Liquidation of a Partnership Firm | Business | Accounting

In this article we will discuss about under what conditions would a partnership firm be liquified.

Introduction:

Partnerships can be rather frail organiza­tions. Termination of business activities followed by the liquidation of partnership property can take place for a variety of reasons, both legal and personal.

In any firm, unless there is continuous open and candid communication among equity partners, and acceptance and buy- in for the business plan chosen by the firm, sooner or later there will be a disso­lution of the firm.

The form of the dissolution is irrelevant, whether by withdrawal of individual partners or wholesale departure and formal liquidation. The end result will be the same- The origi­nal dream of harmonious and collegial growth of the firm will come to an end.

Although a business organized as a partnership can exist indefinitely through periodic changes within the ownership, the actual cessation of operations is not an uncommon occurrence. “Sooner or later, all partnerships end, whether a partner dies, moves to Hawaii, or gets into a different line of business.” The partners simply may be incompat­ible and choose to cease operations. The same choice could be reached if profit figures fail to equal projected levels. “In the best of times, partnerships are fragile.”

The death of a partner is an event that dissolves a partnership and frequently leads to the termination of business operations. Rather than continuing under a new partnership arrangement, the remaining owners could discover that liquidation is necessary to settle the claims of the deceased partner’s estate. A similar action could be required if one or more partners elect to change careers or retire. Under that circumstance, liquidation is often the most convenient method for winding up the financial affairs of the business.

As a final possibility, bankruptcy can legally force a partnership into selling its noncash assets. Laventhol & Horwath, the seventh largest public accounting firm in the United States at the time, filed for bankruptcy protection after the firm came under intense financial pressure from numerous lawsuits. “Laventhol said that at least 100 lawsuits are pending in state and federal courts. Bankruptcy court protection ‘is absolutely necessary in order to protect the debtor and its creditors from the devastating results a destructive race for assets will cause’ the firm said.”

The bankruptcy of Laventhol & Horwath was not an isolated incident. During the period 1998-2004, a study conducted by Hildebrandt International identified 80 U.S. law firms with more than 10 lawyers that dissolved. In investigating the reasons for fail­ure, the researcher identified internal dysfunction, the inability to pay market compen­sation levels, and a weak competitive market position as major factors leading to law firms going out of business.

Termination and Liquidation—Protecting the Interests of all Parties:

According to the chapter on bankruptcy, accounting for the termination and liquidation of a business can prove to be a delicate task. Losses are commonly incurred. For example, “Former partners in Keck, Mahin and Cate have pledged to pay slightly over $3 million to general unse­cured creditors to settle the bankrupt firm’s debts, this figure represents about 36 percent of the money owed.” Here, both the partners and the debtors suffered heavy losses. Other partnerships have experienced a similar fate.

In 1990, prior to the advent of limited-liability partnerships, the accounting firm of Laventhol & Horwath filed for Chapter 11 bankruptcy-court protection, in part due to lawsuits over question­able accounting. The firm’s assets were insufficient to cover the claims of creditors and litigants.

Under a plan negotiated with the firm’s creditors, the 360 partners and former partners who had spent time at the firm since 1984 were required to dig into their own pockets to share a $46 million liability. Under a formula hammered out by partner Jacob Brandzel, now an executive at American Express Co. in Chicago, they were obligated to contribute between about $5,000 and $450,000, depending on factors including seniority. Managers were levied a 5 percent to 10 percent surcharge on top. Everyone was given 10 years to pay.

Consequently, throughout any liquidation, both creditors and owners demand continuous accounting information that enables them to monitor and assess their financial risks.

In gen­erating these data for a partnership, the accountant must record the following:

i. The conversion of partnership assets into cash.

ii. The allocation of the resulting gains and losses.

iii. The payment of liabilities and expenses.

iv. Any remaining unpaid debts to be settled or the distribution of any remaining assets to the partners based on their final capital balances.

Beyond the goal of merely reporting these transactions, the accountant must work to ensure the equitable treatment of all parties involved in the liquidation. The accounting records, for example, are the basis for allocating available assets to creditors and to the individual partners. If assets are limited, the accountant also may have to make recommendations as to the appro­priate method for distributing any remaining funds.

