A general partnership comes into existence automatically whenever two or more people own and operate a business together and don’t form another type of business entity such as a corporation or limited liability company. In other words, partnerships are the default business form for businesses with multiple owners.
Partnerships ordinarily don’t last forever. It’s always best for you to enter into a written partnership agreement that, among other things, establishes what type of actions or events will terminate the partnership and what will happen upon termination. However, written agreements are not required to enter into a partnership; nor are any particular provisions, including termination provisions, required in written partnership agreements. If your partnership lacks a written agreement, or your agreement doesn’t address termination, your state partnership law will govern. But you and your fellow partners can always agree among yourselves not to follow your state law default partnership rules.
When Partnerships Dissolves for Legal Purposes
State partnership laws are not all the same. However, in many states, in the absence of an agreement to the contrary, a partnership dissolves for any of the following reasons:
- a partner dies
- a partner resigns or withdraws from the partnership
- a partner becomes mentally or physically incapacitated
- a partner retires
- one or more partners expel another partner
- the partnership business files for bankruptcy
- the partners agree to dissolve the partnership
- the partnership business is illegal
- a partner obtains a court order that the partnership must be terminated because it can’t accomplish its economic purpose, or another partner has made it impossible to carry on the partnership business, or
- one partner buys out all the other partners (in this event, the partnership ends but the business continues as a sole proprietorship).
In some states, a partnership does not automatically dissolve when a partner dies or withdraws. Instead, the state’s partnership law permits the remaining partners to buy out the interest of such a partner without dissolving the partnership. But if they choose not to do so, the partnership dissolves.
The best practice is for the partners to decide ahead of time what they will do if one or more partners dies or withdraws. The easiest way to do this is by entering into a buy-sell agreement, or buyout agreement, which can be included as part of the partnership agreement or a separate agreement. For more information, see the nolo.com article Partnership Buyout Agreements.
Winding Up the Business of a Dissolved Partnership
When a partnership dissolves it means the individuals involved are no longer partners in a technical legal sense. However, the partnership continues for the limited purpose of winding up the business. This involves selling the partnership’s assets, paying its debts, and distributing any money or property that remains to the partners or their heirs.
As a rule, after dissolution each partner has an equal right to participate in the winding up process and share in the distribution of its assets. If dissolution occurs because of the death of a partner, the surviving partners ordinarily have full power to control and dispose of the assets. The partners may, however, agree that one or more of them will have exclusive authority to dispose of the assets upon dissolution.
When a partnership is dissolved, the partners can’t simply take the partnership’s money and property. Instead, the partnership’s assets must be liquidated (sold or otherwise disposed of), an accounting made, and the assets used to pay all outstanding partnership debts, including those owed to the partners (but outside creditors must be paid first). If anything is left, it is distributed to the partners. If the partnership doesn’t have enough money or property to pay its debts, the individual partners will have to chip in and pay them from their own funds.
It’s wise to publish a notice of the partnership’s dissolution to notify creditors and file a statement of dissolution form with the state Secretary of State or similar official. See “Dissolve a Partnership to End Your Liability.”
Partnership Termination for Tax Purposes
A partnership is a legal entity that may own property and operate a business, but it is not a taxpaying entity. Instead, a partnership is a pass-through entity for tax purposes—that is, it pays no taxes itself. Instead, the profits, losses, deductions, and tax credits of the business are passed through the partnership to the partners’ individual tax returns. However, partnerships are required to file annual information returns with the IRS on Form 1065, U.S. Return of Partnership Income.
A partnership continues for tax purposes until it terminates. A partnership's tax year ends on the date of termination. If a partnership terminates before the end of what would otherwise be its tax year, IRS Form 1065 must be filed for the short period.
There are two types of tax terminations of partnerships: real and technical.
A real termination for tax purposes occurs when a partnership ceases doing business. This occurs if all its operations are discontinued and no part of any business, financial operation, or venture is continued by any of its partners. In this event, the partnership will have to dissolve and cease being a partnership for state law purposes. Its assets will be liquidated, debts paid, and remaining assets distributed to the partners. There may be serious tax consequences for the partners who may have to recognize a taxable gain on any money or property distributed to them, or share in a loss that may reduce their taxable income. However, gain is only recognized if the amount of money distributed exceeds the partner’s basis (total investment) in his or her partnership interest just prior to the distribution.
In contrast to real terminations, there are technical tax terminations of partnerships. These occur if at least 50% of the total interest in partnership capital and profits is sold or exchanged within a 12-month period, including a sale or exchange to another partner. Such terminations are merely technical because the partnership continues for state law purposes—that is, it is not dissolved. The partnership technically ends for tax purposes, but a new partnership for tax purposes immediately begins. This new partnership automatically takes over all the old partnership’s assets and liabilities which are immediately distributed to the partners in the old partnership. The new partnership even keeps the old partnership’s EIN (employer identification) number. Technical terminations usually do not result in the partners recognizing any taxable gain or loss. However, a technical termination of a partnership can result in loss of favorable real estate depreciation and tax accounting methods.