Chapter 14_Partnerships: Formation and Operation
S Corporation Overview
*created as a corporation w/all the legal characteristics of that form w/ the partnership benefit of avoiding double taxation *To Qualify: ONLY one class of stock; limited to 100 stockholders *Advantage: Limited Liability; NO Double Taxation *Disadvantage: limited growth potential, due to the restriction on the number and types of owners *S-Corp losses for the first few years are only deductible to the extent that you have invested
What are the three general forms a business can take?
1. Corporation 2. Sole Proprietorship 3. Partnership
What is the purpose of a drawing account in a partnership's financial records?
*It measures the amount of assets that a partner takes from the business during the current period -Allow withdrawals on a regular periodic basis as a reward for ownership or as compensation for work performed. [should be monitored closely for signs of abuse] -Usually regularly allowed amounts are recorded here and larger amount are recorded in the capital account. DR James, Drawing 1,200 DR Joyce, Drawing 1,500 CR Cash 2,700 *To record withdrawal of cash by partners -Partner Name, Drawing account will be closed into the individual partner's capital account at year-end *Articles of Partnership may require prior approval by the other partners for amounts significantly higher than the partner's periodic drawings. *Withdrawals are NOT Expenses!!!!!!!!
Additional benefit to partnerships with regards to partnership losses:
Income is taxable to the partners as the business earns it, any operating losses can be used to reduce their personal taxable income directly *BUT Passive Losses can only offset Passive Income earned (i.e. rent)
Describe the differences between a Subchapter S corporation and a Subchapter C corporation.
Main Difference: Double Taxation *S-Corp. is NOT taxed at the corporate level **All corporate income, loss, and credits flow through the shareholders' personal returns and are taxed at the shareholders' individual tax rates
Can the amount distributed to a withdrawing partner be directly used to imply the value of a partnership as a whole?
NO ^Paying Windsor $26,000 did NOT indicate that total capital should be $130,000 ($26,000/20%) ^^This computation is appropriate only when (1) a new partner is admitted or (2) the percentage of capital is the same as the profit and loss ratio *Here, an outside valuation of the business indicated that it was worth $80,000 more than book value. As a 20% owner, Windsor was entitled to $16,000, raising the partner's capital account from $10,000 to $26,000
Mutual Agency:
the right that each partner must incur liabilities in the name of the partnership
A new partner enters a partnership and goodwill is calculated and credited to the original partners. How is the specific amount of goodwill assigned to these partners?
• Any goodwill being recognized in a capital transaction that is allocated to the original partners is based on the profit and loss ratio. • The amount is assumed to represent unrealized gains in the value of the business. • To determine the amount of goodwill, the implied value of the business must be calculated based on the price being paid for a portion by the new partner. • The difference between this implied value and the total capital is assumed to be goodwill or some other adjustment to asset value.
By what methods can a new partner gain admittance into a partnership?
1. Admission through Purchase of a Current Interest ^(By acquiring part of all the interest of one or more of the present partners) DR OG Partner, Capital [DR OG Partner, Capital] CR New Partner, Capital 2. Admission by a Contribution Made to the Partnership DR Cash CR New Partner, Capital *Employees (Nick) may be promoted into the partnership or new owners (Schmidt) brought in from outside the organization (The Griffin)
When making a transfer of ownership, a partner can actually convey only two out of the three partnership rights:
1. The right of co-ownership in the business property [^This right justifies the partner's periodic drawings from the business as well as the distribution settlement paid at liquidation or at the time of a partner's withdrawal] 2. The right to share in profits and losses as specified in the articles of partnership 3. The right to participate in the management of the business *Unless restricted by the Articles, every partner has the power to sell or assign the first two of these rights at any time, HOWEVER: ^Partnership Law: the right to participate in the mgmt of the business can be conveyed ONLY w/the consent of ALL partners
What information do the capital accounts found in partnership accounting convey?
*"Measures each partner's or group's interest in the book value of the net assets of the business" *Equity Section of a Partnership B/S: -Composed solely of capital accounts that are affected by such events: -Contributions from partners -Distributions to partners -Earnings -Any other equity transactions
Allocation of Income
*At the end of each fiscal period, partnership revenues and expenses are closed out, accompanied by an allocation of the resulting net income or loss to the partners' capital accounts *Helps to emphasize and reward outstanding performance *From an accounting perspective, the assignment of income and the setting of withdrawal limits are two separate decisions
WHAT IS an Articles of Partnership Agreement?
-Establishes provisions for initial investments, withdrawals, admission of a new partner, retirement of a partner, etc. -Either Oral or Written -*Forms the central governance for a partnership's operation -*Considered the basis for Partnership Accounting -Accountants are often hired "in an advisory capacity to participate in creating this document to ensure the equitable treatment of all parties."
What is a partnership dissolution? Does dissolution automatically necessitate the cessation of business and the liquidation of partnership assets?
