Dissolution of a Firm: Key Steps

The ‘dissolution of a firm’ is a major term used for the ‘partnership firm’ precisely. The dissolution of the firm takes place for numerous reasons like dissolution by agreement, dissolution by legal notice, insolvency of the partners, or simply if the partnership firm is illegal in nature. In case of dissolution of the firm, the entire firm halts from the operation. This is quite different from the ‘dissolution of partnership’. 

Thus, in this context let us know more about the dissolution of the ‘firm’ and its difference from the ‘dissolution of partnership’.

What is the Dissolution of a Firm?

Dissolution of a firm refers to the dissolution of an existing partnership that owns and controls a firm or an organization. While numerous reasons can lead to the partnership’s dissolution in a firm, usually a concerned organization is also dissolved under these circumstances. However, this may not always be the case.

While understanding dissolution meaning, students must note that according to the Partnership Act, 1932, “The dissolution of a partnership between all the partners of a firm is called the dissolution of the firm”. By definition, this distinguishes between the dissolution of a firm and that of a partnership.

Only in the event of an existing agreement among a firm’s partners can it be reconstituted without any dissolution despite the partnership being dissolved. Consequently, a firm’s dissolution always involves the dissolution of a partnership, while it's inverse may or may not be accurate and depends on existing agreements.

Types of Dissolutions

While learning how is a firm dissolved, students must note these ways mentioned below:

1. Dissolution by Agreement: A firm can be dissolved with an agreement among its existing partners, though it should meet the following criteria:

• Every partner of a firm must consent to its dissolution.

• There must be legally binding contracts among existing partners.

2. Mandatory Dissolution: Circumstances under which a firm is dissolved compulsorily are as follows:

• When one or more partners of a firm become insolvent, making them incompetent to enter any contract or agreement.

• If it becomes unlawful for a specific partnership firm to continue its business and revenue generation. Notably, this is not the same as that of dissolution by court order. An example in this regard would be when a partnership firm has a foreign partner and war is declared by this firm’s country of origin on that of its foreign partner. Under such circumstances, this firm must be dissolved.

3. Emergency Dissolution Due to Contingencies: A firm can be dissolved based on an existing contract among its partners only under these circumstances that are listed below:

• If a firm was established for a fixed tenure and that term has expired

• If a firm was established for a specific venture and that venture has been completed

• A partner’s demise

• If a partner of a firm becomes insolvent

4. Dissolution by Notice: If the partnership of a firm is at will, one of its partners can issue a notice for its dissolution. It must be issued in writing to all the existing partners and clearly state his/her intention towards dissolving a firm.

5. Dissolution by the Court: When one of the partners of a firm files a legal suit, a court of law can direct the dissolution of a firm. That can be done on any of the following grounds described below.

• If a partner loses mental stability

• If one partners becomes incapable of fulfilling his/her duties

• When a partner is found guilty of any misconduct that goes on to affect this firm’s business adversely

• If one or more partners turn their whole interest in the partnership to a third party

• When a lawful court deems its dissolution just

Settlement of Accounts

Accounts settlement after the dissolution of a firm, are directed by provisions included in the Indian Partnership Act, 1932. These provisions mention these following guidelines.

1. A firm will pay for its losses and liabilities, including capital deficiency from its profits. If this profit is inadequate to clear its losses, a firm must pay for it from its partners’ capital. If it still does not clear all a firm’s losses, partners will have to clear it in the same ratio as that of their profit sharing.

2. When the firm is dissolved, its assets are applied to make for existing deficiencies and losses. The firm should begin by clearing third-party debts, followed by loans and advances made by any partner. Once these debts are cleared, the capital of every partner must be cleared. If a firm still has surplus funds, it should be divided among partners in the same ratio as that of profit-sharing.