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. No one needs to file anything with the state, nor do the partners need to enter into a written agreement between. (For more information on forming a partnership, see How to Form a Partnership).
But a partnership agreement is good to have, even if it’s not required. Your agreement should, among other things, establish what type of actions or events will terminate the partnership and what will happen upon termination (also known as “dissolution”). If your partnership lacks a written partnership agreement, or your agreement doesn’t address termination, your state partnership law will determine when and how your partnership terminates.
Ways a Business Partnership Terminates
A general partnership can terminate by the partners agreeing to end it or automatically under state law. (We cover termination for tax purposes later.)
Dissolution by Agreement of the Partners
Partners may agree, either at the outset of the business or at any point in the business’s life, to end the partnership. If a partnership agreement is in place, the partners should review it carefully and follow any of its provisions about termination.
If you don’t have a partnership agreement, once you and your partners have decided to dissolve the partnership, you should consider entering into a separate partnership termination agreement. That termination agreement should spell out the termination process and the rights and responsibilities of the partners in that process.
Dissolution Under State Law
If partners don’t have an agreement that deals with termination, state law determines when and how the partnership terminates. State partnership laws differ, but in many states a partnership dissolves when any of these events happens:
- a partner dies
- a partner resigns or withdraws from the partnership
- a partner becomes mentally or physically incapacitated
- one or more partners expel another partner
- the partnership business files for bankruptcy
- the partners agree to dissolve the partnership
- the partnership business becomes illegal (for example, when state or federal law prohibits a good or service that had previously been legal)
- a partner gets a court order stating that the partnership must be terminated because it can’t accomplish its economic purpose
- a 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 doesn’t automatically dissolve when a partner dies or withdraws. Instead, the state’s partnership law lets the remaining partners buy out the interest of the dead or withdrawing partner without dissolving the partnership. But if the partners choose not to do so, the partnership dissolves.
Partners can agree ahead of time to a specific outcome in the event of the death, incapacity, or withdrawal of a partner. The best practice is for the partners to enter into a buy-sell agreement, or buyout agreement, which can be a separate document or part of a broader partnership agreement. (For more information, see Partnership Buyout Agreements.)
Winding Up the Business of a Dissolved Partnership
When a partnership is dissolved, the individuals involved are no longer partners in a legal sense. But the partnership continues for the limited purpose of winding up the business. Winding up involves selling the partnership’s assets, paying its debts, and distributing any remaining money or property to the partners or their heirs.
After dissolution, each partner has an equal right to participate in the winding-up process and share in the distribution of the business’s assets. The partners may, however, designate one or more partners to conduct the winding up process.
If dissolution happens because of the death of a partner, the surviving partners ordinarily have full power to control and dispose of the assets.
Steps in the Winding-Up Process
Once the partnership has dissolved, the partners must take the following steps to complete the termination process:
- Liquidate (sell or otherwise dispose of) the partnership’s assets.
- Make an accounting of the business’s assets and the proceeds from liquidation.
- Use the proceeds from liquidation to pay all outstanding partnership debts, including anything owed to the partners. But the partners must pay outside creditors first. Because general partners don’t have limited liability for partnership debts, if the partnership doesn’t have enough money or property to pay its debts, the individual partners will have to chip in from their own funds to pay them.
- If any assets (money or property) remain after all debts have been paid, distribute those assets to the partners.
For more information on winding up a partnership, see Winding Up a Business and Distributing Assets.
A dissolved partnership should let the world (including creditors) know that it’s no longer in business by publishing a notice in a local newspaper and filing a statement-of-dissolution form with the state secretary of state (or similar official).
For more information on ending your liability for partnership debts when the partnership dissolves, see Dissolve a Partnership to End Your Liability.
Tax Consequences of Partnership Termination
A partnership is a legal entity that might own property and operate a business, but it isn’t a taxpaying entity. Instead, a partnership is a pass-through entity for tax purposes—that is, it pays no taxes itself.
The profits, losses, deductions, and tax credits of the business are passed through the partnership to the partners’ individual tax returns. Note, though, that 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, the partners must file IRS Form 1065 for the short period. For example, if a partnership has a December 31 tax year but terminates on September 30, it would file a partnership return for the period of January 1 – September 30.
There are two types of partnership termination for tax purposes: real and technical.
Real Termination of Partnerships
A real termination for tax purposes occurs when a partnership stops doing business. A partnership no longer does business if all its operations are discontinued and none of its partners continue any part of the business, financial operation, or venture. In this event, the partnership will have to dissolve and cease being a partnership for state law purposes. The partners will need to wind up the partnership by liquidating the partnership assets, paying the partnership debts, and distributing the remaining assets.
Be aware that partners might have to recognize a taxable gain on any money or property distributed to them, or share in a loss that might 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. Taxable gain or loss on the distribution of partnership assets is complicated, and you should consult a tax professional for guidance.
Technical Termination of Partnerships
Technical tax termination happens if at least 50% of the total interest in the capital and profits of the partnership is sold or exchanged within a 12-month period. This rule also applies when there’s a sale or exchange to another partner.
These kinds of terminations are considered technical because the partnership continues for state law purposes—that is, it isn’t 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.
The new partnership even keeps the old partnership’s EIN (employer identification number). Technical terminations usually don’t result in the partners recognizing any taxable gain or loss. However, a technical termination of a partnership can result in the loss of favorable real estate depreciation and tax accounting methods. The treatment of real estate depreciation and tax accounting methods in a technical termination is complicated, and you should consult a tax professional for guidance.
For more information on the taxation of partnerships, including the tax implications of terminating a partnership, see IRS Publication 541 – Partnerships.