-The breakup or cessation of the partnership due to +/- partner or termination/liquidation of the business *any alteration in the specific individuals composing a partnership automatically leads to legal dissolution *Generally leaves business operations unimpeded *Dissolution does NOT directly lead to the liquidation of the business, BUT it is the first step
Unlimited Liability
-any partner can be held personally liable for ALL debts of the business -If the partnership fails to pay these debts, creditors can seek satisfactory remuneration from any partner that they choose
A co. is being created and the owners are trying to decide whether to form a general partnership, a limited liability partnership, or a limited liability company. What are the advantages and disadvantages of...a General Partnership?
Advantages: -Ease of creation -No double taxation Disadvantages: -Unlimited liability
What are the advantages and disadvantages of operating a business as a partnership rather than as a corporation? [Simple Answer]
Advantages: Ease of Creation, No Double Taxation Disadvantages: Unlimited Liability (lawsuits/creditors), Business Liabilities, Difficult growing to a significant size, [Difficulty attracting large amounts of capital]
Ease of Creation:
only an oral agreement is necessary to create a legally binding partnership, whereas incorporation requires various forms and applications
Admittance into an Existing Partnership- Two Methods: *NOT regarding intangible contributions
Bonus Method- To retain the book value of all partnership assets and liabilities Goodwill Method -To revalue these accounts to their present values *Question to be considered: Should the dissolved partnership and the newly formed partnership be viewed as two separate reporting entities? If the new partnership is merely an extension of the old- no basis for restatement
What valuation should be recorded for non-cash assets transferred to a partnership by one of the partners?
Fair Value. *For taxation purposes, book value is retained
Intangible Contributions (Bonus Method)
*assumes that a specialization such as Joyce's artistic abilities does NOT constitute a recordable partnership asset with a measurable cost *Only recognizes the assets that are physically transferred to the business
What are the 3 important capacities that capital balances serve?
1. Influence the assignment of profits and losses to partners 2. Serves as a factor when determining the final distribution that will be received by a partner at the time of withdrawal or retirement 3. Ending capital balances indicate the allocation to be made of any assets that remains following the liquidation of a partnership
3 partnership rights:
1. The right of co-ownership in the business property 2. The right to share in profits and losses as specified in the articles of partnership 3. The right to participate in the management of the business
According to UPA Section 6 what is the most common legal definition of a partnership?
an association of two or more persons to carry on a business as co-owners for profit
No Double Taxation:
-Conduit or flow-through basis: partnership itself does not pay taxes, the individual owners pay through individual taxes [Form 1040- Indiv. Tax return] -"A corporation's income is taxed twice: when earned and again when conveyed as a dividend" pg. 664 *Pg. 664- Double Taxation Example/Comparison
Uniform Partnership Act
-Proposed in 1914 -Revised in 1997 *provides uniform standards in such areas as the nature of a partnership, the relationship of the partners to outside parties, and the dissolution of the partnership.
If no agreement exists in a partnership as to the allocation of income, what method is appropriate?
Equal division among all partners is presumed
Intangible Contributions (general)
*particular expertise or clientele list -Bonus Method vs. Goodwill Method *Should be addressed in Articles of Partnership *Because the initial equity figures result from negotiation, they do not need to correspond directly with the individual investments
When a partner withdraws from a partnership, why is the final distribution often based on the appraised value of the business rather than on the book value of the capital account balance?
• Book value measures historical cost that has undergone years of allocation/changes in value, so it does not resemble actual value. • In addition, goodwill might not be reflected in book value. • Partnership articles should spell out equitable settlement method.
Under what circumstance might goodwill be allocated to a new partner entering a partnership?
• New partner brings a nontraditional accounting asset (business reputation, etc.) OR • If cash is urgently needed and a larger share has to be offered as enticement for the investment
Does the relationship of the capital accounts to one another correspond with the partners' profit and loss ratio?
NO, Capital balances are historical cost figures that result from contributions, withdrawals, and allocation of partnership income made throughout the life of the business
Will a final distribution necessarily equal the book value of the partner's capital account?
NO, a capital balance is only a recording of historical transaction and rarely represent the true value inherent in a business *instead, payment is frequently based on the value of the partner's interest as ascertained by either negotiation or appraisal
Compensation Plans [Allocation of Income/Loss]
Recognize contributions to: -revenue -growth -time spent with the firm -management skill development -etc.
Reasons to form a partnership:
Reduce expenses, Expand services, Increased expertise
How can one get around the disadvantages of a partnership while still maintaining the advantages?
S corporations, limited liability partnerships, and limited liability companies combine the benefits of corporations and partnerships
What happens if the partnership agreement only specifies the division of profits?
Then losses must be divided in the same manner as directed for profit allocation
What provisions in a partnership agreement can be used to establish an equitable allocation of income among all partners?
• should be designed to give fair and equitable treatment to each partner • interest factor is used to reward the capital investment of the partners • salary allowance is utilized as a means of recognizing the amount of time worked by an individual or a certain degree of business expertise • also refined by a ratio that is divided evenly among the partners or weighted in favor of one or more members [i.e. 4:2:4 means 40% 20% 40%]
Statement of Partners' Capital
*Because a partnership does not separately disclose a retained earnings balance, the Stmt. of Retained Earnings usually reported by a corporation is replaced by Stmt. of Partnership Capital *See PROBLEMs#10,11,22 for more on this *Generally, requires Allocation of Partnership Net Income Schedule to determine Net income allocation totals
Concern with using the Goodwill Method Solution?
