Apply Formation And Termination Rules - CPA Reg

SECTION 1

Historical Context & Motivation

The rules governing how legal relationships are created and dissolved have deep roots in Anglo-American common law, stretching back to medieval England. Understanding why these rules evolved is essential for any aspiring CPA, because the formation and termination of contracts, agencies, and business entities directly affect a client's tax obligations, liability exposure, and financial reporting. Before the Uniform Commercial Code and the Restatements standardized much of commercial law, merchants and professionals navigated a patchwork of local customs, creating uncertainty that stifled interstate commerce and complicated professional engagements.

1677 • Statute of Frauds Enacted

The English Parliament passes the Statute of Frauds, requiring certain contracts—such as those for the sale of land or goods above a threshold value—to be in writing. This principle persists in every U.S. jurisdiction today and is tested heavily on the REG exam.

1932 • Restatement (First) of Contracts

The American Law Institute publishes its first Restatement of Contracts, synthesizing centuries of common-law precedent into coherent rules governing offer, acceptance, consideration, and defenses to formation—categories that CPA candidates must master.

1952 • Uniform Commercial Code Drafted

Karl Llewellyn and the ALI draft the UCC, with Article 2 governing the sale of goods. The UCC modifies many common-law formation rules—such as the mirror-image rule—creating a more flexible commercial framework that the CPA exam tests alongside common law.

1997 • Revised Uniform Partnership Act

RUPA replaces the original 1914 UPA in most states, redefining partnership formation as an association of co-owners and establishing default rules for dissolution and winding up—concepts central to the REG exam's business-entity questions.

2010s • Modern Entity Flexibility

States adopt revised LLC acts and benefit-corporation statutes, expanding the menu of formation and termination options. The CPA exam reflects these developments, requiring candidates to distinguish among entity types and their respective formation and dissolution rules.

The central question this lesson addresses is both practical and doctrinal: What elements must be present for a legal relationship to come into existence, and what events or actions cause that relationship to end? Mastering these rules is non-negotiable for the REG section, where formation and termination questions appear across contract law, agency law, and business-entity law.

SECTION 2

Core Principles & Definitions

Formation and termination rules operate across three interconnected domains on the CPA REG exam: contract law, agency law, and business-entity law. Although each domain has its own doctrinal vocabulary, they share a common structural logic—every legal relationship requires certain elements to come into being and specific triggers to end. The following grid distills the foundational principles that cut across all three domains.

Contract Formation

A valid contract requires offer, acceptance, consideration, capacity, and legality. Under the UCC (Article 2), additional flexibility applies to the sale of goods, relaxing the mirror-image rule and the pre-existing duty rule.

Contract Termination

Contracts terminate by performance, agreement (rescission, novation, accord and satisfaction), operation of law (impossibility, impracticability, frustration of purpose, statute of limitations), or breach.

Agency Formation & Termination

Agency arises by actual authority (express or implied), apparent authority, or ratification. It terminates by act of the parties (revocation, renunciation) or by operation of law (death, incapacity, bankruptcy of either party).

Entity Formation

Partnerships form by association (no filing required). Corporations and LLCs require state filing of articles of incorporation or organization. A de facto corporation may exist even with defective formation if certain conditions are met.

Entity Termination (Dissolution)

Dissolution triggers winding up, where assets are liquidated and distributed. Partnerships dissolve by dissociation, agreement, or judicial decree. Corporations dissolve voluntarily (board/shareholder vote) or involuntarily (state action). LLCs follow their operating agreement or default statutory rules.

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KEY TAKEAWAY

Think of formation rules as the ignition sequence for a rocket launch—every switch must be flipped in the correct order, or the legal relationship never achieves liftoff. Termination rules, by contrast, are the controlled shutdown procedures: some are planned (landing), others are emergency responses (abort). Just as skipping a pre-flight check can ground a mission, missing one element of contract formation renders the agreement void or voidable. A CPA must diagnose where in the lifecycle a legal relationship sits to advise on tax, liability, and reporting consequences.