Protecting the interests of partnership creditors is an especially significant duty because the Uniform Partnership Act specifies that they have first priority to the assets held by the business at dissolution. The accountant’s desire for an equitable settlement is enhanced, no doubt, in that any party to a liquidation who is not treated fairly can seek legal recovery from the responsible party.

Not only the creditors but also the partners themselves have a great interest in the financial data produced during the period of liquidation. They must be concerned, as indicated by the possibility of incurring substantial monetary losses. The potential for loss is especially signif­icant because of the unlimited liability to which the partners are exposed.

Even the new legal formats that have been developed do not necessarily provide safety.

As long as a partnership can meet all of its obligations, a partner’s risk is normally no more than that of a corporate stockholder. However, should the partnership become insolvent, each partner faces the possibility of having to satisfy all remaining obligations personally?

Although any partner suffering more than a proportionate share of these losses can seek legal retribution from the remaining owners, this process is not always an effective remedy. The other partners may themselves be insolvent, or anticipated legal costs might discourage the damaged party from seeking recovery. Therefore, each partner usually has a keen interest in monitoring the progress of a liquidation as it transpires.

Termination and Liquidation Procedures Illustrated:

The procedures involved in terminating and liquidating a partnership are basically mechanical. Partnership assets are converted into cash that is then used to pay business obligations as well as liquidation expenses. Any remaining assets are distributed to the individual partners based on their final capital balances. Because no other ledger accounts exist, the partnership’s books are permanently closed. If each partner has a capital balance large enough to absorb all liquidation losses, the accountant should experience little difficulty in recording this series of transactions.

To illustrate the typical process, assume that Morgan and Houseman have been operating an art gallery as a partnership for a number of years. Morgan and Houseman allocate all prof­its and losses on a 6:4 basis, respectively. On May 1, 2009, the partners decide to terminate business activities, liquidate all noncash assets, and dissolve their partnership.

Although they give no specific explanation for this action, any number of reasons could exist. The partners, for example, could have come to a disagreement so that they no longer believe they can work together. Another possibility is that business profits could have been inadequate to warrant the continuing investment of their time and capital.

Following is a balance sheet for the partnership of Morgan and Houseman as of the termi­nation date. The revenue, expense, and drawing accounts have been closed as a preliminary step in terminating the business. A separate reporting of the gains and losses that occur during the final winding-down process will subsequently be made.

We assume here that the liquidation of Morgan and Houseman proceeds in an orderly fash­ion through the following events:

2009:

June 1 – The inventory is sold at auction for $15,000.

July 15 – Of the total accounts receivable, the partnership collected $9,000 and wrote off the remainder as bad debts.

Aug. 20 – The fixed assets are sold for a total of $29,000.

Aug. 25 – All partnership liabilities are paid.

Sept. 10 – A total of $3,000 in liquidation expenses is paid to cover costs such as accounting and legal fees as well as the commissions incurred in disposing of partnership property.

Oct. 15 – All remaining cash is distributed to the owners based on their final capital account balances.

Accordingly, the partnership of Morgan and Houseman incurred a number of losses in liq­uidating its property. Such losses are almost anticipated because the need for immediate sale usually holds a high priority in a liquidation. Furthermore, a portion of the assets used by any business, such as its equipment and buildings, could have a utility that is strictly limited to a particular type of operation. If the property is not easily adaptable, disposal at any reasonable price often proves to be a problem.

To record the liquidation of Morgan and Houseman, the following journal entries would be made. Rather than report specific income and expense balances, gains and losses are tradi­tionally recorded directly to the partners’ capital accounts. Because operations have ceased, determination of a separate net income figure for this period would provide little informational value. Instead, a primary concern of the parties involved in any liquidation is the continuing changes in each partner’s capital balance.

After liquidating the partnership assets and paying off all obligations, the cash that remains can be divided between Morgan and Houseman personally.

The following schedule is utilized to determine the partners’ ending capital account balances and, thus, the appropriate distribu­tion for this final payment:

Schedule of Liquidation:

Liquidation can take a considerable length of time to complete. Because the various parties involved seek continually updated financial information, the accountant should produce fre­quent reports summarizing the transactions as they occur.

