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 does the dissolution of a firm mean as per the Indian Partnership Act, 1932?
According to Section 39 of the Indian Partnership Act, 1932, the dissolution of a partnership among all the partners of a firm is known as the dissolution of the firm. This event signifies the complete discontinuation of the business operations, leading to the winding up of its affairs, which includes selling all assets and settling all liabilities.
2. What is the main difference between the dissolution of a firm and the dissolution of a partnership?
The primary difference lies in the continuation of the business. The dissolution of a firm means the business itself ceases to exist. In contrast, the dissolution of a partnership only refers to a change in the legal relationship between partners (e.g., due to admission or retirement), while the firm's business can continue under a new, reconstituted agreement.
3. Under what circumstances can a partnership firm be dissolved?
A partnership firm can be dissolved under several circumstances, which are broadly classified as follows:
- Dissolution by Agreement: When all partners mutually decide to end the firm.
- Compulsory Dissolution: If the business of the firm becomes unlawful or if all partners (or all but one) become insolvent.
- On the Happening of Certain Contingencies: This includes the expiry of the firm's fixed term, completion of its specific venture, death of a partner, or a partner being declared insolvent.
- Dissolution by Notice: In a 'partnership at will,' any partner can initiate dissolution by giving a written notice to all other partners.
- Dissolution by the Court: A court can order dissolution if a partner files a suit on grounds like another partner's insanity, misconduct, permanent incapacity, or if the court finds it just and equitable.
4. What are the key steps involved in settling accounts after a firm is dissolved?
As per the CBSE 2025-26 syllabus, the settlement of accounts upon dissolution follows a strict legal order. First, all assets are sold to raise cash. This amount is then used to:
- Pay off debts to third parties (e.g., creditors, bank loans).
- Settle any loans or advances made by individual partners to the firm.
- Return the capital contributed by each partner.
- Distribute any remaining surplus among the partners in their designated profit-sharing ratio.
5. Why is it said that the dissolution of a firm always includes the dissolution of the partnership, but not vice versa?
This distinction is crucial. A 'firm' is the collective business entity run by the partners. When the firm is dissolved, the business itself ends, which automatically terminates the legal relationship (partnership) among all partners. However, a partnership can be dissolved (e.g., a partner retires) without ending the firm, as the remaining partners can form a new agreement and continue the same business.
6. How are the firm's assets and liabilities treated during the settlement of accounts upon dissolution?
During dissolution, the firm's assets are first converted into cash through a process called Realisation of Assets. This cash is then applied in a specific order of priority to settle liabilities. External liabilities, such as creditors and bank loans, are paid first. After settling all outside debts, any loans made by partners to the firm are repaid. Finally, the capital accounts of the partners are settled. This sequential process ensures an orderly and legally compliant winding up of the firm's finances.
7. Can a court order the dissolution of a firm even if all partners wish to continue the business?
Yes, a court has the authority to order the dissolution of a firm against the partners' collective wishes. This typically happens if one partner files a suit and the court finds valid grounds. For example, if a partner is found guilty of misconduct that negatively affects the business, if the business consistently operates at a loss, or if the court believes dissolution is 'just and equitable' for any reason, it can legally enforce the closure of the firm to protect the stakeholders' interests.
8. If one partner in a firm of four becomes insolvent, does the entire firm have to be dissolved?
It depends on the partnership agreement. Under the Indian Partnership Act, 1932, the insolvency of a partner is a valid reason for dissolution. However, it is not always compulsory. If the partnership deed includes a specific clause allowing the remaining solvent partners to continue the business, the firm can be reconstituted and avoid dissolution. If no such agreement exists, the insolvency of one partner will lead to the dissolution of the entire firm.