SECTION 3

Visual Explanation — Contract Formation & Termination Lifecycle

This diagram traces the lifecycle of a contract from the formation elements (offer, acceptance, consideration, capacity, and legality) through the performance phase to the four principal termination paths. Note the distinction between common-law mirror-image acceptance and the UCC's more flexible §2-207 approach.

The flowchart above illustrates the sequential logic that exam questions typically follow. A CPA REG question may present a scenario and ask whether a valid contract was formed—in which case you trace the top row—or whether the contract has been properly terminated—in which case you evaluate the bottom row. The key insight is that formation defects and termination events are mirror-image analytical exercises: both require methodical element-checking. Notice how the UCC relaxes the mirror-image rule for goods transactions under §2-207, permitting acceptance with additional or different terms, while the common law demands exact correspondence between offer and acceptance. This distinction generates a high volume of exam questions and is a frequent trap for candidates who fail to identify whether the transaction involves goods or services.

SECTION 4

How Formation & Termination Mechanisms Work

Contract Formation: Common Law vs. UCC

Contract formation under the common law demands strict compliance with the mirror-image rule: an acceptance that adds or changes any term is treated as a counteroffer, destroying the original offer. Under the UCC Article 2, which governs transactions in goods, an acceptance that contains additional terms still operates as a valid acceptance between merchants, with the additional terms becoming part of the contract unless they materially alter the deal, the offer expressly limits acceptance to its terms, or the offeror objects within a reasonable time. This distinction is crucial for REG candidates, because the exam frequently presents fact patterns that hinge on whether the transaction falls under common law (services, real estate) or the UCC (goods).

The Statute of Frauds

Even when all formation elements exist, certain contracts must satisfy the Statute of Frauds to be enforceable. The mnemonic MY LEGS captures the categories: Marriage promises, contracts not performable within one Year, Land interests, Executor promises to pay estate debts personally, Goods over $500 (UCC §2-201), and Suretyship agreements. A writing signed by the party to be charged must contain the essential terms. Under the UCC, the writing need only indicate that a contract was made and state the quantity; between merchants, a confirmatory memo can satisfy the statute unless the recipient objects within ten days.

Agency Formation Mechanisms

An agency relationship arises when a principal manifests assent that an agent shall act on the principal's behalf and subject to the principal's control, and the agent manifests assent or otherwise consents. Express actual authority is created by explicit communication from the principal. Implied actual authority flows from the agent's reasonable belief that the principal has authorized acts necessary to carry out express duties. Apparent authority arises when a third party reasonably believes, based on the principal's manifestations, that the agent has authority to act. Finally, ratification occurs when the principal retroactively approves an agent's unauthorized act, provided the principal had full knowledge of all material facts at the time of ratification.

Entity Formation: Filing vs. Association

The critical formation distinction among entity types is whether the entity requires a state filing to come into existence. A general partnership forms automatically when two or more persons carry on a business as co-owners for profit—no filing, no written agreement required, though a written partnership agreement is advisable. By contrast, a corporation requires the filing of articles of incorporation with the secretary of state, and an LLC requires articles of organization. A limited partnership also requires a state filing (certificate of limited partnership). Failure to comply with mandatory filing requirements may result in personal liability for the entity's owners—a fact the REG exam tests by presenting promoter-liability and defective-incorporation scenarios.

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CPA Exam Alert

The REG exam frequently tests the equal dignities rule: if a contract is required by the Statute of Frauds to be in writing, the agency authority to enter into that contract on the principal's behalf must also be in writing. For example, an agent authorized orally to sell the principal's real property lacks enforceable authority because real-property sales fall within the Statute of Frauds.

SECTION 5

Detailed Breakdown — Termination Triggers by Domain

Termination analysis on the REG exam demands that candidates distinguish how a relationship ends within each domain—contracts, agencies, and entities. The diagram below maps the primary termination triggers in a unified framework, followed by a detailed classification table.

This comparative diagram organizes termination triggers across contracts, agency, and business entities. Note the parallels: death terminates agency automatically but does not necessarily terminate a contract or an entity. An agency coupled with an interest is the exception to the general rule that a principal can revoke at any time.