Consequently, a statement (often referred to as the schedule of liquidation) can be prepared at periodic intervals to disclose:

i. Transactions to date.

ii. Property still being held by the partnership.

iii. Liabilities remaining to be paid.

iv. Current cash and capital balances.

Although the preceding Morgan and Houseman example has been condensed into a few events occurring during a relatively brief period of time, partnership liquidations usually require numerous transactions that transpire over months and, perhaps, even years. By receiv­ing frequent schedules of liquidation, both the creditors and the partners are able to stay apprised of the results of this lengthy process.

See Exhibit 15.1 for the final schedule of liquidation for the partnership of Morgan and Houseman. The accountant should have distributed previous statements at each important juncture of this liquidation to meet the informational needs of the parties involved. The example here demonstrates the stair-step approach incorporated in preparing a schedule of liquidation.

The effects of each transaction (or group of transactions) are outlined in a horizontal fashion so that current account balances and all prior transactions are evident. This structuring also facilitates the preparation of future statements: A new layer sum­marizing recent events can simply be added at the bottom each time a new schedule is to be produced.

Deficit Capital Balance—Contribution by Partner:

In Exhibit 15.1, the liquidation process ended with both partners continuing to report positive capital balances. Thus, each partner was able to share in the remaining $63,000 cash. Unfor­tunately, such an outcome is not always possible. At the end of a liquidation, one or more part­ners could have a negative capital account, or the partnership could be unable to generate even enough cash to satisfy all of its creditors’ claims.

Such deficits are most likely to occur when the partnership is already insolvent at the start of the liquidation or when the disposal of non­cash assets results in material losses. Under these circumstances, the accounting procedures to be applied depend on legal regulations as well as the individual actions of the partners.

To illustrate, assume that the partnership of Holland, Dozier, and Ross was dissolved at the beginning of the current year. Business activities were terminated and all noncash assets were subsequently converted into cash. During the liquidation process, the partnership incurred a number of large losses that have been allocated to the partners’ capital accounts on a 4:4:2 basis, respectively. A portion of the resulting cash is then used to pay all partnership liabilities and liquidation expenses.

Following these transactions, assume that only the following four account balances remain open within the partnership’s records:

Holland is now reporting a negative capital balance of $6,000; the assigned share of part­nership losses has exceeded this partner’s net contribution. In such cases, the Uniform Part­nership Act (Section 18[a]) stipulates that the partner “must contribute toward the losses, whether of capital or otherwise, sustained by the partnership according to his share in the prof­its.”

Therefore, Holland legally is required to convey an additional $6,000 to the partnership at this time to eliminate the deficit balance. This contribution raises the cash balance to $26,000, which allows a complete distribution to be made to Dozier ($15,000) and Ross ($11,000) in line with their capital accounts.

The journal entry for this final payment closes out the part­nership records:

Deficit Capital Balance—Loss to Remaining Partners:

Unfortunately, an alternative scenario can easily be conceived for the previous partnership liq­uidation. Although Holland’s capital account shows a $6,000 deficit balance, this partner could resist any attempt to force an additional investment, especially because the business is in the process of being terminated.

The possibility of such recalcitrance is enhanced if the indi­vidual is having personal financial difficulties. Thus, the remaining partners may eventually have to resort to formal litigation to gain Holland’s contribution. Until that legal action is con­cluded, the partnership records remain open although inactive.

Distribution of Safe Payments:

While awaiting the final resolution of this matter, no compelling reason exists for the partner­ship to continue holding $20.000 in cash. These funds will eventually be paid to Dozier and Ross regardless of any action that Holland takes. An immediate transfer should be made to these two partners to allow them the use of their money. However, because Dozier has a $15,000 capital account balance and Ross currently reports $11,000, a complete distribution is not possible. A method must be devised, therefore, to allow for a fair allocation of the avail­able $20,000.

To ensure the equitable treatment of all parties, this initial distribution is based on the assumption that the $6,000 capital deficit will prove to be a total loss to the partnership. Hol­land may, for example, be completely insolvent so that no additional payment will ever be forthcoming. By making this conservative presumption, the accountant is able to calculate the lowest possible amounts (or safe balances) that Dozier and Ross must retain in their capital accounts to be able to absorb all future losses.

