Abstract:
Liquidating a business usually proves to be more complicated than initiating a business. When it comes to partnership firms in India, which are governed by the Indian Partnership Act, 1932, dissolution is not just the choice of ceasing operations. It is a legal procedure that entails settling of debts, allocating of assets and important tax requirements. A lot of business owners have the wrong perception that through winding up business activities, the firm will automatically be closed. But until the actual dissolution process is completed, and public notices are made, the partners are liable to acts committed by any partner. The legal entity also technically still persists in the government records. This paper gives a helpful step wise process of closing a partnership firm in India legally. It discusses the different types of dissolution, the procedures that must be followed in the event of winding up, the difference between a registered and unregistered firm and the final important step of filing Income Tax Returns of the dissolved firm.
Understanding the Legal Basis: Dissolution vs. Closure
Under Section 39 of the Indian Partnership Act, 1932, the dissolution of a partnership between all the partners of a firm is called the “dissolution of the firm.” This should not be confused with the “reconstitution” of a firm where a partner either retires or passes away but the business still exists. In a case of dissolution of a firm, the business is completely removed. The rest of the process is nothing more than winding up, which involves selling of assets, settling of creditors as well as allocating the rest of the money among partners in accordance with their pre-determined profit-sharing agreement.
Forms of Dissolution: Dissolution of a Partnership.
The closure should be initiated by determining the process through which the dissolution is occurring since this determines the amount of paperwork and notice. The most prevalent and the first is dissolution by agreement under Section 40. The decision to dissolve the business is agreed upon by all partners either by a certain provision in the original deed of partnership or by signing a dissolution deed. The second approach is the dissolution by notice under Section 43. In case it is an at-will partnership, i.e. no specific time exists, any partner is free to end the firm by giving written notice of ending the firm to all other partners. The third approach is the mandatory dissolution in Section 41. It automatically happens when all the partners or all except one partner fail, or when the trade of the company is illegalized. The fourth approach is court dissolution under Section 44. One of the partners can go to the court and dissolve the firm on basis of insanity or permanent incapability of a partner, chronic violation of agreement or misconduct.
Step-by-Step Procedure for Legal Closure
Whichever mode of dissolution may be used, the procedure involved when legally closing the firm is usually similar. The initial process is a call of a meeting, and approving a resolution. The partners are obliged to assemble to determine the dissolution. All partners should sign a dissolution deed. This act normally describes the date of dissolution, a winding-up partner to assist in the winding up and the manner in which the assets will be sold and liabilities paid. The second is under Section 48 – settlement of accounts. The law stipulates that there must be a certain order in settling accounts. To begin with, the company has to settle third-party debts like creditors, banks and suppliers. Second, it has to pay loans and advances that are offered by partners to the firm. Third, it will be required to pay back the capital raised by partners. Lastly, any surplus is divided based on share of profit. In case the firm is insolvent (liabilities are higher than the assets), the partners should pay their share of the losses in proportion to their profit share.
The third one is the filing of a public notice of dissolution. It is a crucial legal measure to reduce the liability in the future. Partnership Act section 45 says that the partners are liable to the acts committed, after the dissolution, until a public notice is made. Thus, the company will have to advertise on a local newspaper and the Official Gazette based on state regulations. Also, in case the firm is incorporated, the partners are required to submit a statement of dissolution to the Registrar of Firms. This takes the name of the firm off the active register. The fourth step is to get no-objection certificates and legal clearances. The company needs to dissolve all the existing bank accounts which is usually achieved through a partnership resolution. It should also submit cancellation of GST registration through Form GST REG-16 since the firm cannot be closed down and have active GST number. Lastly, the company should make sure that there are no pending tax bills with any government department.
The Final Tax Filing: ITR-5 for Dissolved Firms
The final Income Tax return is one of the most common steps that are overlooked. The firm is a taxable entity until the assets are completely distributed even when the business has ceased. Partnership firms are required to make ITR-5 filing every financial year until the winding-up process is accomplished by law. A return should be filed even with a zero income or a loss. Of special importance is the notion of carrying forward losses. In case the firm incurs business losses, it is important to file on time. Under tax policies, if the filing is not made by the due date, then the loss can be held over a maximum of eight years to offset future gains. Late filing forever waives the privilege of carrying forward such losses which in the case of partners may be a colossal financial blow. The partners are required to divide the income in two, before and after dissolution in the year the firm is dissolved, in case the business persisted to wind-up. The company is taxed on the income of the business to the dissolution date and the partners are taxed on the excess received in the course of final settlement.