Termination Event	Contracts	Agency	Business Entities
Death	Does not terminate most contracts (obligations pass to estate); exception: personal-service contracts	Terminates automatically (both principal and agent)	Partnership: may cause dissociation; Corporation/LLC: no effect (perpetual existence)
Bankruptcy	May discharge obligations under bankruptcy law; does not void the contract retroactively	Principal's bankruptcy terminates; agent's bankruptcy generally does not	May trigger dissolution or reorganization depending on entity type and governing documents
Mutual Agreement	Yes—rescission, novation, or accord and satisfaction	Yes—parties can mutually terminate at any time	Yes—owners vote to dissolve per governing documents or default rules
Unilateral Action	Breach by one party; anticipatory repudiation; but wrongful breach triggers damages	Revocation by principal or renunciation by agent (may create liability but power exists)	Partner dissociation (rightful or wrongful); judicial dissolution on petition

Cross-domain comparison of common termination events

SECTION 6

Worked Example — Contract Formation & Agency Termination Scenario

The following integrated scenario mirrors the style and complexity of a CPA REG simulation. It tests both contract formation and agency termination analysis in a single fact pattern.

Scenario: Greenfield Corp. and Agent Torres

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Step 1 — Read the Fact Pattern

Greenfield Corp. (principal) orally authorizes Agent Torres to purchase office equipment costing up to $10,000. Torres sends a written purchase order to Apex Supplies for $8,500 of equipment, listing all material terms. Apex responds with an acknowledgment form that matches every term but adds a clause requiring arbitration for disputes. One week later, Greenfield's CEO dies in an accident. Torres, unaware of the CEO's death, places a second order with Apex for $4,000 of supplies. Question: (a) Was a valid contract formed on the first order? (b) Is the agency terminated after the CEO's death? (c) Is the second order binding on Greenfield?
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Step 2 — Analyze Contract Formation (First Order)

Identify the transaction type: this involves the sale of goods (office equipment), so UCC Article 2 governs. Check formation elements: (1) Offer—Torres's purchase order is a definite offer with price, quantity, and identity of goods. (2) Acceptance—Apex's acknowledgment form constitutes acceptance. (3) The additional arbitration clause is analyzed under UCC §2-207. Both parties are merchants. The arbitration clause is an additional term that likely materially alters the contract because it changes the dispute-resolution mechanism. Therefore, the arbitration clause does not become part of the contract, but the rest of the acceptance is valid. (4) Consideration exists—goods for money. (5) Capacity and legality are not in question.

Result: A valid contract was formed on the first order, but without the arbitration clause.
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Step 3 — Analyze Statute of Frauds

Under UCC §2-201, contracts for goods priced at $500 or more require a writing. Torres's written purchase order and Apex's written acknowledgment satisfy this requirement. The $8,500 price exceeds the threshold, but the writings are sufficient. Also check whether agent authority needed to be in writing under the equal dignities rule: because the underlying purchase does not fall within a Statute-of-Frauds category requiring written authority (it is a UCC goods transaction, not a land conveyance), Torres's oral authorization from Greenfield suffices.

Result: Statute of Frauds satisfied by the written purchase order and acknowledgment.
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Step 4 — Analyze Agency Termination

Under agency law, the death of the principal terminates the agent's actual authority automatically, regardless of whether the agent has notice. This is a bright-line rule under the common law of agency. Greenfield is a corporation, however, and the death of the CEO does not equate to the death of the corporate principal. A corporation has perpetual existence; the CEO's death is an internal management event, not a dissolution of the entity itself. Therefore, the agency relationship is not terminated by the CEO's death because Greenfield Corp., the principal, still exists.

Result: Agency NOT terminated. The corporate principal survives the death of its officer.
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Step 5 — Analyze the Second Order

Since the agency was not terminated (Greenfield Corp. still exists and has not revoked Torres's authority), Torres retains actual authority to make purchases up to $10,000. The second order of $4,000 is within the scope of authority. Assuming the same UCC formation elements are satisfied (offer, acceptance, consideration, capacity, legality, and Statute of Frauds compliance), the second order creates a binding contract between Greenfield Corp. and Apex. Had Greenfield been an individual sole proprietor who died, the result would be different—death of the individual principal would terminate the agency, and Torres's second order would not bind the estate unless Apex could establish apparent authority.