Should Holland’s $6,000 deficit (or any portion of it) prove uncollectible, the loss will be written off against the capital accounts of Dozier and Ross. Allocation of this amount is based on the relative profit and loss ratio specified in the articles of partnership. According to the information provided, Dozier and Ross are credited with 40 percent and 20 percent of all part­nership income, respectively. This 40:20 ratio equates to a 2:1 relationship (or 2/3 : 1/3) between the two.

Thus, if no part of the $6,000 deficit balance is ever recovered from Holland $4,000 (two-thirds) of the loss will be assigned to Dozier and $2,000 (one-third) to Ross:

These amounts represent the maximum potential reductions that the two remaining partners could still incur. Depending on Holland’s actions, Dozier could be forced to absorb an additional $4,000 loss, and Ross’s capital account could decrease by as much as $2,000. These balances must therefore remain in the respective capital accounts until the issue is resolved.

Hence, Dozier is entitled to receive $11,000 in cash at the present time; this distribution reduces that partner’s capital account from $15,000 to the minimum $4,000 level. Likewise, a $9,000 payment to Ross decreases the $11,000 capital balance to the $2,000 limit. These $11,000 and $9,000 amounts represent safe payments that can be distributed to the partners without fear of creating new deficits in the future.

After this $20,000 cash distribution, only a few other events can occur during the remain­ing life of the partnership. Holland either voluntarily or through legal persuasion, may con­tribute the entire $6,000 needed to eradicate the capital deficit. If so, the money should be immediately turned over to Dozier ($4.000) and Ross ($2,000) based on their remaining cap­ital balances. This final distribution effectively closes the partnership records.

A second possibility is that Dozier and Ross could be unable to recover any part of the deficit from Holland. These two remaining partners must then absorb the $6,000 loss themselves. Because adequate safe capital balances have been maintained recording a complete default by Holland serves to close out the partnership books.

Deficit is Partly Collectible:

One other ending to this partnership liquidation is conceivable. The partnership could recover a portion of the $6,000 from Holland but the remainder could prove to be uncollectible. This partner could become bankrupt, or the other partners could simply give up trying to collect. The partners could also negotiate this settlement to avoid protracted legal actions.

To illustrate, assume that Holland manages to contribute $3,600 to the partnership but sub­sequently files for relief under the provisions of the bankruptcy laws. In a later legal arrange­ment, $1,000 additional cash goes to the partnership, but the final $1,400 will never be collected.

This series of events creates the following effects within the liquidation process:

1. The $3,600 contribution is distributed to Dozier and Ross based on a new computation of their safe capital balances.

2. The $1,400 default is charged against the two positive capital balances in accordance with the relative profit and loss ratio.

3. The final $1,000 contribution is then paid to Dozier and Ross in amounts equal to their ending capital accounts, a transaction that closes the partnership’s financial records.

The distribution of the first $3,600 depends on a recalculation of the minimum capital balances that Dozier and Ross must maintain to absorb all potential losses. Each of these com­putations is necessary because of a basic realization- Holland’s remaining deficit balance ($2,400 at this time) could prove to be a total loss. This approach guarantees that the other two partners will continue to report sufficient capital until the liquidation is ultimately resolved.

These accounts continue to remain on the partnership books until the final resolution of Holland’s obligation.

In this illustration, the $1,000 legal settlement and the remaining $1,400 loss ultimately allow the parties to close out the records:

Marshaling of Assets:

One partner (Holland) became insolvent during the liquidation process. Personal bankruptcy is not uncommon and raises questions as to the legal right that damaged partners have to proceed against an insolvent partner. More specifically, is a deficit capital balance the legal equivalent of any other personal liability? Do partners who must absorb additional losses have the same rights against their partners as other creditors?

Addressing this issue, the Uniform Partnership Act (Section 40 [i]) stipulates the following:

Where a partner has become bankrupt or his estate is insolvent the claims against his separate property shall rank in the following order:

(I) Those owing to separate creditors,

(II) Those owing to partnership creditors,

(III) Those owing to partners by way of contribution.

