Temporary Nature of Partnership.—Because of its personal character, a partnership has necessarily a limited duration. It must look forward to the time when its business will have to be closed up. The chief causes leading to a dissolution are briefly reviewed here.

Causes of Dissolution

1. The withdrawal of any partner. Under ordinary circumstances a partner cannot be held to a specific performance of his contract. If he becomes dissatisfied, suspicious, or desires for other reasons to withdraw from his contract before its expiration, he has that power. Such withdrawal cannot be looked upon as a right but only as a power to be exercised under unusual circumstances. If his withdrawal before the agreement terminates results in damage to his copartners, they have a lawful claim against him for the amount of the damage. Under extraordinary conditions, specific performance of the contract might be decreed, i.e., the partner would not be allowed to withdraw.

Withdrawal does not relieve a partner from liability for partnership debts incurred while he was a member of the firm. Any creditors not paid by the firm may hold the withdrawing partner liable for the debts. To be relieved from the liability on debts arising after his withdrawal, personal notice of withdrawal must be given to all the firms with which the partnership has been dealing; a published notice being considered sufficient for the parties not dealing with the firm until after withdrawal.

2. Sale of a partner’s interest or admission of a new partner. When a partner, with the consent of his copartners, sells his interest in the firm to another, or when a new member is admitted to the partnership, in the eyes of the law the old partnership has ceased to exist and a new one has taken its place.

3. Limitations in the partnership agreement. The agreement may specify the period for which the partnership is to exist. If it is a special partnership, the object it is to accomplish may be stated and the law considers the firm automatically dissolved as soon as that object is attained.

4. Mutual consent of the partners. Whether or not the partnership period is limited by the agreement, the partners may at any time rescind their contract by mutual consent.

5. Misconduct, insanity, death, assignment, or bankruptcy of a partner. The happening of any of these contingencies effects a dissolution. By misconduct may be understood a member’s failure to pay the agreed contribution of capital, failure to perform his duties, his acting in bad faith towards his copartners, etc.

6. Illegal object. A partnership entered into for the pursuit of an object which later becomes illegal is automatically dissolved.

7. War between nations of which partners are citizens. This dissolves the partnership, though such dissolution may be more in the nature of a suspension, inasmuch as the relation may be resumed upon cessation of hostilities.

8. Bankruptcy of the firm. This results in the firm’s assets being sold to satisfy the claims of its creditors and the firm as such ceases to exist.

9. Sale or transfer. A firm may sell out to another firm or change its form of organization to that of a corporation. The old firm, therefore, no longer exists.

Problems Incident to Dissolution.—It is purposed to consider some of the problems involved in winding up the affairs of a partnership. From the schedule of causes of dissolution given above it will be seen that a firm may be either solvent or insolvent at dissolution. The three statements sometimes set up in the case of insolvency—the Statement of Affairs, the Deficiency Account, and the Realization and Liquidation Statement—will not be explained here but results obtained through them will be taken into account. These statements are seldom met in practice and are not standardized either as to form or content. Their treatment is deferred to the work of the second year.

Partnership Provisions Covering Liquidation.—Because of the certainty of final dissolution, it is not unusual for the partnership agreement to make definite regulations concerning the method of liquidation. The appointment of one of the members as liquidating partner, the manner of distributing the proceeds from liquidation whether by instalments or otherwise, the manner of paying the liquidator for his services—all these contingencies should be provided for.

Where dissolution is forced by the death of one of the partners, to determine the interest of his heirs it is necessary to take inventory and make appraisal of the firm’s assets. To avoid this inconvenience to the business, provision is sometimes made in the agreement that the remaining partners shall continue the business until the end of the regular fiscal period. The deceased partner’s share in the profits for the current period up to the date of his death is determined by prorating the year’s profit over the period in which the deceased had an interest. The method of calculating the firm’s good-will is usually provided for in the partnership agreement so that the estate of the deceased partner will share in it also. Usually interest is allowed the estate of the deceased partner from the date of his death until the settlement of his share.