Registered vs. Unregistered Firms: Does it Matter?
Registration is optional when it comes to the Partnership Act, but it influences the procedure of closing. By the registered firm, the partners will be required to submit a dissolution form to the Registrar of Firms. The inability to do so keeps the firm on record, and result in legal notifications and liability. In the case of an unregistered firm dissolution forms are not obligatory to be filed by the partners with the Registrar. They are however required to issue public notices and pay all the tax and GST. The biggest drawback is that unregistered companies are limited to the ability to sue third parties to recover their debts when winding up. Thus, although registration is not mandatory, it makes the lawful shut down more enforceable and cleaner.
Case laws on this aspect
In order to bring out the intricacies of a dissolution of a partnership firm, a well-known Supreme Court ruling is educative. A dispute arose in the case of Guru Nanak Industries & Anr. v. Amar Singh in which a two-partner firm was involved. One of the partners said that the other had retired, and the other partner said that the firm should be dissolved. The Supreme Court reaffirmed a very important technicality of partnership law. In the case of two partners, the dissolution of one partner will automatically lead to the dissolution of the firm. The reason is that a partnership cannot be supported by less than two partners. The court also observed that in a situation like this the other partner cannot proceed with the business on his own using the same firm name. The winding-up procedure should be carried out in accordance with all the legal requirements, such as account clearing and publication. The case is a good cautionary measure to the real-life example that oral agreements or presumptions regarding the closure of a firm are not enough. The process of dissolution should be observed to the letter, particularly when the relationship between the partners is terminated.
Real-life Problems and Disputes with Partners in the Process of Dissolution
It is easy to dissolve a partnership firm on paper. It is quite another thing to do it without fights, delays, or without money. Although the legal framework is well-defined in the Indian Partnership Act, 1932, the practical procedure of closing a firm is usually a sham. Friends or relatives who become partners at one point decide to disagree on valuations, payment of debts or on the balance cash to share. In this section, the most common practical issues and conflicts that can be encountered in the process of dissolution are discussed, and how they can be resolved practically without going to court.
The most common and the initial conflict is on the valuation of assets. When a partnership firm is to be closed down, all assets are to be sold or inherited by partners. This argument usually begins when one of the partners desires to sell an asset, machinery or property at a certain price, and the other partner thinks that the asset has a greater value. According to section 48 of the partnership act, the assets shall be used to settle the external debts first, followed by the partner loans and then capital repayment and finally the surplus distribution. The Act however does not state who determines the price of sale. Practically, the partners have to settle on a valuer. When they are unable to agree, the stalemate may postpone the entire procedure of winding-up months. One possible way out is to add a dissolution clause to the original partnership deed itself, specifying an independent valuer or arbitrator. Unless there is such a clause, the partners tend to employ different valuers and then settle on a compromise that wastes time and money.
The second significant challenge is the goodwill treatment. Goodwill refers to reputation and client base of the company which brings about the future profits. Goodwill is an asset that should be sold or given out when a firm is dissolved. The conflict is due to the fact that goodwill is not tangible and is challenging to appreciate. One of the partners might wish to carry on the same business in a new name and claim that the goodwill is his personal property. The other partners can insist on a share in its value. Goodwill has always been regarded by Indian courts as a partnership asset except where it is indicated to the contrary in the deed as in the case of Haldiram Bhujiawala v. Anand Kumar. When it took the firm years to be established and there are loyal customers, the good will can be high. When partners neglect this, they usually end up in lawsuits long after the company is out of business. The most secure method is to clearly present in the dissolution deed the treatment of goodwill including a formula of its valuation like multiple of average annual profits.
The third real-life issue is the third-party unpaid debts. A lot of partnership firms fail as they are due money by the customers or suppliers who fail to pay. In case the firm goes out of business, it becomes difficult to recover these outstanding receivables. In case the firm was not registered, then Section 69 of the Partnership Act prevents the firm to sue third parties to collect debts. This is a bitter yet a factual restriction. Even when the firm is registered, partners usually differ on the issue whether to recover the money legally or just write off the debts as bad. One of the partners might desire to sue, and another partner might desire to get in and out. The dissolution act must preferably empower a designated partner or a third-party liquidator to make decisions on the actions to be taken on recovery. Without such authority, any partner may technically seek recovery, although the legal expenses must be paid by all the partners.