This ranking of the claims against an individual partner is normally referred to as the marshaling of assets and allows for an orderly distribution of property in bankruptcy cases. It clearly shows that partners rank last in collecting from a bankrupt partner.

To demonstrate the effects created by this legal doctrine, assume that Stone is a partner in a business that is undergoing final liquidation. The partnership is insolvent- All assets have been expended, but liabilities of $15,000 still remain. Stone is also personally insolvent.

The assets that Stone currently holds cannot satisfy all obligations:

Under these circumstances, the ranking established by the Uniform Partnership Act becomes extremely important. Stone holds $50,000 in assets. However, because these assets are limited, recovery by the various parties depends on the pattern of distribution. According to the marshaling of assets doctrine, Stone’s own creditors have first priority. After these claims have been satisfied the $10,000 in remaining assets should be used to remunerate any partnership creditors who have sought recovery directly from Stone.

As stated partnership debts are $15,000, and its creditors can seek to collect from Stone (or any other general partner). Only then, after paying personal creditors and partnership creditors, can the other partners claim the residual portion of Stone’s assets. Obviously, because of Stone’s financial condition, the chances are not good that these partners will be able to recover all or even a significant portion of the $19,000 deficit capital balance. By ranking last on this priority list, partners are forced to accept whatever assets remain.

To help analyze and understand the possible effects created by the marshaling of assets concept, we consider a variety of other scenarios. Assume, as an alternative to the previous example that Stone failed to have sufficient property to satisfy even personal creditors- Stone holds $50.000 in assets but $80,000 in personal liabilities. Because of the volume of these debts, neither the partnership creditors nor the other partners will be able to recoup any money from this partner.

All personal assets must be used to pay Stone’s own obligations. Even with preferential treatment, the personal creditors still face a $30,000 shortfall because of the limited amount of available assets. This potential loss raises another legal question- Can Stone’s personal creditors seek recovery of the $30,000 remaining debt directly from the partnership?

In response to this question, the marshaling of assets doctrine specifies that personal creditors can, indeed claim a partner’s share of partnership assets.

However, recovery of all, or even a portion, of the $30,000 is possible only by meeting two specific criteria:

1. Payment of all partnership debts is assured.

2. The insolvent partner has a positive capital balance.

Even if both of these conditions are met, personal creditors have no right to receive more than the total of that partner’s capital balance nor more than the amount of the debt.

This priority ranking of claims provides legal guidance in insolvency cases. Three addi­tional examples follow to present a more complete demonstration of the marshaling of assets principle. Each presents the legal and accounting responses to a specific partnership liquidation problem. In the first two illustrations, one or more of the partners is personally insolvent. The third analyzes the marshaling of assets in connection with an insolvent partnership.

Preliminary Distribution of Partnership Assets:

A liquidation can take an extended time to complete. During this lengthy process, the partnership need not retain any assets that will eventually be disbursed to the partners. If the business is safely solvent, waiting until all affairs have been settled before transferring property to the owners is not war­ranted. The partners should be allowed to use their own funds at the earliest possible time.

The objective in making any type of preliminary distribution is to ensure that the partner­ship maintains enough capital to absorb all future losses. Any capital in excess of this maxi­mum requirement is a safe balance, an amount that can be immediately conveyed to the partner. To determine safe capital balances at any time, the accountant simply assumes that all subsequent events will result in maximum losses: No cash will be received in liquidating remaining noncash assets and each partner is personally insolvent.

Any positive capital bal­ance that would remain even after the inclusion of all potential losses can be paid to the part­ner without delay. Although the assumption that no further funds will be generated could be unrealistic, it does ensure that negative capital balances are not created by premature payments being made to any of the partners.

Preliminary Distribution Illustrated:

To demonstrate the computation of safe capital distributions, assume that a liquidating part­nership reports the following balance sheet:

Assume also that the partners estimate that $6,000 will be the maximum expense incurred in carrying out this liquidation. Consequently, the partnership needs only $46,000 to meet all obligations- $40,000 to satisfy partnership liabilities and $6,000 for these final expenses. Because the partnership holds $60,000 in cash, it can transfer the extra $14,000 to the partners immediately without fear of injuring any participants in the liquidation. However, the appro­priate allocation of this money is not readily apparent; safe capital balances must be computed to guide the actual distribution.

