Sooner or later every business partnership changes shape. A partner retires, another wants to move on, someone falls ill or dies, or the partners simply decide it is time to go their separate ways.

When that happens, those involved need to know: how do we settle up? The answer depends largely on whether there is a written partnership agreement, and what it says.

What does a partnership agreement actually do?

A partnership agreement is a rulebook for the business, setting out who contributes what, how profits and losses are shared, how decisions are made and, crucially, what happens when a partner leaves.

A written agreement is not a legal requirement. Without one, the partnership is governed by the default rules of the Partnership Act 1890, which rarely reflect what modern business partners would choose for themselves. For example, unless the partners have agreed otherwise:

• profits and losses are shared equally, regardless of how much capital or effort each partner has put in;
• a partnership with no fixed term can be brought to an end by any partner simply giving notice; and
• the death of a partner, or their bankruptcy (known in Scotland as sequestration), dissolves the partnership, regardless of the number of remaining partners.

That last point surprises many people. Without the right wording, one partner's departure can end the whole firm, even where everyone else wants to carry on.

The clauses that matter when it is time to settle up

A well-drafted agreement plans for the end of the relationship as carefully as the beginning. The key provisions usually include:

• Continuation. Confirming that the business carries on among the remaining partners when someone retires, dies or leaves, rather than the firm being dissolved.
• Notice and retirement. How much notice a partner must give, and whether retirement can only take place at certain times, such as the end of a financial year.
• Valuing the outgoing share. How the leaving partner's share is calculated, whether goodwill is included, and whether an independent valuer steps in if the partners cannot agree.
• Payment terms. When the outgoing partner is paid, and whether payment can be spread over instalments to avoid draining the business of cash.
• Capital and current accounts. How the partner's capital, undrawn profits and any loans to the firm are dealt with.
• Restrictive covenants. Limits on the departing partner competing with the firm or approaching its clients. We looked at these in detail in our recent article on restrictive covenants in business.

Settling up when the business carries on

Where one partner leaves and the others continue, the process is essentially a buy-out. Accounts are drawn up to the leaving date, the outgoing partner's share is valued in line with the agreement, and the remaining partners arrange to pay it.

The departing partner will also want an indemnity from the continuing partners against the firm's debts, while those continuing will want certainty that clients and goodwill stay with the business.

Delay can be expensive. If the continuing partners keep using a former partner's share without paying it out, that former partner, or their executors, may be entitled to a share of the profits earned in the meantime or to interest.

Where a partner dies, it is their executors who deal with the settlement on behalf of the estate. That is a good reason to make sure your Will and your partnership agreement work together.

Settling up when the partnership is dissolved

Where the partnership ends altogether, the business has to be wound up. The partners keep their authority to collect what is owed, complete unfinished work and sell assets.

Once the assets have been realised, the law sets out a clear order of payment, subject to anything the partners have agreed:

1. first, debts owed to outside creditors;
2. next, any loans or advances made to the firm by individual partners;
3. then, each partner's capital contribution; and
4. finally, any surplus, which is divided in the same proportions as profits.

If there is not enough to go round, the shortfall is shared in the profit-sharing proportions too, and partners may have to contribute from their own pockets.

Personal liability does not end when you leave

In Scotland, a partnership is a separate legal person from its partners, but that does not shield the partners from the firm's debts. Partners are jointly and severally liable, so while a creditor will normally pursue the firm first, they can then look to any one of the partners for the full amount.

A partner who leaves remains liable for debts the firm ran up while they were a partner. They can also be caught by later debts if people dealing with the firm were not told of the change, which is why notifying the bank, clients and suppliers matters, and why a formal notice in the Edinburgh Gazette is usually recommended.

The practical loose ends

Settling up is not only about the numbers. The practical checklist usually includes:

• notifying HM Revenue & Customs, completing final tax returns and dealing with any VAT registration;
• updating or closing bank accounts and changing signing authorities;
• dealing with leases, and with any property held in the names of individual partners as trustees for the firm; and
• reviewing contracts, insurance and licences, and meeting the firm's obligations to its employees.

A departing partner should also speak to their accountant, as disposing of a partnership share can have capital gains tax consequences.

How Paris Steele Can Help

Whether you are setting up a partnership, reviewing an agreement that has been in a drawer for years, or facing a partner's departure right now, early advice can save a great deal of time, money and goodwill. If relations have already become strained, our article on what happens if you fall out with your business partner may also help.

At Paris Steele, we can prepare or review your partnership agreement, guide you through a retirement or buy-out, and support you through winding up the business if required. Talk to us today. Call our North Berwick office on 01620 892138 or our Dunbar office on 01368 862746, or get in touch online.

This article is provided for general information purposes only and is not intended to constitute legal advice. The information contained in this article is accurate to the best of our knowledge as at the date of publication. As laws, regulations, guidance, and other relevant information may change over time, the content of this article may no longer reflect the current position.

The information contained herein may not apply to your specific circumstances and should not be relied upon as a substitute for professional legal advice.

If you require advice about your own situation, we recommend that you seek advice from a qualified solicitor. If you would like to discuss your circumstances or find out how we may be able to assist, please do not hesitate to contact our team for advice tailored to your individual needs.