*Recognition is not based on historical cost, and no objective verification of the capitalized amount can be made *Hybrid method- used to revalue assets of a business w/out recording goodwill
Hybrid Method
*Revalues all partnership assets and liabilities to fair value without making any corresponding recognition of goodwill *Applies to the need: *TO adjust land/building/etc. accounts to fair value as a preliminary step in a partner's withdrawal OR *TO record current fair value of land/building/etc. in preparation for admission of a new partner+ BUT NOT *TO recognize a new partner's artistic abilities
Additional Capital Contributions/Withdrawals
*Additional Contributions: made to stimulate expansion or to assist the business in overcoming working capital shortages or other problems *based on Fair Value *Withdrawals: allow withdrawals on a regular periodic basis as a reward for ownership or as compensation for work performed for the business *Recorded initially in a separate drawing account that is closed into the indiv. partner's capital account at year-end *Articles of Partnership should clearly specify the amount and timing of such withdrawals
At what point in the accounting process does the allocation of partnership income become significant?
*At the end of the fiscal period -the revenue and expense accounts must be closed out with the resulting income figure being assigned to the indiv. capital accounts -The method of allocating income to the capital accounts should be established within the Articles of Partnership. 1. Equal division of profits and losses 2. Can select any method that is designed to arrive at an equitable allocation. -Such factors as the total amount of capital invested, the time worked in the business, and the degree of business expertise may all serve to influence the assignment of income *If no arrangement has been specified, state partnership law normally holds that all partners receive an equal allocation of any income or loss earned by the business
Intangible Contributions (Bonus Method vs. Goodwill Method)
*Bonus method allocates the $80,000 invested capital according to the percentages designated by the partners, whereas the goodwill method capitalizes the implied value of Joyce's intangible contribution.
Dissolution-Withdrawal of a Partner
*Could sell interest to outside parties or to one or more of the remaining partners *OR the business can distribute cash or other assets as a means of settling a partner's right of co-ownership *Life Insurance Policies are often held to provide adequate cash to liquidate a partner's interest upon death *A bonus could be attributed to either of the parties involved *Any revaluation of partnership property (as well as the establishment of a goodwill balance) is allocated among all partners to recognize possible unrecorded gains **Hybrid Method: restates assets and liabilities to fair value but does not record goodwill [reflects the legal change in ownership but avoids the theoretical problems associated w/partnership goodwill
What INFORMATION should an Articles of Partnership Agreement contain?
*an explicit understanding should always be reached regarding the following: 1. Name and address of each partner. 2. Business location. 3. Description of the nature of the business. 4. Rights and responsibilities of each partner. 5. Initial contribution to be made by each partner and the method to be used for valuation. 6. Specific method by which profits and losses are to be allocated. 7. Periodic withdrawal of assets by each partner. 8. Procedure for admitting new partners. 9. Method for arbitrating partnership disputes. 10. Life insurance provisions enabling remaining partners to acquire the interest of any deceased partner. 11. Method for settling a partner's share in the business upon withdrawal, retirement, or death.
Intangible Contributions (Goodwill Method)
*assumes that an implied value can be calculated mathematically and recorded for any intangible contribution made by a partner Joyce ($10,000 cash contribution + artistic abilities) invested $60,000 less cash than James ($70,000 cash contribution) but receives an equal amount of capital according to the partnership agreement. *Joyce's artistic talent has an apparent value of $60,000. If not recorded, Joyce's primary contribution to the busness is ignored completely within the accounting records *Reservations: the value attributed to this asset (artistic ability) is based solely on a negotiated agreement b/w the partners; the $60,000 has NO objectively verifiable basis.
A co. is being created and the owners are trying to decide whether to form a general partnership, a limited liability partnership, or a limited liability company. What are the advantages and disadvantages of...a Limited Liability Company?
*classified as a partnership for tax purposes and court purposes Advantages: o Depending on state laws, the owners risk only their own investments o Like the S Corp, the LLC provides liability protection for its owners and managers o Unlike S Corp, growth potential is increased because the # of owners is not usually restricted
MC #4: Pat, Jean Lou, and Diane are partners with capital balances of $50,000, $30,000, $20,000, respectively. These three partners share profits and losses equally. For an investment of $50,000 cash (paid to the business), Mary Ann will be admitted as a new partner with a 1/4th interest in capital and profits. Based on this information, which of the following best justifies the amount of Mary Ann'e Investment?
*i.e. why would Mary Ann not be given 1/3rd interest in the business? *The book value of the partnership's net assets was less than the fair value [by $50,000] immediately prior to Mary Ann's investment.
A co. is being created and the owners are trying to decide whether to form a general partnership, a limited liability partnership, or a limited liability company. What are the advantages and disadvantages of...a Limited Liability Partnership?
*most like a general partnership; Partners can still lose their investment in the business and are still responsible for the contractual debts of the business. Advantages: o *Significantly reduces the partner's liability resulting from damage o "Partners are responsible for only their own acts or omissions plus the acts and omissions of individuals under their supervision"