Before demonstrating the allocation of this $14,000, we examine the appropriate handling of a partner’s loan balance. According to the balance sheet, Mason has conveyed $20,000 to the business at some point in the past, an amount that was considered a loan rather than addi­tional capital. Perhaps the partnership was in desperate need of funds and Mason was willing to contribute only if the contribution was structured as a loan.

Regardless of the reason, the question as to the status of this account remains- Is the $20,000 to be viewed as a liability to the partner or as a capital balance? The answer becomes especially significant during the liq­uidation process because available funds often are limited. In this regard, the Uniform Part­nership Act (UPA) (Section 40[b]) stipulates that loans to partners rank behind obligations to outside creditors in order of payment but ahead of the partners’ capital balances.

Although this legal provision indicates that the debt to Mason must be repaid entirely before any distribution of capital can be made to the other partners, actual accounting practice takes a different view. “In preparing pre-distribution schedules, accountants typically offset partners’ loans with the partners’ capital accounts and then distribute funds accordingly.”

In other words, the loan is merged in with the partner’s capital account balance at the begin­ning of liquidation. Thus, accounting practice and the UPA seem to differ on the handling of a loan from a partner.

To illustrate the potential problem with this conflict, assume that a partnership has $20,000 in cash left after liquidation. Partner A has a positive capital balance of $20,000 whereas Part­ner B has a negative capital balance of $20,000. In addition, Partner B has previously loaned the partnership $20,000. If Partner B is insolvent, a distribution problem arises. If the provisions of the UPA are followed literally, the $20,000 cash should be given to Partner B (probably to the creditors of Partner B) to repay the loan.

Because Partner B is insolvent, no more assets can be expected from this individual. Thus, Partner A would have to absorb the entire $20,000 deficit capital balance and will get no portion of the $20,000 in cash that the business holds.

However, despite the UPA, common practice appears to be that the loan from Partner B will be used to offset that partner’s negative capital balance. Using that approach, Partner B is left with a zero capital balance so that the entire $20,000 goes to Partner A; neither Partner B nor the creditors of Partner B get anything.

Thus, when a loan comes from a partner who later becomes insolvent and reports a negative capital balance, the handling of the loan becomes significant. Unfortunately, further legal guidance does not exist at this time because “no reported state or federal opinion has directly ruled on the right of offset of potential capital deficits.”

To follow common practice, this article accounts for a loan from a partner in liquidation as if the balance were a component of the partner’s capital. By this offset, the accountant can reduce the amount accumulated as a negative capital balance for any insolvent partner. Any such loan can be transferred into the corresponding capital account at the start of the liquida­tion process. Similarly, any loans due from a partner should be shown as a reduction in the appropriate capital balance.

Proposed Schedule of Liquidation:

Returning to the current illustration, the accountant needs to determine an equitable distribu­tion for the $14,000 cash presently available. To structure this computation, a proposed sched­ule of liquidation is developed based on the underlying assumption that all future events will result in total losses. Exhibit 15.2 presents this statement for the Mason, Lee, and Dixon part­nership. To expedite coverage, the $20,000 loan has already been transferred into Mason’s cap­ital account. Thus, regardless of whether this partner arrives at a deficit or a safe capital balance, the loan figure already has been included.

Production of Exhibit 15.2 forecasts complete losses ($140,000) in connection with the dis­position of all noncash assets and anticipates liquidation expenses at maximum amounts ($6,000). Following the projected payment of liabilities, any partner reporting a negative cap­ital account is assumed to be personally insolvent.

These potential deficit balances are written off and the losses are assigned to the remaining solvent partners based on their relative profit and loss ratio. Lee, with a negative $13,800, is eliminated first. This allocation creates a deficit of $2,857 for Mason, an amount that Dixon alone must absorb. After this series of maximum losses has been simulated, any positive capital balance that still remains is considered safe; a cash distribution of that amount can be made to the specific partners.

