Guide to Drafting a Sample Partnership Dissolution Agreement
Overview of Partnership Dissolution
A partnership is a business relationship where two or more individuals share the assets, liabilities and profits of a business. Business partnerships can be formal or informal (sometimes called traditional partnerships). A partnership can also be an implied or a written agreement with a limited lifespan or one that continues until the death of a partner. A partnership may dissolve in a number of different ways. A partnership agreement (if there is one) likely specifies the duration of the partnership. It may be dissolved at the end of that period or by one or more partners or by the withdrawal , incapacity or death of one or more of the partners. A partner may also dissolve the partnership by mutual agreement, by an operation of law (such as bankruptcy) or by statute (a partner committing a crime). Other reasons for partnership dissolution include disagreements between the partners, loss of customers, reduced profitability, market changes, unemployment of a partner, disagreements about how to spend partnership revenues, a general economic decline and changes to personal circumstances (such as marriages, divorces, illness and deaths).
Essential Terms of a Partnership Dissolution Agreement
The key components of a partnership dissolution agreement are critical to ensure the agreement’s validity and that it lasts for as long as possible. The following elements are essential to include in a sample partnership dissolution agreement.
The agreement should include a clear definition of the partners and who is to be considered a partner. The definition should include both the current partners and any existing partners that hold an ownership interest in the partnership, even if a partner dies or the partnership terminates. This will help protect the business and its assets in the event of future action brought against the partnership by a partner that has died, or whose partnership interest was otherwise terminated.
It is also important for the agreement to clearly state the reasons for the dissolution of the partnership. The reasons for such a dissolution should be clearly defined. The general reasons for a dissolution of a partnership are:
- Expiration of the period for which the partnership was formed;
- Mutual agreement between the partners to dissolve the partnership;
- If a partner has assigned his share in the partnership to someone else or has made an offer to buy out his partnership interest;
- A partner becomes incapable of performing his share of the partnership duties; or
- The illegality of the business.
Of course, it is important to include other reasons for the dissolution of the partnership. It is important for the agreement to address bankruptcy proceedings. If one of the partners files for bankruptcy, the partnership must be dissolved in order to protect its assets from being liquidated as part of the bankruptcy. There are also partnership agreements that contain non-compete clauses that provide for the dissolution of the partnership if a partner competes with the partnership.
In the agreement, the parties must also define how the partnership will be dissolved and how the assets and liabilities will be divided. In every partnership, there are always certain debts and liabilities that must be paid off before the partnership is dissolved. The partnership must pay off all debts, including but not limited to taxes, accounts payable, mortgages, notes and loans. Regardless of how the creditors and liabilities are paid, the partnership must ensure its assets are used to pay them off.
Sample Wording of Common Provisions
Non-Compete Clause
The parties hereto agree that during the term of this Agreement and for a period of ____ years following the termination of ________, neither shall directly or indirectly enter or engage in any business that would compete with the business of the partnership (as conducted immediately prior to such termination), within a radius of ______ from any part of the locality in which the business of this Agreement is being conducted.
Confidentiality Clause
The parties agree that they will hold as strictly confidential all information acquired by the parties in connection with this dissolution and the liquidation of the aforementioned partnership. No information shall be disclosed to any third party, except as may be required by law or regulation.
Dispute Resolution Clause
Any dispute arising out of or relating to the interpretation, construction, or application of this Agreement, or as to the performance or non-performance of the terms, covenants, and conditions of this Agreement shall be resolved by arbitration in accordance with the rules of the American Arbitration Association then in effect. The arbitrators’ decision shall be final and binding and judgment thereon may be entered in any court having jurisdiction.
Legal Guidance for Dissolution
Legal considerations in dissolution may involve the compliance with the state’s laws and with other forms of notification to creditors.
A number of states have laws governing a partnership’s dissolution. Those statutes address such issues as authority to bind the partnership to third parties, the actions that must be taken in order to dissolve a partnership (such as filing notice with the state as to dissolution), and filing final tax returns. These statutes also address the disposition of a partner’s interests in the dissolved partnership.
In addition to complying with the state statutory requirements for dissolving a partnership, the partners have obligations under the Uniform Partnership Act and common law principles.
First, notice of dissolution must be given to existing creditors. Notice is effective with respect to unknown creditors only if it is published or mailed to creditors.
Second, notification to new creditors is required in order for them to understand that the partnership has been dissolved and their credit risk may be greater as a result of the dissolution. A creditor that issues credit to the post-dissolution partnership may be operating under the false presumption that all the general partners who originally bound the partnership still carry that power to bind the partnership.
Third, notification may be provided to the general partners to notify them that a partnership has been dissolved and that they may no longer legally bind the partnership. In the absence of notification, a partner must be aware of the dissolution or have a duty to know of it.
Tax Aspects of Partnership Dissolution
The IRS requires the partners of a partnership that has been dissolved to report certain information about the dissolution on their tax returns for the year-of-dissolution, and it also requires that form IRS Schedule K-1 accompany each tax return. In connection with the dissolution of a partnership, any capital gain or loss may be recognized. If the partnership operates at a gain when it is being dissolved, the partners may be taxed on the loss unless their basis in the property is larger than the amount realised from the sale by the dissolved partnership.
