Distributions from a general partnership – rules, limitations, and consequences

The rules regarding distributions from a general partnership differ markedly from the regulations for limited liability companies. This is a direct consequence of the fundamental difference in liability between the types of companies. While shareholders have limited liability for the company's obligations, participants in a general partnership have personal, unlimited, and joint liability. This article provides an overview of the legal rules governing distributions from a general partnership, with emphasis on both the fundamental principles and the practical consequences for participants and creditors.

The Principle of Free Distribution Access

Unbound Capital as a Main Rule

The fundamental principle for distributions from general partnerships is nearly unlimited access to make distributions. Unlike limited liability companies, where the bound equity serves as a buffer against distributions, there are no rules in general partnerships regarding distribution prohibitions or limitations to protect a company's bound capital.

This principle can be explained by referring to the participants' personal liability for the company's obligations, cf. the Companies Act § 2-4 first paragraph. Since creditors can directly target the personal assets of the participants, the lawmakers did not see the same need to protect the company's capital base as in limited liability companies.

This implies that:

1. The entire surplus can, in principle, be distributed

2. Distributions can also attack the company's equity

3. In the ultimate consequence, the law also allows distributions that attack external capital (company debt)

This fundamental principle is also reflected in the accounting laws. The income statement's item "annual result" should be allocated among the participants and credited or charged to their respective equity accounts in the company's balance sheet, cf. the Accounting Act § 6-1 first paragraph nr. 24 and § 6-2 first paragraph C II nr. 2.

Distribution of Profit and Loss

The Principle of Equal Distribution

The discretionary main rule of the Companies Act § 2-25 first paragraph states that profit and loss should be shared equally among the participants - that is, per head and not according to capital contribution. This principle is based on two main justifications:

1. All participants have the same personal responsibility for the company's debt

2. Larger capital contributions are generally not made in general partnerships

The equal distribution rule is particularly suitable for small companies with few participants, where each also contributes with labor or other factors in addition to any capital contributions.

Freedom of Contract and Alternative Distribution Models

For companies with more participants and different capital contributions, the Companies Act § 2-25 fourth paragraph allows participants to agree on other distribution keys:

• Distribution based on the size of capital contributions

• Distribution according to a specific fraction

• Distribution based on the participants' capital accounts at a given time

This freedom to contract allows general partnerships to adapt profit distribution to the participants' specific contributions and desires.

Special Remunerations Before Final Profit Distribution

Before the final distribution of profit or loss, it must be decided whether some participants should be credited with special remunerations.

Remuneration for Work Contribution

A participant who contributes with work in the company's operations is entitled to special remuneration for this, cf. the Companies Act § 2-26 first paragraph. This is considered an operational expense, which means that:

• The remuneration shall be part of any operational deficit

• It is paid to the participant before equal distribution of profit/loss

• The participant is entitled to this remuneration regardless of whether the company is running a profit

This rule is deviable, cf. § 2-26 fifth paragraph, so participants can agree that no remuneration for work contribution shall be paid.

Interest Remuneration for Capital Contributions

Participants who have made capital contributions to the company shall be credited with interest on these based on the value at the beginning of the fiscal year, cf. the Companies Act § 2-25 second paragraph.

In contrast to remuneration for work contribution:

• Interest remuneration is a profit allocation

• The participant is only entitled to this with a positive annual result

• The interest is calculated according to the rate for late payment interest under the Interest Act

This provision is also deviable, so participants can agree on other arrangements for interest remuneration.

Limitations on Distribution Access

Despite the principle of unlimited distribution access, there are certain limitations:

Operational Limitations

According to the Companies Act § 2-26 third paragraph, distribution cannot occur if the funds are needed for:

• Payment of company obligations

• The company's operations

This limitation is primarily justified by consideration for the participants themselves and their interest in avoiding personal liability. The rule is therefore deviable.

Mandatory Set-off with Matured Contribution Obligation

A participant with a matured contribution obligation cannot demand payment of their share of the surplus as long as it is used to cover the obligation, cf. the Companies Act § 2-26 third paragraph second sentence. This represents a compulsory set-off right for the company.

The Irrevocable Distribution Prohibition

The most important limitation on distribution access is found in the Companies Act § 2-26 fourth paragraph: "The company's assets cannot be distributed or demanded distributed to the participants as long as this would obviously harm the company's or creditors' interests."

This constitutes an irrevocable exception from the main rule of unbound company capital and protects:

• The creditors' interests

• The company's interests, including a potential minority of participants

The prohibition applies not only to the distribution of annual surplus but to any distribution of the company's assets that directly or indirectly benefits a participant.

Consequences of Illegal Distributions

If distributions are made in contravention of the irrevocable prohibition in the Companies Act § 2-26 fourth paragraph, this has the following consequences:

Obligation to Return

The distributed amount must be returned to the company, cf. § 2-26 fourth paragraph last sentence. This obligation to return:

• Is a pure restitution rule

• Applies regardless of whether the company has suffered a loss

• Does not require that the conditions for liability are met

• Is independent of the recipient's good or bad faith

In this respect, the legal status is stricter than in limited liability companies, where the Company Act § 3-7 first paragraph second sentence contains a limitation for good faith.

Liability for Damages

In addition to or instead of a return, participants who have received illegal distributions can be held liable for damages under the Companies Act § 2-43. This is the general rule of liability for responsible companies, in contrast to the special rule in the Limited Company Act § 3-7 second paragraph.

Liability for damages here presupposes:

• That the participant acted intentionally or negligently

• That there is a causal relationship between the act and the loss

• That there has been an economic loss

Practical Consequences and Recommendations

For the Company Agreement

Given the extensive freedom of contract in the Companies Act, it is important that participants carefully consider the following elements in the company agreement:

• Choice of distribution key for profit and loss

• Rules on remuneration for work contribution

• Determination of interest remuneration for capital contributions

• Any voluntary limitations on distribution access

For Ongoing Operations and Distribution Decisions

Even though the law's starting point is free distribution access, participants should:

• Carefully assess the company's liquidity situation before distributions

• Be particularly mindful of the irrevocable distribution prohibition

• Document the assessments that form the basis for distribution decisions

• Ensure that any special remuneration for work contribution is reasonably proportionate to the work contribution

For New Participants

Upon joining a general partnership, new participants should be aware of:

• That their personal finances may be affected by previous distributions

• The distribution between contributions and loans to the company

• Existing obligations that may reduce the value of the company share

Conclusion

The rules on distributions from general partnerships reflect the distinctive characteristics of the company type - especially the participants' personal and unlimited liability for company obligations. The principle of free distribution access stands in sharp contrast to the regulations for limited liability companies but is justified in that creditor protection is ensured through the participants' personal liability.

The most central barrier to distributions is the irrevocable prohibition against distributions that would obviously harm the company's or creditors' interests. This serves as a "safety valve" intended to prevent entirely disloyal dispositions by the majority of the participants.

Otherwise, the Companies Act gives participants great freedom to agree on distribution keys and remuneration arrangements tailored to their specific conditions and needs.