Exhibit 15.2 indicates that only Dixon has a large enough capital balance at the present time to absorb all possible future losses. Thus, the entire $14,000 can be distributed to this partner with no fear that the capital account will ever report a deficit. Based on current prac­tice, Mason, despite having made a $20,000 loan to the partnership, is entitled to no part of this initial distribution. The loan is of insufficient size to prevent potential deficits from occur­ring in Mason’s capital account.

One series of computations found in this proposed schedule of liquidation merits additional attention. The simulated losses initially create a $13,800 negative balance in Lee’s capital account while the other two partners continue to report positive figures. Mason and Dixon must then absorb Lee’s projected deficit according to their relative profit and loss percentages.

Mason was allocated 50 percent of net income with 20 percent recorded to Dixon. These figures equate to a ⁵⁰₇₀ : ²⁰/₇₀ or a ⁵/₇ : ²/₇ ratio. Based on this realigned relationship, the $13,800 potential deficit is allocated between Mason (⁵/₇, or $9,857) and Dixon (²/₇, or $3,943), reducing Mason’s own capital account to a negative balance as shown in Exhibit 15.2.

Continuing with the assumption that maximum losses occur in all cases, Mason’s $2,857 deficit is accounted for as if that partner were also personally insolvent. Therefore, the entire negative balance is assigned to Dixon, the only partner still retaining a positive capital account. Because all potential losses have been recognized at this point, the remaining S 14.000 capital is a safe balance that should be paid to Dixon. Even after the money is distributed, Dixon’s capital account will still be large enough to absorb all future losses.

Liquidation in Installments:

In practice, maximum liquidation losses are not likely to occur to any business. Thus, at vari­ous points during this process, additional cash amounts can become available as partnership property is sold. If the assets are disposed of in a piecemeal fashion, cash can actually flow into the company on a regular basis for an extended period of time. As needed updated safe capital schedules must be developed to dictate the recipients of newly available funds. Because numerous capital distributions could be required, this process is often referred to as a liquidation made in installments.

To illustrate, assume that the partnership of Mason, Lee, and Dixon actually undergoes the following events in connection with its liquidation:

i. As the proposed schedule of liquidation in Exhibit 15.2 indicates, Dixon receives $14,000 in cash as a preliminary capital distribution.

ii. Noncash assets with a book value of $50,000 are sold for $20,000.

iii. All $40,000 in liabilities are settled.

iv. Liquidation expenses of $2,000 are paid; the partners now believe that only a maximum of $3,000 more will be expended in this manner. The original estimation of $6,000 was appar­ently too high.

As a result of these transactions, the partnership has an additional $21,000 in cash now available to distribute to the partners- $20,000 received from the sale of noncash assets and another $1,000 because of the reduced estimation of liquidation expenses. Once again, the accountant must assume maximum future losses as a means of determining the appropriate distribution of these funds.

The accountant produces a second proposed schedule of liquida­tion (Exhibit 15.3), indicating that $12,143 of this amount should go to Mason with the remaining $8.857 to Dixon. To facilitate a better visual understanding, actual transactions are recorded first on this schedule, followed by the assumed losses. A dotted line separates the real from the potential occurrences.

Predistribution Plan:

The liquidation of a partnership can require numerous transactions occurring over a lengthy period of time. The continual production of proposed schedules of liquidation could become a burdensome chore. The previous illustration already has required two separate statements, and the partnership still possesses $90,000 in noncash assets awaiting conversion.

Therefore, at the start of a liquidation, most accountants produce a single predistribution plan to serve as a guideline for all future payments. Thereafter, whenever cash becomes available, this plan indi­cates the appropriate recipient(s) without the necessity of drawing up ever-changing proposed schedules of liquidation.

A predistribution plan is developed by simulating a series of losses, each of which is just large enough to eliminate, one at a time, all of the partners’ claims to partnership property. This approach recognizes that the individual capital accounts exhibit differing degrees of sen­sitivity to losses.

Capital accounts possess varying balances and could be charged with losses at different rates. Consequently, a predistribution plan is based on calculating the losses (the “maximum loss allowable”) that would eliminate each of these capital balances in a sequential pattern. This series of absorbed losses then forms the basis for the predistribution plan.