Partners’ Rights and Procedure During Liquidation.—When dissolution is accompanied by liquidation, as happens in many instances, all the partners have an equal right to share in the work of liquidation. Since the work usually does not require the time of all the partners, a customary procedure is to appoint one member—or an outsider—as the liquidator. Notice of the dissolution, in which the name of the liquidator is given, is published in the leading newspapers. If liquidation is necessary because of the death of a partner, great responsibility rests upon the liquidator. He must act in strict good faith and endeavor to realize the best price possible for the assets of the firm in the interest of the deceased partner’s estate. A similar responsibility rests upon him when liquidation is carried on in the interest of absent members.

The expenses and losses incident to liquidation must be borne by all in the profit and loss ratio. The liquidator may be paid either by means of a commission on the sums realized or by a salary. If the liquidator is a partner, settlement may take place privately between the partners but usually his commission or salary is charged to the firm’s liquidation expenses.

Liquidation may proceed by sale of the assets in regular order and may even permit the purchase of additional goods where necessary to fulfil existing contracts or to complete partly manufactured goods, or where stock on hand can be disposed of to better advantage by the addition of side lines or specialties.

Distribution of Proceeds.—Upon the realization of the assets, application of the proceeds must be made in the following order: First, the claims of outside creditors must be met in full or by compromise where not fully recognized. Second, the claims of the partners on account of loans or advances made to the firm must be satisfied. Third, the partners share in the remainder, by first taking out their respective capital contributions and then, if there is a balance, by sharing it in their profit and loss ratios. If there is a loss, this must be shared in the profit and loss ratio before withdrawal of any capital contributions. The remainder, if any, is divided among the partners in the ratio of their capitals as diminished by the loss. Whether the net assets are either more or less than the total amount of the capitals, the difference is shared in the profit and loss ratio, and what remains is shared in the capital ratio. If a careful accounting is made of the profit or loss at the time of the sale of each piece of property and these profits and losses together with the dissolution expenses are summarized and distributed to the partners’ capital accounts, those accounts will of course show the claims of the various partners on the net assets of the business after all assets have been converted into cash and all liabilities paid.

Instead of a complete liquidation of the firm’s assets, certain of the assets may, by mutual consent, be taken over by each partner at agreed values and applied toward the satisfaction of his capital and loan interests. Such use of assets is spoken of as a conversion to that particular purpose. It must be distinctly understood that this is not a right which any partner can demand, but only a privilege granted by the mutual agreement of the partners. Any partner can demand that all the assets be sold and that the proceeds be applied in satisfaction of the interests concerned.

Sharing Losses.—In the case of insolvency, the partners are compelled to share the losses in the profit and loss ratio, not in capital ratio, and these losses are chargeable against their capital accounts. If the capital account of any of the partners is not large enough to satisfy his share in the losses, a deficit in that partner’s interest results, which is represented by the debit balance in his capital account. This shows the amount which he must contribute to the firm in order that all claims may be satisfied. The rule that profits and losses in liquidation cannot be shared in the same ratio as capitals, unless this ratio is also the profit and loss ratio, is responsible for the fact that upon dissolution one or more partners may have to make additional contributions, while others may not be obliged to do so. This duty of contributing to make up a deficit is inherent in the partnership relation and can be enforced by the copartners.

A few illustrations will set forth the main problems in connection with the liquidation of partners’ capitals:

1. Sharing Losses Equally

A, B, and C share profits and losses equally.

The above balance sheet shows, in summary form, the condition of the firm previous to liquidation, and also indicates the shares of the partners in the net assets as on that date, i.e., the partners share in the net assets in the ratio 15:20:25 or 3:4:5. Dissolution becomes necessary and in the course of liquidation the expenses and losses incurred amount to $15,000. After the net loss of $15,000 is divided equally among the partners, the capitals will amount to, A $10,000, B $15,000, and C $20,000. The result is that the capital ratio has changed from 3:4:5 to 10:15:20, or 2:3:4, and the net assets of $45,000 are to be shared in this new ratio.

