Reconstitution of a Partnership Firm: Retirement or Death of a Partner

Introduction

A partnership business consists of many individual partners who share the profit and losses of the firm according to the profit-sharing ratio mentioned in the partnership deed. The partnership deed is a legal document that contains all legal procedures that may be needed to follow while operating the partnership firm.

However, when a partner retires or dies, a new partnership deed has to be created for the remaining partners. There are legal bindings as to how to proceed with the new deed in place after paying the due amount to the representative of the deceased or retired partner.

A partner may retire in three ways from a partnership business which are

• With the consent of all other existing partners.

• In the case of retirement at will, or

• By providing notice to all other members.

Disposal of Due Amount To The Retiring Partner

The partnership deed is considered supreme while disposing of the amount due to a partner who has either retired or deceased. The payments could be made in full amount or in installments as mentioned in the partnership deed. Moreover, if it is mentioned in the partnership deed the amount due can be disposed of a part in cash and the remaining amount in installments or fully in cash too.

However, if there is no partnership deed of a business, Section 37 of the Indian Partnership Act, 1932 is applicable. The act states that the retiring or deceased partner has a choice to receive interest at a rate of 6% annually until the date of payment or such share of gains that has been earned with his or her money (i.e., which is based on the capital ratio).

It is notable therefore that the retired or deceased partner should be paid his amount due instantly when he retires or dies according to the rate mentioned in the partnership deed or the stated rate mentioned in the Indian Partnership Act 1932. the overdue is being transferred to the retiring or outgoing Partner’s Loan A/c if the enterprise cannot make the payment right away.

The required journal entries for the transactions are recorded as follows:

When a retiring partner is paid the full amount in cash:

Retiring Partner’s Capital

A/c Dr. To Cash/Bank A/c

When the whole amount of the retiring partner is treated as a loan:

Retiring Partner’s Capital

A/c Dr. To Retiring Partner’s Loan A/c

When the retiring partner is paid in a mix of cash and a loan:

Retiring Partner’s Capital A/c Dr. (Total amount due) To Cash/Bank A/c (Amount Paid)

To Retiring Partner’s Loan A/c (Amount of Loan)

When the Loan account is settled by paying in installments including principal and interest:

For interest on the loan Interest A/c

Dr. To Retiring Partner’s Loan A/c

For payment of an installment Retiring Partner’s Loan A/c Dr.

To Cash/Bank A/c

New Profit Sharing Ratio

The ratio at which remaining members will share the profits after the exit of a member is termed the new profit-sharing ratio. The new profit-sharing ratio is usually calculated by adding the old ratio and the portion of the exiting partner’s share of profit.

$$\mathrm{New\:share\:=\:old\:share\:+\:Acquired\:share\:from\:retiring\:partner}$$

When nothing is stated about the new profit-sharing ratio

If there is no mention of what will happen to the profit-sharing ratio after exit of a partner, then the old profit-sharing ratio remains intact. For example, if the profit sharing ratio among A, B, and C is 5:3:2, and C retires, the new profit sharing ratio of A and B will be 5:3.

When remaining partners acquire the share of the retiring partner in a specified ratio

In such a case, there is a need to calculate the new profit-sharing ratio among the existing members.

For example, let’s say the share of profit among A, B, and C is 5:3:2 and B retires from the business and B’s share was distributed at a ratio of 2:1 between A and C.

B’s share = 3/10

A’s new share = 5/10 + (3/10 x ⅔) = 21/30

C’s new share = 2/10 + (3/10 x1/3) = 9/30

So, the new profit sharing ratio between A and B is = 21/30: 9/30 = 7:3

The remaining partners may also decide to have a completely new profit-sharing ratio. In such a case, the profit will be shared according to the new ratio after the retirement or death of a partner.

Gaining Ratio

The ratio that shows how the existing partners of a partnership firm acquire the share of the retiring partner is called the gaining ratio.

When nothing is mentioned about gaining ratio in the partnership deed.

When there is no mention of the gaining ratio of the existing members after the departure of the exiting member, then the gaining ratio remains the same as the old profit-sharing ratio. So, there is no need in such a case to calculate the gaining ratio when a partner leaves the firm.

When there is a mention of a new profit-sharing ratio.

When there is a mention of a specific new profit-sharing ratio after the retiring member leaves the firm, the new gaining ratio must be calculated.

For example, say A, B, and C has a profit-sharing ratio of 5:3:2. B retires and A, and C decides to share the gain at a ratio of 7:3

Gaining Ratio = New Ratio - Old Ratio

So,So, A’s gain=

$$\mathrm{\frac{7}{10}}\:-\:\frac{5}{10}\:=\:\frac{2}{10}$$

C’s gain =

$$\mathrm{\frac{3}{10}}\:-\:\frac{2}{10}\:=\:\frac{1}{10}$$

Conclusion

It is important for partnership firms to have a keen eye on the reconstitution of the firm due to the retirement and death of a partner. There are specific legal procedures following which the existing partners may avoid financial tensions among them. The knowledge of reconstitution or restructuring of a partnership firm should be optimum for all partnership businessmen.

FAQs

Qns 1. What are the three ways in which a partner may retire from a partnership firm?

Ans. A partner may retire in three ways from a partnership business which are

• With the consent of all other existing partners.

• In the case of retirement at will, or

• By providing notice to all other members.

Qns 2. What is the rate of return a retiring partner should get on his capital according to the Indian Partnership Act 1932?

Ans. The rate of return a retiring partner should get on his capital during retirement according to the Indian Partnership Act 1932 is 6% per annum.

Qns 3. Can a retiring partner be paid partly in cash and partly in installments when he retires?

Ans. Yes, but it must be mentioned in the partnership deed.