To demonstrate the creation of a predistribution plan, assume that the following partnership is to be liquidated:

The partnership capital reported by this organization totals $121,000. However, the indi­vidual balances for the partners range from $30,000 to $51,000, and profits and losses are assigned according to three different percentages. Thus, differing losses would reduce each partner’s current capital balance to zero.

As a prerequisite to developing a predistribution plan, the sensitivity to losses exhibited by each of these capital accounts must be measured:

According to this initial computation, Rubens is the partner in the most vulnerable posi­tion at the present time. Based on a 50 percent share of income, a loss of only $60,000 would reduce this partner’s capital account to a zero balance. If the partnership does incur a loss of this amount, Rubens can no longer hope to recover any funds from the liquidation process.

Thus, the following schedule simulates the potential effects of this loss (referred to as a Step 1 loss):

The predistribution plan is based on describing the series of losses that would eliminate each partner’s capital in turn and thus, all claims to cash. In the Step 1 schedule, the $60,000 loss did reduce Rubens’s capital account to zero. Assuming, as a precautionary step, that Rubens is personally insolvent, all further losses would have to be allocated between Smith and Trice. Because these two partners have shared part­nership profits and losses on a 20 percent and 30 percent basis, a 20/50 : 30/50 (or 40% : 60%) relationship exists between them.

Therefore, these realigned percentages must now be utilized in calculating a Step 2 loss, the amount just large enough to exclude another of the remaining partners from sharing in any future cash distributions:

Because Rubens’s capital balance already has been eliminated Trice is now in the most vul­nerable position- Only a $55,000 Step 2 loss is required to reduce this partner’s capital account to a zero balance.

According to this second schedule, a total loss of $115,000 ($60,000 from Step 1 plus $55,000 from Step 2) leaves capital of only $6,000, a balance attributed entirely to Smith. At this final point in the simulation, an additional loss of this amount also ends Smith’s right to receive any funds from the liquidation process. Having the sole positive capital account remaining, this partner would have to absorb the entire amount of the final loss.

Once this series of simulated losses has reduced each partner’s capital account to zero, a predistribution plan for the liquidation can be devised. This procedure requires working back­ward through the preceding final schedule to determine the effects that will result if the assumed losses do not occur.

Without these losses, cash becomes available for the partners; therefore, a direct relationship exists between the volume of losses and the distribution pattern. For example, Smith will entirely absorb the last $6,000 loss. Should that loss fail to material­ize, Smith is left with a positive safe capital balance of this amount. Thus, as cash becomes available, the first $6.000 received (in excess of partnership obligations and anticipated liqui­dation expenses) should be distributed solely to Smith.

Similarly, the preceding $55.000 Step 2 loss was divided between Smith and Trice on a 4:6 basis. Again, if such losses do not occur, these balances need not be retained to protect the partnership against capital deficits. Therefore, after Smith has received the initial $6,000, any additional cash that becomes available (up to $55,000) will be split between Smith (40 per­cent) and Trice (60 percent).

For example, if the partnership holds exactly $61,000 in cash in excess of liabilities and possible liquidation expenses, this distribution should be made:

The predistribution plan can be completed by including the Step 1 loss, an amount that was to be absorbed by the partners on a 5:2:3 basis. Thus, all money that becomes available to the partners after the initial $61,000 is to be distributed according to the original profit and loss ratio.

At this point in the liquidation, enough cash would have been generated to ensure that each partner has a safe capital balance- No possibility exists that a future deficit can occur. Any additional increases in the projected capital balances will be allocated by the 5:2:3 allocation pattern. For this reason, once all partners begin to receive a portion of the cash disbursements, any remaining funds are divided based on the original profit and loss percentages.

To inform all parties of the pattern by which available cash will be disbursed, the predistribution plan should be formally prepared in a schedule format prior to beginning liquidation. Following is the predistribution plan for the partnership of Rubens, Smith, and Trice. To com­plete this illustration, liquidation expenses of $12,000 have been estimated. Because these expenses have the same effect on the capital accounts as losses, they do not change the sequen­tial pattern by which assets eventually will be distributed.