Dissolution of the Partnership Firm
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:
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.
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.
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
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.
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.
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.
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.
FAQs on Dissolution of a Firm: Key Steps
1. What is meant by dissolution of a firm?
Dissolution of a firm means the partnership between all partners comes to an end, and the business itself is closed. Unlike retirement or admission of a partner, dissolution leads to the final closure of business activities and the distribution of assets and liabilities among the partners. In accounting and legal terms, dissolution terminates the partnership agreement, after which the firm’s name and its earnings cease to exist. All partners settle their accounts as per the partnership deed or prevailing laws. Understanding the dissolution of a firm is essential for proper closure procedures and fair settlement of claims.
2. What is the accounting treatment for dissolution of firm?
When a firm is dissolved, accounting treatment ensures a fair and transparent settlement of all accounts. The assets and liabilities are accounted for carefully, and the process typically involves specific steps:
- Transfer all assets (except cash) to a realization account.
- Transfer all liabilities (except those due to partners) to the same realization account.
- Sell assets and pay liabilities using realization account transactions.
- Distribute residual cash or losses among partners, based on capital or profit-sharing ratios.
3. What are the grounds of dissolution of firm by court?
A court can order the dissolution of a firm under certain circumstances, especially when continuing the partnership becomes impossible or unfair. Below are some key grounds for such dissolution:
- Partner insanity or unsoundness of mind
- Permanent incapacity of a partner
- Partner's misconduct that negatively affects the business
- Persistent breach of the partnership agreement
- Losses making business unprofitable
- Any other just and equitable cause recognized by the court
4. What happens when a company is dissolved?
When a company is dissolved, its legal existence ends permanently, and it cannot conduct any further business. This involves selling all assets, clearing liabilities, and distributing remaining funds among the shareholders according to their entitlements. The registrar then removes the company from official records, making it a non-entity in the eyes of law. Dissolution of a company is different from winding up, as dissolution marks the final closure and legal death of the entity, while winding up is the process leading to this end.
5. What are the modes of dissolution of a partnership firm?
A partnership firm may be dissolved through various modes, depending on the reason and manner of closure. The main modes of dissolution include:
- Dissolution by agreement among all partners
- Compulsory dissolution (such as insolvency of all partners or illegal business)
- Dissolution on the happening of certain contingencies (like expiry of term or completion of business)
- Dissolution by notice in case of partnership at will
- Dissolution by court order when there are valid grounds
6. What is the difference between dissolution of partnership and dissolution of firm?
The dissolution of partnership and dissolution of firm are two distinct legal concepts in business law. Dissolution of partnership refers to a change in the relationship between existing partners, like retirement or admission, but the firm continues to operate. In contrast, dissolution of the firm involves ending the entire partnership business, ceasing all operations, and settling liabilities. Thus, while every dissolution of firm is a dissolution of partnership, not all partnership dissolutions result in the closure of the firm.
7. How are the assets and liabilities settled during the dissolution of a firm?
During the dissolution of a firm, the settlement of assets and liabilities follows a specific procedure to ensure fairness. The assets are realized, and liabilities are paid in a set order:
- Realize firm’s assets by selling them or converting them into cash
- Pay off external liabilities and creditors, including loans
- Settle partner advances, if any
- Distribute the remaining amount to partners according to capital balances, after adjusting for all dues
8. What are the legal consequences of dissolution of a firm?
When a firm dissolves, several legal consequences follow. First, the partnership agreement is terminated and all rights and obligations among partners come to an end. The firm loses its legal entity, and the name cannot be used for new business except through a fresh agreement. Outstanding contracts are settled, and third parties are notified to avoid ongoing liability. It is crucial for firms to follow proper legal processes during dissolution to safeguard against potential claims and to ensure smooth closure. This finality is what marks the true end of a partnership business.
