Understanding the Process of Partnership Dissolution
Dissolution of a partnership in California means the termination of a general association of two or more persons to carry on a trade or business where the profits are to be shared by these persons. Pursuant to California Corporations Code Section 16101(6), a general partnership is defined as "an association of two or more persons to carry on as co-owners a business for profit and not as a limited liability company." Partnerships are akin to sole proprietorships in that their formation does not require a formal document. Partners are generally free to contract in any way they choose and may distribute profits in whatever manner they feel appropriate. Dissolution may be necessary for a number of reasons, such as breach of fiduciary duties, lack of profit, or disagreements or loss of confidence amongst the partners .
There are also a number of proceedings that may trigger dissolution by operation of law. A partnership may be dissolved, depending on the type, by the express will of any partner if the partnership has no remaining partners or upon entry of a decree of dissolution by the court. After a dissolution is initiated, it is recommended that a partnership attempt a voluntary dissolution by agreement of all partners, as court proceedings are time-consuming and expensive.
California law governing partnership dissolution can be found in Corporations Code Sections 16800 et seq. A partnership is generally terminated once the partners cease to carry on the business and wind up partnership affairs. The winding up process includes paying or providing for all creditors of the partnership, and distributing capital among the partners in the manner agreed upon prior to the dissolution.
Requirements for Dissolving a Partnership
Guide to Dissolving a Partnership in California: Step-by-Step Process
The process of dissolving a partnership in California must comply with various legal requirements, and general partnerships, limited liability partnerships ("LLPs"), and limited partnerships ("LPs") all have different dissolution processes. General partnerships can be dissolved with the written consent of all partners or due to some other legal cause such as: LLPs can be dissolved with the written consent of all the partners or due to the events described in Section 1730 of the Corporations Code. These events include: The dissolution of an LLP is also governed by the partnership agreement, which may establish other ways or events that can lead to dissolution. Dissolution of LPs may occur due to several events, including: Dissolution of an LP also may be caused by certain other events, as described in Section 1732 of the Corporations Code. Once it has been established that grounds exist to dissolve a partnership or part ways with some of its partners, notice of dissolution must be provided to the California Secretary of State. Once the Secretary of State’s filing fee has been paid and the Secretary of State has accepted the notice of dissolution, the partnership will begin the process of winding down its operations and affairs. If a general partnership is sued prior to filing a notice of dissolution, a Plaintiff can obtain a judgment against the partnership itself as well as all the individual partners. Even if one partner has winded down operations and terminated their relationship with the partnership, the judgment can still be enforced against the remaining partners. There are options that allow one partner to avoid having their personal assets seized should their partner be subject to a lawsuit and unable to pay any related judgments.
How to Dissolve a Partnership in California
The dissolution process requires the consensus of all partners and takes precedence over any other business decision, such as winding down day-to-day operations, the process for dissolving a partnership usually follows these steps:
1. Officially approve the dissolution.
This step requires a vote taken during a partnership meeting. For general partnerships, an official vote is unnecessary; all partners must unanimously agree to dissolve the partnership. For limited partnerships, general partners must be in complete agreement to dissolve the partnership.
Written consent from at least half of all limited partners is also required. Even if the limited partners did not state an official manner to dissolve the business in the partnership agreement, federal law states that a limited partnership might be dissolved if notice is given to all limited partners that a general partner has voluntarily withdrawn. The notice must specify either a deadline by which the limited partners can file objections against the continuing the business or its liquidation.
If any partner votes against the dissolution, a partnership cannot be dissolved and continues to exist.
2. Notify creditors and others.
Once the partnership has voted unanimously to dissolve, creditors, investors and other parties must receive notification. Notices must be sent by mail or electronic means and must state the last date that the partnership will continue to operate while debts are paid off and remaining assets are divided.
3. Settle debts.
Creditors and investors must be repaid before any assets are distributed to partnership members. Debts must be paid off according to the order specified in the partnership agreement or in equal shares. If direct creditors are not made whole, a partnership likely faces direct legal action from them. Similarly, if the partnership was dissolved while another level of creditors (e.g., stockholders) remained unpaid, they can sue to recover their portion of the remaining assets.
4. Distribute remaining assets.
Assets can only be distributed after all debts are settled. Once all liabilities are paid off, remaining assets can be distributed in shares specified by the partnership agreement. If a partnership agreement does not specify how to divide up remaining assets, the partnership must distribute assets in a reasonably fair manner based on value. A court may step in if partners fail to reach an agreement over how to divide up remaining assets.
5. Formally cancel the partnership.
The agreement must be formally canceled in accordance with the provisions of the partnership agreement. In addition, limited partnerships must file a Certificate of Cancellation with the California Secretary of State. As soon as this is filed, the partnership ceases to exist.
File Your Certificate with the Secretary of State
As a general rule, the certificate of dissolution submitted to the California Secretary of State once signed by all partners is filed by first-class mail. A business partnership name that has been rejected will be mailed back along with an explanation. Once the document is filed and accepted, the Secretary of State will return the original copy with a filing date stamp to the partnership. There are no filing fees for filing a dissolution document, though expediting fee schedules do apply.