Result: Second order is binding on Greenfield Corp. Key distinction: corporate principal's perpetual existence prevents agency termination by officer death.

SECTION 7

Common Law vs. UCC — Formation & Termination Compared

One of the most frequently tested distinctions on the CPA REG exam is the divergence between common-law contract rules and UCC Article 2 rules. While many principles overlap, the differences are precisely where exam questions are crafted to create traps. The table below synthesizes the critical distinctions across both formation and termination.

Issue	Common Law	UCC Article 2
Subject Matter	Services, real estate, employment, intellectual property	Sale of goods (movable, tangible personal property)
Acceptance	Mirror-image rule: acceptance must match offer exactly; any variance = counteroffer	§2-207: acceptance with additional/different terms still valid; additional terms between merchants become part of contract unless materially altering
Consideration Modification	Pre-existing duty rule: modification requires new consideration	§2-209: modification needs no new consideration if made in good faith
Statute of Frauds Threshold	Specific categories (MY LEGS); writing must contain all essential terms	Goods ≥ $500; writing need only indicate a contract + state quantity; merchant confirmatory memo exception
Firm Offer / Option	Option contract requires separate consideration to keep offer open	§2-205: merchant's signed, written offer to keep offer open is binding without consideration (up to 3 months)
Termination by Impracticability	Requires objective impossibility or severe impracticability arising after formation	§2-615: commercial impracticability standard; seller excused if performance made impracticable by unforeseen contingency
Perfect Tender Rule	Substantial performance generally suffices (unless contract expressly requires strict compliance)	§2-601: buyer may reject goods that fail to conform in any respect; seller has right to cure before delivery deadline

Key distinctions between common-law and UCC formation/termination rules

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KEY TAKEAWAY

Think of common-law contract rules as a formal ballroom dance where every step must be perfectly mirrored by your partner—one misstep and the dance breaks down (mirror-image rule, pre-existing duty rule). The UCC, by contrast, is more like a jazz improvisation session: the musicians share a basic structure, but they can riff on it (additional terms accepted, modifications without new consideration) as long as the performance serves the shared commercial purpose. Recognizing which "genre" of rules applies—by identifying whether the transaction involves goods or services—is the threshold question on virtually every formation-and-termination exam problem.

SECTION 8

Connection to Advanced Theory — Defenses, Third-Party Rights & Entity Piercing

Formation and termination rules provide the analytical scaffolding for more advanced doctrines that the REG exam also tests. Understanding how these foundational rules connect to defenses, third-party beneficiary rights, assignment and delegation, and entity-liability doctrines strengthens a candidate's ability to handle multi-issue simulations. The table below maps basic formation and termination concepts to their advanced counterparts.

Basic Concept	Advanced Extension	REG Exam Relevance
Formation: Capacity	Defenses to Formation — minority, intoxication, mental incapacity, duress, undue influence, fraud, misrepresentation, unconscionability	Voidable vs. void contracts; who has power to disaffirm; ratification after capacity restored
Formation: Consideration	Promissory Estoppel — substitute for consideration when promisor should reasonably expect reliance, promisee does rely, and injustice results	Tested as an alternative basis for enforcement when traditional consideration is absent
Termination: Performance	Third-Party Rights — assignment of rights, delegation of duties, third-party beneficiaries (intended vs. incidental)	When can a non-party enforce? When does delegation discharge the original obligor?
Entity Formation: Filing	Piercing the Corporate Veil — alter ego doctrine, undercapitalization, commingling of funds, failure to observe formalities	Tests whether defective or abused formation can expose owners to personal liability
Agency Termination: Apparent Authority	Lingering Apparent Authority — principal must notify third parties of revocation; otherwise agent may still bind principal	Critical in scenarios where principal revokes but fails to inform customers or vendors

How formation and termination rules connect to advanced REG topics

As you progress through your REG preparation, recognize that formation and termination analysis is rarely the final step in a multi-issue question. The exam may ask you to determine whether a valid contract was formed and then immediately pivot to whether the injured party can recover under a third-party beneficiary theory or whether a defense defeats enforcement. Similarly, entity-formation questions often lead to follow-up issues about promoter liability, piercing the veil, or the tax consequences of choosing one entity type over another. Treating formation and termination as the threshold analytical framework through which all subsequent doctrines are filtered will improve both your speed and accuracy on exam day.