2. Capital Deficit

Jones and Smith share profits and losses equally.

The above balance sheet shows the condition of the firm after liquidation. It is necessary, first, to distribute the liquidation losses among the partners, after which they share in the net assets according to capital ratios. Accordingly, each capital account is debited with an equal share in the loss of $15,000, after which Jones’ capital is $12,500 and Smith’s account shows a debit balance of $2,500. This means that Jones not only gets the entire cash of $10,000, but Smith must contribute $2,500 to the firm and this also goes to Jones.

3. Personal Insolvency of One Partner

Smith and Jones each have a ⅖ share and Green a ⅕ share in profits and losses.

The above balance sheet shows the financial condition of the firm after taking into consideration the losses incident to liquidation. From this it is seen that Jones owes the business $9,000. Assume that he is personally insolvent and cannot contribute the share due from him. The net assets available for distribution consist of $16,000 in cash. Inasmuch as Jones’ interest is entirely wiped out and a contribution is due from him which he cannot pay, the amount of that contribution is an additional loss to be borne by the two remaining partners. Their respective shares in this loss are determined by their original profit and loss ratios ⅖ and ⅕, so that as between themselves Smith must bear ⅔ of the loss or $6,000, and Green ⅓ or $3,000; after which Smith’s capital and share in the net assets is $9,000, and Green’s $7,000.

Where a partner, in his private capacity, and the firm of which he is a member are both bankrupt, his personal creditors have first claim on his personal estate and the firm’s creditors on the assets of the firm.

Distribution by Instalments.—Where the liquidation is of long duration, the partners may desire to receive what is due them by instalments rather than wait to receive their respective shares in one amount. Where the capital ratio differs from the profit and loss ratio, it is difficult to determine the proper ratio in which the instalments should be paid, due to the fact that expenses and losses have not yet been determined. Consequently it is impossible to tell what the ultimate ratios will be in which the partners are to share the net assets. As the payment of instalments on an arbitrary basis might result ultimately in an overpayment of some partners and an underpayment of others, the only safe method of handling the situation is to pay the first instalments to those partners whose capital ratios are in excess of their profit and loss ratios until their capitals are reduced to the point where the capital ratios of all the partners are the same as their profit and loss ratios. As soon as this point is reached, the proceeds of the assets may be distributed to the partners on the basis of their profit and loss ratios, because these are now identical with their capital ratios. A more complete treatment of this problem will be found on pages 650 to 654 of the author’s second volume.

Treatment of Good-Will upon Liquidation by Sale.—When dissolution is brought about by the sale of the entire business, it may happen that the amount realized on the assets is smaller than their book value, and the difference must be treated as a loss in accordance with the principles previously stated. Similarly, where the assets are sold and the price realized is larger than their book value, the excess constitutes a profit and must be distributed among the partners in profit and loss ratio. Usually such an excess is treated as a receipt on account of good-will, and two standard methods of booking it are employed. When good-will is mentioned in the sale contract and its value has been determined, it is brought on the books as an asset and transferred immediately to the partners’ accounts. Thus, if the value is $15,000 and the profit and loss ratio is ⅖ to A, ⅖ to B, and ⅕ to C, the entry is:

Good-will is now shown as an asset, and the entry closing it off is the same as for the sale of the other assets, viz., a debit to Cash and a credit to Good-Will.

On the other hand, when good-will is not specified as such in the sale contract, but the amount realized on the sale of the assets is larger than their book values, this excess may be credited to Good-Will, which is then treated not as an asset account (as in the case given above) but as a profit and loss account. The balance of this account is closed out to the partners’ accounts in profit-sharing ratios in the same way as above. The ultimate result is the same in either case; the first method is a little more complete since it shows the value of the asset good-will previous to its sale.

The formal entries by which the sale of any business is recorded on its books, whether single proprietorship, partnership, or corporation, are treated in Chapter XXXIX under corporations.