Dissolution of a Partnership Firm: Meaning, Modes of Dissolution, Modes of Settlement of accounts (Section 48)

What is Dissolution of a Partnership Firm?

When the relationship between all the partners of a firm is terminated/dissolved, it is called the dissolution of a firm. It is a formal termination of an organised body(the firm), constituted under Indian Partnership Act,1932. In other words, dissolution of a firm means that the firm ceases to exist. Hence, all the assets held by the firm are sold off and all the liabilities of the firm are settled.

According to Section 39 of the Indian Partnership Act, 1932, “Dissolution of the firm means dissolution of partnership among all the partners in the firm.”

What is Dissolution of Partnership?

Dissolution of partnership refers to a change in the existing relations among the various partners of a firm. It is noteworthy that such a change in the partners’ relationship does not have any impact on the firm. The firm continues its business. A partnership dissolves when any of the following events occurs:

  • Admission of a new partner
  • Retirement of an existing partner
  • Death of an existing partner
  • Merger/Acquisition of the firm by another firm.

Modes of Dissolution of a Partnership Firm

A. Voluntary Dissolution:

This refers to the situations where all the partners of a firm mutually agree to terminate its operations. These are:

1. By Agreement (Section 40): Section 40 of the Indian Partnership Act grants the authority to the partners to dissolve their firm, provided they all provide their consent to such dissolution. An extant contract can also be used for the purpose of officiating the dissolution.

2. Compulsory Dissolution (Section 41): Section 41 of the Indian Partnership Act, 1932 deals with the concept of compulsory dissolution. It states that the dissolution of a firm becomes compulsory if the occurrence of a certain event renders its operations unlawful. In cases where a firm owns multiple business units, and one of them becomes illegal, then it can continue to carry its operations out of the other ones.

3. On the happening of certain contingencies (Section 42): This section states certain contingencies which lead to the immediate dissolution of a firm. These are:

  • When the tenure for which a firm was constituted comes to an end, the firm also dissolves.
  • The death of a partner can lead to the dissolution of the firm if the partners so decide.
  • Insolvency of partners.
  • Upon completion of undertakings.

4. By notice of partnership at will (Section 43): Where a partnership has been constituted as per the will of the partners, any partner can serve a written notice to all the other partners informing them about his will to dissolve the firm. The firm is dissolved on the date specified in the notice. If no date is specified, the date of the firm’s dissolution is the date of notification.

B. Dissolution By Court Order:

A court may dissolve a partnership firm on any of the following grounds:

1. Insanity/Unsound Mind: If an active partner of the firm becomes insane or of an unsound mind, and the other partners file a suit in the court, the court may dissolve the firm, provided such illness is permanent. It is important to note that the court may not dissolve such a firm if any dormant/sleeping partner goes insane.

2. Permanent Incapacity: Permanent incapacity of a partner may also lead to the court dissolving a firm. Permanent incapacity refers to the inability of a partner to perform his duties and obligations towards the firm and may be a result of physical disability, illness, etc.

3. Misconduct: When a partner is guilty of conduct that may negatively impact the operations of the firm, and the other partners file a suit against him, the court may dissolve the firm. It is important to note that such misconduct may or may not be directly related to the business. It is for the court to analyze the impact of such conduct upon the business.

4. Persistent Breach of the Agreement: Where a partner has persistently and willfully breached the partnership deed, and the other partners have filed a suit against him in court, the court may dissolve the firm. A partner can breach the agreement by way of embezzlement, keeping erroneous accounts, holding more cash than allowed, refusing to show accounts despite repeated requests, etc.

5. Continuous/Perpetual Losses: Where the firm has been making losses for subsequent years and the court believes that the firm would keep on incurring losses in the future too, it may dissolve the firm.

6. Just and Equitable Grounds: A court may also order the dissolution of the firm on the basis of just and equitable grounds. Some of these are:

  • Management standoff
  • Partners not communicating with one another 
  • Loss of the very foundation of the business
  • Gambling at the stock exchange

Modes of Settlement of accounts on Dissolution(Section 48)

The following rules, subject to agreement by the partners, are followed while the settlement of accounts in the event of the dissolution of a firm:

1. Losses, particularly capital shortfalls, must be paid first from profits, then from the capital, and, if required, by the partners personally in the proportions in which they were allowed to share earnings.

2. The firm’s assets, including any sums provided by the partners to make up capital deficits, shall be applied in the following manner:

  • Firstly, the debts owed by the firm to third parties are paid off.
  • Secondly, each partner is paid whatever the firm owes him for advances apart from the partner’s capital.
  • Thirdly, each partner is to be paid whatever the firm owes him on account of his capital.
  • Any residue, if any, is to be divided among the partners in their profit-sharing ratio.

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