The Right Way to Terminate a Partnership Agreement

There are many reasons why you’d want to terminate a partnership agreement. The goals of one or both partners have changed, your working styles are incompatible, or there are fundamental disagreements about business operations and decisions. Whatever the reason, the partners must understand and follow the correct procedures and regulations for partnership termination, so all parties are legally separated from liability.

What is a Partnership?

A partnership is a legal entity where two (or more) people own and operate a business, and each partner owns a percentage of the assets and liabilities of the company. The critical difference is that the partnership agreement details the partners’ ownership and responsibilities. Although a partnership agreement is not legally required, it is highly recommended for both the partnership’s success and an amicable termination, if necessary.

What’s in a Partnership Agreement?

For a general partnership, the partnership agreement should contain the following:

• Business Name. Unlike a sole proprietorship which is usually named after the sole owner, a partnership should have an official business name that should be used on all bank accounts and documents.
• Contributions. The partners are not required to make equal financial contributions to the business—their financial obligations can vary. The agreement should contain any past, current, and future financial stakes.
• Distributions. How the company plans to distribute partner profits should also be documented. If there is no documentation for allocations, the Internal Revenue Service (IRS) considers each partner equal.
• Ownership. Here, the agreement should outline what happens if:
  • The business is sold
  • One or more of the partners wants out
  • The partnership takes on new partners
  • One of the partners is bought out
• Decision-making. Which partner has daily management decision-making power? What about group decisions? Or financial decisions?
• Disputes. In this section, the agreement documents how to handle conflicts. The goal is to keep arguments from turning into costly court cases.
• Critical Developments. This part lays out how to amend or terminate the agreement when/if a partner dies or wants to retire.

Once the partnership agreement is drawn up, it’s a good idea to have an attorney look it over to clear up any confusing language and make sure nothing is missing.

What Is Considered a Partnership Termination?

Legally a partnership continues to exist until it is terminated. What causes a partnership to end? As mentioned above, there could be numerous reasons to terminate a partnership, including personality conflicts or irreconcilable differences. However, it can also be something less dramatic, such as the partners want to change the business’s legal structure. A partnership is considered terminated if no part of its business, financial operations, or activities continues.

In any case, the partnership agreement dictates what happens when the partnership is terminated. Without an agreement, the termination terms are left up to the courts in your state. In the event of a partner’s death, the agreement could require the partnership to terminate immediately and have the deceased partner’s assets be reassigned to the remaining partner(s). Or there may be a succession plan in place for the deceased partner’s family to have a stake in the business. In that scenario, the partnership is still intact because the beneficiaries are part of the business. Likewise, if one partner wants out and sells his portion to the remaining partners, the partnership still exists.

A partnership termination is necessary when the company is reduced to one owner, ceases to do business, or changes legal structure. For example, if the latter is the case:

• From a partnership to a sole proprietorship: The steps to transfer ownership of the business from partners to a sole proprietorship should be documented in the partnership agreement. In many cases, this means one partner is buying out the others partners, and the assets and liabilities of the company will be redistributed to the remaining owner. However, without an agreement, the assets and liabilities typically are divided equally among the original partners, who then need to create documents about each aspect of the business, including company name, customer lists, etc., and how they will be distributed.
• From a partnership to a Limited Liability Company (LLC): There are several reasons a partnership may decide to restructure as an LLC. Whether there’s been a change in ownership or just a desire to change the company’s business structure, the partners need to follow the compliance rules for LLCs in their home state. This usually entails searching and filing for a legal business name, filing an LLC application with the Secretary of State, and filing an operating agreement and articles of organization. The new LLC must also obtain a Federal Tax ID number from the IRS.
• From a partnership to a C Corporation: Likewise, if the partnership decides to restructure as a C Corporation, the remaining partner/s must follow the compliance rules for incorporating in their home state. This entails searching and filing for a legal business name, filing to incorporate with the Secretary of State, and creating a board of directors, creating and filing bylaws and articles of incorporation. The new corporation must also obtain a Federal Tax ID number from the IRS.

Once the partnership votes to restructure and files for the new structure, all assets and liabilities should be transferred to the new structure. After the transfer occurs, the partners can begin the dissolution of a partnership and terminate the partnership agreement.

Difference Between Dissolution and Termination of a Partnership

In basic terms, the dissolution of a partnership refers to the steps involved in winding up the business, preparing for termination. Termination is the final result; the company has ceased all business activity and no longer exists.

How to dissolve a partnership? Generally, the steps include paying off or settling all the company’s debts, liabilities, and obligations. If all debts cannot be paid, the creditors must be notified of the dissolution so they can try and recoup some monies in court.

Once the partnership has started the dissolution process, the company can no longer conduct any business activity. A partner can dissolve a partnership if he or she withdraws from the partnership or if the partner dies.

If the partnership is registered to do business in other states, the partners must follow that state’s rules for dissolution and termination.

Tax Consequences

Any change in a business structure can result in tax consequences. Partnership termination tax consequences depend on what happens after the partnership ceases or restructures. Partnerships are considered non-tax-paying entities. The partnership itself does not pay income tax. The partners are not employees, and the partnership passes both profits and losses through to the partners.

When the partnership terminates, partners must pay taxes on any remaining profits and the liquidation of current and fixed assets. If the partners are not equal, per the agreement, then the distribution of remaining assets and losses will also not be equal. If the partnership restructures, then the assets and liabilities of the partnership can become part of the new entity, and the tax consequences depend on how the new company chooses to be taxed.