SECTION 9

Practice Problems

Question 1: CONCEPTUAL

Explain why a general partnership can come into existence without any written agreement or state filing, while a corporation requires articles of incorporation filed with the secretary of state. What policy rationale underlies this distinction, and what practical consequence does it create for unintentional partners?

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A general partnership forms by the mere association of two or more persons carrying on a business as co-owners for profit under RUPA §202. The law does not require formalities because partnership is the oldest and simplest form of joint business activity—requiring filings would impose burdens on small, informal enterprises. By contrast, a corporation is a creature of statute that provides its owners with limited liability, a privilege that requires compliance with formation procedures as a quid pro quo. The practical consequence of the informal partnership-formation rule is that individuals who share profits and co-manage a venture may become general partners without intending to, thereby assuming unlimited personal liability for partnership obligations. This is a classic REG exam trap: the question describes a business relationship and asks whether a partnership was formed, testing whether the candidate recognizes the RUPA formation elements irrespective of the parties' subjective intent.

Question 2: BASIC CALCULATION

Seller sends Buyer a signed letter offering to sell 500 widgets at $3 each. Buyer responds with a signed purchase order for 500 widgets at $3 each but adds a clause requiring disputes to be resolved in Buyer's home state. Both parties are merchants. Under UCC §2-207, was a valid contract formed, and does the forum-selection clause become part of the contract? Identify each formation element.

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Yes, a valid contract was formed. Under UCC §2-207(1), a definite and seasonable expression of acceptance operates as acceptance even though it contains additional or different terms. Buyer's purchase order matches all essential terms (quantity: 500, price: $3/unit, subject matter: widgets) and constitutes acceptance. Formation elements are satisfied: (1) Offer—Seller's signed letter; (2) Acceptance—Buyer's purchase order; (3) Consideration—$1,500 in exchange for 500 widgets; (4) Capacity—both are merchants; (5) Legality—no issue. Under §2-207(2), the forum-selection clause is an additional term between merchants. It will become part of the contract unless it materially alters the offer, the offer expressly limits acceptance to its terms, or Seller objects within a reasonable time. A forum-selection clause is generally considered a material alteration because it affects litigation rights. Therefore, the contract exists without the forum-selection clause. Note that the Statute of Frauds is satisfied because the total price ($1,500) exceeds $500, and both parties have signed writings indicating the quantity.

Question 3: INTERMEDIATE

Priya orally authorizes her agent, Dev, to sell Priya's commercial building for at least $600,000. Dev finds a buyer willing to pay $650,000 and signs a purchase agreement on Priya's behalf. The buyer later sues Priya for breach when Priya refuses to close. Does the buyer have an enforceable contract against Priya? Analyze all relevant formation and authority issues.

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The buyer likely does not have an enforceable contract against Priya. While the underlying contract elements appear satisfied (offer, acceptance, consideration of $650,000, capacity, legality), two critical issues arise. First, the sale of real property falls within the Statute of Frauds, requiring a writing signed by the party to be charged. The purchase agreement signed by Dev may satisfy this if Dev had proper written authority. Second, however, the equal dignities rule requires that if the underlying contract must be in writing, the agent's authority must also be in writing. Priya authorized Dev only orally, which is insufficient for a real-property transaction. Dev's authority is therefore defective, and the contract signed by Dev on Priya's behalf is unenforceable against Priya by the buyer. Priya could choose to ratify the agreement if she wished, provided she had full knowledge of the material facts—but she has no obligation to do so. The buyer's remedy, if any, would lie against Dev personally for the agent's implied warranty of authority.

Question 4: APPLIED

Northwind LLC has three members: Adams, Baker, and Carter, each holding a one-third interest. The operating agreement provides that dissolution requires a unanimous vote. Adams and Baker vote to dissolve; Carter objects. Meanwhile, a state audit reveals that Northwind failed to file its annual report for three consecutive years. Analyze: (a) Is Northwind voluntarily dissolved? (b) Can the state act, and if so, how? (c) What is the priority of distributions during winding up?

