Should partners take out income during dissolution?

Partnership Dissolution

The simple answer is NO.

The following considers whether partners should continue receiving an income distribution during the winding up of the partnership when the partnership has a significant debt obligation, and the partnership does not have a partnership agreement in place. We look specifically at the scenario of when a partner decides to leave, and discuss how this triggers partnership dissolution process.

Partnerships are Dissolved Upon Notice

First, the partnership is dissolved either on the date the partner decides to leave or on a later date as negotiated by the partners. The leaving partner’s notice triggers the beginning of the winding up. Regardless whether the businesses continue under the other partners, this automatically triggers dissolution of the partnership because the continuing partners form a completely different partnership that doesn’t include the exiting partner. The former partnership no longer exists. Hence, dissolution ensues.

ARS 29-1071 dissolution

A partnership is dissolved, and its business shall be wound up…in a partnership at will [when] the partnership [has] notice from a partner … of that partner’s express will to withdraw as a partner, or on a later date specified by the partner. ARS 29-1071(1).

Therefore, the partnership receives notice of a partner’s intent to dissociate, and the winding up of partnership affairs begins.

What happens to the partnership assets during this time?

Second, during the winding up process, the partnership business assets, including contributions of the partners, must be used to discharge obligations to creditors.

ARS 29-1077(A)

A. In winding up a partnership’s business, the assets of the partnership, including the contributions of the partners required by this section, shall be applied to discharge its obligations to creditors, including, to the extent permitted by law, partners who are creditors. Any surplus shall be applied to pay in cash the net amount distributable to partners in accordance with their right to distributions under subsection B of this section. ARS 29-1077(A).

Partners Exercising their Duty of Care During Dissolution

Last, each partner has a duty of care to the partnership that supersedes any right to a distribution. See ARS 29-1034. The partnership is a legal entity that is distinct from each partner. Partners cannot demand a distribution of partnership profits during the winding up period, but they are entitled to have partnership profits, less debt obligations, credited to their account and settled at the end of dissolution.

This duty of care means that the partners cannot fulfill their duty to the partnership by continuing to take distributions of partnership principal because distributions increase partnership debt and there is waste of partnership principal to higher interest payments. While keeping debt down and not increasing debt should be the standard if the partners were continuing business as normal, however, this duty is particularly applicable during the winding up period because disregarding the Arizona Revised Uniform Partnership Act is a violation of each partner’s duty of care. Therefore, continuing to take an income distribution without a partnership agreement to do so, would violate the partner’s duty of care because it would afford less partnership principal at dissolution.

Therefore, partners should not receive an income distribution during the winding up of the partnership affairs when there is a debt obligation and no partnership agreement that states otherwise.

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