When a partnership or a corporation winds up its operations, it has to liquidate and distribute its assets to the owners or shareholders. The partnership or corporation must assemble its assets, settle with creditors and debtors, and distribute its remaining assets among the owners or shareholders.
Typically, when a partnership is dissolved, the partnership business is wound up and terminated. A partnership can conduct business as well as be sued during the dissolution process, but dissolution generally precludes any new or future business transactions. Instead, existing contracts are performed, receivables collected, and debts paid.
The issue of how to deal with debts is often of paramount importance when a partnership business is terminated. This is because in a general partnership each partner is personally liable for all partnership debts. This means that the partners will have to pay out of their own pockets any debts the dissolved partnership can’t pay with its own money or property.
To protect creditors, most states have laws that govern the distribution of assets when a partnership dissolves. A dissolving partnership will usually have two basic categories of unpaid debts: debts owed to outside creditors and those owed to the partners themselves. Subject to any agreement to the contrary, partnership debts must be paid in the following order:
- to creditors other than partners—that is, all the outside creditors
- to partners for debts other than for their capital contributions to the partnership (that is, their investment in the partnership) and their share of any partnership profits that remain unpaid
- to partners for their capital contributions to the partnership, and
- to partners for their share of any unpaid partnership profits.
The partners may agree to vary these priorities among themselves, but they cannot change the rule that outside creditors must be paid first.
Of course, many dissolved partnerships don’t have enough money to pay their outside creditors, let alone pay anything to the partners. If any debts to outside creditors remain unpaid after the partnership’s money and property is used up, the partners must pay them from their own funds.
Subject to these restrictions, the partners may include in their partnership agreement any terms they wish about how the partnership’s debts will be paid upon dissolution and how any remaining money or property will be distributed among the partners. If dissolution is not covered in the partnership agreement, the partners can later create a separate dissolution agreement for that purpose. However, the default rule is that any remaining money or property will be distributed to each partner according to their ownership interest in the partnership. This is often called the “partner’s lien” rule.
A dissolved partnership should let the world know that it is no longer in business by filing a dissolution form with the Secretary of State or similar state official, as well as publishing a notice in a local newspaper. For more details, see "Dissolve a Partnership to End Your Liability."
Corporations can also be dissolved and liquidated. Such dissolution may be voluntary upon vote by the shareholders. A corporation may also be dissolved involuntarily upon court order. Following dissolution, a corporation continues to exist only for the purpose of winding up its business. This involves collecting the corporation’s assets, paying or providing for payment of all the corporations debts and other liabilities, and distributing any remaining assets to the shareholders or others entitled to them. Once winding up is completed, the corporation is said to be liquidated—it no longer exists.
In a voluntary dissolution, the shareholders usually adopt a plan of dissolution, which outlines the steps the directors will take to liquidate the corporation. The liquidation itself is handled by the directors. Liquidation of an insolvent corporation is usually carried out by a trustee in bankruptcy. If a corporation is dissolved as a result of court action, a court-appointed trustee must work out a liquidation plan under court supervision.
Unlike the partners in a general partnership, the shareholders of a corporation ordinarily are not personally liable for the corporation’s debts. When their corporation is dissolved, the corporation’s creditors must be paid first before any money or property is distributed to the shareholders. If this is not done, the shareholders may be held personally liable for the corporation’s debts, although such liability may not exceed the assets they received at liquidation. To avoid such liability, notice must be provided to the creditors so they may present their claims. This involves providing written notice to known creditors and publishing a notice of dissolution, typically in a local newspaper. After all the creditors’ claims are paid, any money or property left over is distributed to the shareholders. However, in most cases the corporation’s creditors will recover only a fraction of their claims and there will be nothing left for the shareholders.
Once dissolution is complete, a certificate of dissolution or similar document is filed with the Secretary of Sate where the corporation was formed. In addition, in some states, a corporation may not complete the dissolution process unless it files a final tax return with the state tax agency and pays any taxes due. In these states, the corporation must obtain from the state tax agency a tax clearance, consent to dissolution, or verification of good standing with the Secretary of State. For more details, see “50-State Guide to Dissolving a Corporation.”