The fourth issue has to do with the liabilities of partners upon dissolution. Partners are also personally liable under Partnership Act 45 in relation to anything that is done by any partner following dissolution until such time that they give public notice. This forms a hazardous gap. Consider a scenario in which Partner A believes that the firm has been shut down, yet Partner B goes ahead to purchase items on behalf of the firm and goes into debt. Until a public notice is published in a newspaper and filed with the Registrar of Firms, Partner A can be held liable for Partner B’s actions. It is not one of the hypothetical risks. Cases of creditors having to be paid by the retired or dissenting partner due to late or non-issuance of the public notice abound in small court cases. Thus, the first step to be taken upon a dissolution decision should be to write and post the public notice, even prior to the assets being sold. Most partners commit the inability to concentrate on assets initially and leave the liability window open weeks.
The fifth typical problem is the final tax liability. Partnership firms are taxed as separate entities. Upon the dissolution of the firm, the Income Tax Department would need a final return (ITR-5) covering the period between the commencement of the financial year and dissolution date. In case the firm suffered a loss, the firm can just set off the loss against subsequent income of the partners but only when the return is prepared on time. Conflicts occur when one partner has a high personal income and desires to receive the losses of the firm, and another partner has no income and desires to give up to the losses. This situation is rarely taken care of in the partnership deed. The tax law does not necessarily designate carried forward losses to be assigned to the partners in a certain percentage unless otherwise agreed upon. The answer is to enter into a separate agreement during dissolution and how the unabsorbed losses and unabsorbed depreciation will be shared among partners. In the absence of such an agreement, the partners can not only find themselves in a law suit against each other, but also be punished by the tax department due to non-filing.
The other challenge is the shutdown of statutory registrations outside the GST and income tax. A lot of partnership firms are registered in Professional Tax, Shop and Establishment Act license, Import Export Code (IEC), Employee Provident Fund (EPF) and Employee State Insurance (ESI). All these registrations must have their own closure application. Partners will not cancel these registrations and thus they receive automatic annual compliance notices, penalties and even legal notices many years after the firm is ceased to operate.
Conclusion
Partnership firm In India, the procedure of closing a partnership firm is a multi-step process that it is necessary to pay much attention to partnership law and tax regulations. It is not sufficient to put the business to a halt. The partners have to resolve passing, paying all the debts according to the established legal order, publicity of the notices, cancelling the GST registration, closing the bank accounts, and submitting final income tax returns. The difference between a registered and unregistered firm is important because it is the only difference that is considered when filing by the Registrar of Firms, yet tax and liability are the same in the registered and unregistered firm. The most frequent slip is not filing the last ITR-5 which may result in the loss of carry forward of business losses and the firm may technically be alive on tax books. Legal couples that go through the entire legal procedure save themselves a future liability, penalties, and a clean disengagement of the business. It is highly advisable to consult a chartered accountant or a lawyer because the details of the procedures are a bit different in each state and the specifics of the partnership deed.
References
Statutes
- The Indian Partnership Act, 1932
- The Income Tax Act, 1961
- The Central Goods and Services Tax Act, 2017
- The Indian Contract Act, 1872
- The Insolvency and Bankruptcy Code, 2016
- The Registration Act, 1908
- The Indian Stamp Act, 1899
Books
- Pollock & Mulla – The Indian Partnership Act (LexisNexis)
- Avtar Singh – Law of Partnership (Eastern Book Company)
- N. Chaturvedi & S.M. Pithisaria – Income Tax Law (LexisNexis)
- ICSI – Guide to Partnership & LLP Closure
Case Laws
- Guru Nanak Industries & Anr. v. Amar Singh (2020) – [MANU/SC/0453/2020, AIR SC 2484]
- Haldiram Bhujiawala v. Anand Kumar Deepak Kumar (2000) – Supreme Court [AIR 2000 SC 1287, (2000) 3 SCC 250]
- CIT v. R. M. Chidambaram Pillai (1977) – Supreme Court [1977] 106 ITR 292, AIR 1977 SC 489
- Shivram Poddar v. Income Tax Officer (1964) – Supreme Court [AIR 1964 SC 1095, (1964) 51 ITR 823]