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(a) Northwind is NOT voluntarily dissolved because the operating agreement requires a unanimous vote and Carter objects. Under most LLC statutes, the operating agreement governs internal affairs including dissolution triggers. A two-thirds vote is insufficient when unanimity is required. (b) However, the state can pursue administrative dissolution because Northwind failed to file its annual report for three consecutive years. Most state LLC acts authorize the secretary of state to dissolve an LLC that fails to comply with statutory filing obligations, typically after notice and a cure period. If Northwind does not cure, the state will dissolve the entity. (c) During winding up, the statutory priority of distributions is generally: (1) creditors, including members who are creditors, in the order of priority provided by law; (2) members for any unreturned capital contributions; (3) members for any remaining assets distributed in accordance with their respective ownership percentages (here, one-third each). The operating agreement may modify the distribution waterfall among members, but it cannot subordinate outside creditors' claims. This scenario illustrates how voluntary and involuntary dissolution pathways can intersect and how the operating agreement interacts with default statutory rules.

Question 5: CRITICAL THINKING

Consider a scenario in which a principal, MedTech Inc., appoints Agent Reeves under a written agency agreement to negotiate supply contracts with hospitals. Unknown to MedTech, Reeves begins negotiating unauthorized side deals with a competing supplier, receiving personal kickbacks. MedTech discovers the misconduct and revokes Reeves's authority, but several hospitals claim they have binding contracts with MedTech based on Reeves's representations. Analyze the interplay of formation, authority, termination, and third-party reliance. Under what circumstances would the hospitals prevail, and what defenses does MedTech have?

Show answer

This multi-layered problem requires analysis of actual authority, apparent authority, breach of fiduciary duty, and contract formation. First, Reeves had express actual authority to negotiate supply contracts—the written agreement establishes this. The unauthorized side deals exceed this authority, so Reeves lacked actual authority for the kickback arrangements. However, the hospitals may prevail if they can establish apparent authority: if MedTech's conduct (introducing Reeves as their agent, providing business cards, allowing Reeves to use company letterhead) created a reasonable belief in the hospitals that Reeves had authority to enter these specific deals, MedTech may be bound regardless of the internal limitation. MedTech's defenses include: (1) arguing the hospitals knew or should have known Reeves was exceeding authority; (2) that the side deals were so unusual that reasonable third parties should have verified authority; (3) ratification was never given. Upon revocation, MedTech must also provide actual notice to hospitals that dealt with Reeves and constructive notice (publication) to others to cut off lingering apparent authority. Regarding Reeves's breach of fiduciary duty (duty of loyalty), MedTech can pursue disgorgement of kickbacks and damages against Reeves, but this does not automatically void contracts with innocent third parties. The key insight is that the principal's exposure to third parties turns on apparent authority, while the principal's claims against the disloyal agent are governed by fiduciary duty law—two separate analytical tracks running simultaneously.

SUMMARY

Summary — Formation & Termination Rules

Summary

Formation and termination rules form the backbone of the Business Law portion of the CPA REG exam. Contract formation requires five elements—offer, acceptance, consideration, capacity, and legality—with the critical threshold question being whether the common law or UCC Article 2 governs. The UCC's relaxation of the mirror-image rule, the pre-existing duty rule, and the firm-offer doctrine creates testable distinctions that candidates must master. The Statute of Frauds (MY LEGS) imposes a writing requirement on specific categories, and the equal dignities rule extends this requirement to the agent's authority when the underlying contract falls within the statute.

Contracts terminate by performance, agreement, operation of law, or breach. Agency relationships form by actual authority (express or implied), apparent authority, or ratification, and terminate by act of the parties or operation of law—with the important exception of an agency coupled with an interest, which is irrevocable. Business entities vary in formation requirements—partnerships form by association without filing, while corporations and LLCs require state filings—and they dissolve through voluntary action, judicial decree, or administrative dissolution, followed by winding up and distribution with creditors taking priority over owners. Mastering these interconnected rules equips candidates to handle the multi-issue fact patterns that define the REG exam's business-law questions.