The form required for the Certificate of Cancellation is called a Form IL (Limited-Liability Company Certificate of Cancellation). This may be filed with the California Secretary of State by mail or in person, and the filing fee is $30.
The form required for Certificate of Dissolution is called a Form D (Limited-Liability Company Certificate of Dissolution). This may be filed with the California Secretary of State by mail or in person, and the filing fee is $100.
Resolving Financial Accounts and Liabilities
The first step in winding up partnership finances is to settle your business debts. This should also be a collaborative process. A debt that you had with a customer does not need to be separately renegotiated or addressed. If the customer still owes money to your former partnership and you do not intend to pursue collection yourself, the partnership’s other members can pursue collection in the name of the partnership itself. Again, it’s a collaborative process.
Any debts owed by the partnership can be paid out of your partnership assets or from selling partnership property. From an enforcement standpoint, banks and financial institutions will require that the partnership actually be dissolved before they will close the accounts and consolidate the balance . Also, ensure that all vendors are notified so that you are not charged your membership fee by mistake (even by credit card). The one-step approach is usually the better choice because it is less likely that the former partners will disagree on how to divide up the assets, including cash accounts in a bank.
After obtaining the consent of all of the other partners to do so, you will notify each of your creditors and inform them that the partnership is being dissolved and that we will no longer be making payments on the former partnership’s behalf. You should provide them with the address of the principal business of the partnership if they need to have a forwarding address, along with the individual partner addresses.
After approximately 60 days, the creditors will generally cease to contact the remaining partners if they have not been paid.
The Tax Implications of Dissolution
Partnerships are generally pass-through entities within the tax code, meaning that they do not directly pay income tax, with the profits and losses passing through to the individual partners to be reported on their personal tax returns. As a result, one of the most important elements of dissolving a partnership is taking care of the tax implications of the end of the partnership business.
In most cases, partnerships must file a final return if they owed any excise tax or if they received correspondence from the Internal Revenue Service requesting a return. Here are some of the specific tax issues you may need to address at this time:
- Return of capital contributions: Each partner must determine his or her tax basis in the partnership (in other words, how much he or she has paid into the entity). For each capital contribution, you will recover the entire basis tax-free. If you recover as much basis as you paid in, this is a completely tax-free transaction. If the partnership distributed more than your tax basis, then you are required to pay capital gain tax on that amount.
- Tax return filing: The partnership must file the same information returns it files regularly, even if it is no longer doing business. Because IRS requirements change from year to year, your CPA can help you determine what is appropriate for the year in question. An LLC that is taxing as a corporation must file a final Form 1065.
- IRS Form 8594: Both parties must file IRS Form 8594 when they sell a partnership interest or an asset. This includes reporting the sale or transfer in the year of the dissolution. Form 8594 includes both IRS Form 8871 (Asset Acquisition Statement) and IRS Form 8883 (Asset Acquisition Statement-Part I).
Tax issues can often add complexity to dissolving a partnership, so if you have questions about this or any other part of the process, consult with your attorney and CPA firm for guidance.
Common Errors, and How to Avoid Them
Partnerships are disbanded and dissolved for many reasons, and it can be a complex process. The dissolution process, while straightforward, can be full of pitfalls. Failure to follow the correct process can have major business consequences. The following common mistakes can be easily avoided by reading the process carefully and following each step individually. A little bit of rule-following can go a long way.
The biggest mistake By far the most frequent mistake in partnership dissolution is failure to communicate with creditors to apprise them of the dissolution. If the partnership owes money to third parties, such as employees, suppliers and other creditors, the partnership must notify them upon dissolution. Failing to provide notice can expose both the partnership and the individual partners to increased personal liability. Notice should go to all known creditors, and if the partnership has been doing business for some time there will be few exceptions. This is not the same as notice to the Secretary of State, which is designed to protect third parties from the potential liability of a defunct business.
The notice requirement is compounded when a partnership has a website. Partnerships with websites should include a statement that the partnership is being dissolved and that it is shutting down. Closing down a website does not require a "soft" shutdown, which means that the business owners can simply leave up a page or two describing the business and its dissolution in order to accommodate prior customers. Such inactivity neither satisfies the notice obligations nor complies with the partnership rules. Once the business is closed, that’s exactly what the website must say.
Hiring an Attorney
Engaging legal advice early in the dissolution process can smooth the passage through, and ultimately save costs in the winding up of a partnership or joint venture. Obtaining legal advice sooner rather than later is important in any business context but particularly so where there are a large number of third parties, and disputes with partners can become protracted . It is equally advisable to seek assistance from accounting and tax advisors and to involve them in the decision-making process from the time a partnership is set up. Custodial functions and transactions between those winding up the affairs of the partnership should be transparent. The advice of the lawyers who assisted in the formation of the partnership should also be sought to reduce the risk that the partnership and partners will incur liability for the other’s professional negligence.
