Short answer. When a partnership is liquidated, Article 1839 of the Civil Code ranks its liabilities in this order: first, debts owed to outside creditors; second, debts owed to partners other than for capital and profits; third, partners' capital; and last, partners' profits. Outside creditors are always paid before the partners themselves.
What the law says
The liabilities of the partnership shall rank in order of payment, as follows: (a) Those owing to creditors other than partners, (b) Those owing to partners other than for capital and profits, (c) Those owing to partners in respect of capital, (d) Those owing to partners in respect of profits.
Civil Code, Article 1839 — Settling Accounts After Dissolution. Read the full provision →
First, gather the assets
Before debts are paid, the law identifies what there is to pay them with. Article 1839 of the Civil Code, which governs settling accounts after a partnership dissolves, says the assets are twofold: The partnership property and The contributions of the partners necessary for the payment of all the liabilities. In plain terms, the firm's own property is used first, and if that is not enough, the partners themselves must put in money to cover what is owed. These rules apply subject to any agreement to the contrary, so partners may arrange things differently among themselves, but never to the prejudice of the outside creditors.
The order the debts are paid
Here is the heart of the answer. The article provides that The liabilities of the partnership shall rank in order of payment, as follows: (a) Those owing to creditors other than partners, (b) Those owing to partners other than for capital and profits, (c) Those owing to partners in respect of capital, (d) Those owing to partners in respect of profits. Outside creditors come first, always. Only after they are fully paid do partners recover loans they made to the firm, then their capital, and finally their share of profits. A partner therefore stands last in line for his own investment.
When the firm cannot cover its debts
If partnership property runs short, the partners must reach into their own pockets. The article says The partners shall contribute, as provided by article 1797, the amount necessary to satisfy the liabilities. Article 1797 sets how losses are shared: in the absence of a stipulation, the share of each partner in the profits and losses shall be in proportion to what he may have contributed, but the industrial partner shall not be liable for the losses. So a partner who contributed only his work, and not capital, is generally shielded from having to pay the firm's losses, though the capitalist partners are not.
Competing creditors and insolvency
The article also settles clashes between the firm's creditors and each partner's personal creditors. Where a court holds both the partnership property and the partners' individual property, partnership creditors shall have priority on partnership property and separate creditors on individual property, subject to the rights of secured creditors. And if a partner is insolvent, claims on his separate property rank as: (a) Those owing to separate creditors; (b) Those owing to partnership creditors; (c) Those owing to partners by way of contribution. The pattern is consistent: each pool of assets answers first to its own class of creditors before the other class can reach it.
Cases citing this provision
These Supreme Court decisions cite the provision above. We list them so you can read them yourself; the summaries of what each decided are not ours to give.
- Primelink Properties & Devt. Corp., et al. vs. Ma. Clarita T. Lazatin-Magat, et al, G.R. No. 167379, June 27, 2006 — read the decision on LawPhil →
- Luzviminda J. Villareal, et al. vs. Donaldo Efren C. Ramirez, et al, G.R. No. 144214, July 14, 2003 — read the decision on LawPhil →