Upon dissolution, the bankruptcy court appoints a trustee to take the bankrupt partner's place. This rule is similar to what happens when a partner dies.
Observation: It is the bankruptcy of a partner and not his insolvency (inability to meet his personal debts as they come due) that requires dissolution. Thus, a lawsuit against the partner individually because he has not paid his personal debts does not by itself constitute bankruptcy and is therefore not grounds for automatically dissolving the partnership.
Decree of Dissolution by a Court of Equity
A court of equity (a court that can grant a person a legal remedy besides money) has the power to dissolve a partnership for a proper cause. A court will not, however, listen to minor or temporary complaints that will not result in serious or permanent damage to the partnership.
Breach of the Partnership Agreement
Where one partner has breached her fiduciary duty, or is guilty of misconduct, rather than expel the partner, the remaining partners can seek a dissolution by applying to a court that has the legal authority to do so.
Inability to Earn a Profit
If the partnership is operating at an excessive loss or it becomes evident that there is no possibility of realizing future profits, a court order of dissolution may be obtained by the partners to prevent further operating losses.
Misconduct of a Partner
The partners may apply for a dissolution when the conduct of a partner seriously interferes with the carrying on of the partnership. Examples include a serious neglect of the firm's business, abandonment of the partner's obligations to the firm, persistent violations of the partnership agreement, dishonesty, and habitual drunkenness on the job.
Example: Val Lawford was a partner in the newly formed LMNO Partnership. During the first year of the partnership's operations, he consistently violated the partnership agreement by failing to attend all required partnership meetings, could not account for monies given to him for partnership purposes, and began drinking heavily, causing a steady loss of customers. The partners may apply for a dissolution.
Incompetence of a Partner
The UPA states that upon application by or for a partner, a court of law can dissolve the partnership where a partner has been declared either a lunatic or of unsound mind and can no longer carry out his partnership duties.
Example: A personal tragedy caused serious emotional problems and an eventual breakdown of one of the general partners in a retail store. Upon application to a court, a court order can be obtained to dissolve the partnership.
Incapacity of a Partner
If the disability of the partner is relatively permanent and not temporary, a motion can be made to a court that the partner does not have the necessary health and physical strength to carry our her duties as a general partner.
Example: The permanent disability of an aging partner preventing him from carrying out his daily activities as a managing partner would be grounds for applying to a court for dissolution.
Any Other Circumstances
The partners may seek relief from possible lawsuit from the other partners under certain circumstances under which they want to dissolve but fear possible lawsuit from other dissenting partners.
Example: The partnership of Bea Ellen, Joe Norton, and Sue Tolliver has been operating for ten years. Norton joined the partnership in the ninth year of the partnership's operations by mere oral agreement with the understanding that the partnership would operate indefinitely. He was, therefore, not prepared when both Ellen and Tolliver gave him written notice that they intended to retire. Rather than risk a possible expensive lawsuit, both partners may apply to a court for a court ordered dissolution thereby avoiding a costly lawsuit.
PARTNERSHIPS STEP-BY-STEP by David Minars, M.B.A., J.D., CPA. Copyright ©1997 by David Minars. Published by arrangement with Barron's Educational Series, Inc.
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