Any gain from selling a capital asset, which is included in a partnership return, is taxable to the partners taking into account their percentage ownership share and any guaranteed payments received by them. Individual partners may offset their capital losses against their capital gains up to $3,000.
When an LLC is dissolved , tax losses can be written off towards other business operations or income. However, if the partnership sold any inventory in the course of its winding up, the income attributed to those sales would be taxed as ordinary income. The allocation of these taxes among the partners is normally provided for in a partnership agreement. However, the Internal Revenue Code sets out rules that generally override these provisions. If there is no partnership agreement, federal tax law typically provides for allocating tax liabilities in the same way it would provide for allocating net profits among the partners.
The Form 1065 tax return also enables the IRS to track the assets, liabilities and amount distributed to partners from the dissolution of a partnership. The LLC and each partner receive a Form K-1, which describes the partnership income under their names.
Finally, any un-deducted, allowed losses can be carried over to the next year.
Finalizing a Partnership Dissolution Agreement
In the most basic sense, finalizing a partnership dissolution agreement consists of five steps:
1. Hold a Meeting to Discuss Dissolution
The process of finalizing a partnership dissolution agreement begins with your partnership’s members holding a meeting to agree upon the terms of the dissolution. In the event your partnership operates under an operating agreement, this meeting must be held according to the rules outlined in the operating agreement.
2. Include Details in the Partnership Dissolution Agreement
When reaching agreement, your partnership should include all pertinent details about the dissolution. Your partnership dissolution agreement should include:
3. Form Filing
This process differs depending on the nature of your entity and where your business is located. If your entity is an LLC, you need to notify the secretary of state where your business is located of your partnership’s decision to dissolve within 60 days of entering the decision. If your partnership is a general partnership, however, you should file a Statement of Dissolution with the secretary of state. To dissolve a Limited Partnership, you need to "wind up" the partnership’s affairs with the secretary of state. A Limited Liability Partnership should file a Certificate of Cancellation after winding up its affairs.
4. Decide upon Making Payments to Former Members
If your partnership agreement does not include provisions for making payment to former partners, you will need to reach agreement among the partnership’s members about how to make payments to partner at the time the partnership dissolves. Generally, the funds are dispersed proportionately to the ownership interest each partner had at the time the partnership dissolved. If liquidity was an issue, the funds might be paid over time.
5. Payment of Debts
You will also need to create a plan for paying off the partnership’s debts. Typically, debt refers to loans your business obtained to launch or grow. If your partnership does not have enough cash to pay off its debts, the partnership should attempt to obtain money from its partners to pay back creditors.
6. Tax Considerations
Some forms of partnerships are required to file a final partnership return (Form 1065, U.S. Return of Partnership Income) with the IRS. However, since a partnership is not a taxable entity, rather than being subject to corporate income taxes, business taxes "pass through" to partners who report them as income on their individual tax returns, the partnership does not usually have to pay business taxes when it dissolves. If the partnership is required to file a final return with the IRS, the partnership should attach a statement to the last return indicating the partnership’s final year is the year it was dissolved.
Best Practices for Partnership Dissolution
A partnership is not only a business, but also a relationship. The dissolution of a partnership, whether an amicable or a contentious one, should be handled delicately, as the departure of a partner or partners can have larger repercussions throughout the company. Once you have reviewed the original partnership agreement or articles of incorporation to determine the procedure for dissolution, you should take a planned approach to the dissolution process. Here are some tips to facilitate a sustainable resolution:
Conduct Yourself Professionally and with Respect
It’s important to approach the dissolution process with restraint. Since the goal is to ensure that the company can move forward without significant impact and that the departing partner or partners can walk away feeling that their contribution and participation was valued, your tone and your behavior should reflect consideration of the other partner and the outgoing partners. It will be necessary to give the departing partner(s) time to have their departure reviewed by legal counsel, review financial information, and investigate all of their options fully.
Focus on the Future
If the partnership is ending amicably, focus on the benefits of the decision and how you can move on without further conditions. If the partnership is ending on less than amicable terms , it will be beneficial to keep the discussions in consultation about the practicalities of the dissolution, rather than personal issues, in order to better facilitate a smooth process.
Communicate Openly and Effectively
Good communication can foster a better process of arriving at a mutual agreement so that the interests of the partnership can be preserved.
Thoroughly Prepare All of the Needed Paperwork
The partnership dissolution process requires documentation and preparation beyond what is needed for an ordinary business termination. You will need to provide information on the size of the company, how its debt obligations will be handled, what assets it has and what debts it owes, what the company’s outstanding checks and notes receivables are, and how employee pensions and benefits will be processed.
Take the Partnership Articles into Account
Sometimes a partnership agreement, articles of incorporation, or bylaws will include a detailed, step-by-step process for dissolution. That document should be read and, if possible, followed when making your partnership dissolution plan. Be sure to talk to an attorney if you have questions or concerns about your partnership articles and how to follow them.