Chapter 14 Partnerships: Formation and Operation

contributions made by one or more of the partners may go beyond assets and liabilities, for example, a particular line of expertise or established clientele:

Bonus Method or Goodwill Method

Regardless, the contribution

Regardless, the contribution is again recorded as an increment in the partner's capital account based on fair value.

Legal dissolution

Any alteration in specific individuals composing a partnership results in ______________. Actual operations of business would probably continue unimpeded by alteration in ownership.

•Partnership revenues and expenses must be closed out

at the end of each fiscal period and the net income allocated to each partners' capital account.

two methods are available to account for the transfer of ownership

book value approach, goodwilll approach

Goodwill

books are first adjusted to F M V, with a proportionate increase allocated to each partner's account. Withdrawing partner is paid based on the balance in individual capital account.

•A corporation has the ability to

carry back net operating losses and reduce previously taxed income and carry forward remaining losses to decrease future taxable income.

The Uniform Partnership Act

establishes standards and rules for partnerships, but a written agreement will supersede the UPA standards.

A corporation's income is taxed twice:

•Once when earned. •Again when conveyed as a dividend.

The goodwill method is based on the assumption that an implied value can

•be calculated mathematically and recorded for any intangible contribution made by a partner.

Articles of partnership

•should stipulate an established procedure.

•The cash goes to the partners, not the partnership.

not the partnership.

Owners may make subsequent contributions

of additional capital amounts during the life of the business.

If no arrangement is specified

state partnership laws dictate that all partners receive an equal allocation of income or loss.

Hybrid

restates assets and liabilities to fair value but does not record goodwill.

Partnership accounting:

•Provides limited amount of equity disclosure in individual capital accounts accumulated for every partner or every class of partners. •Balances measure each partner's or group's interest in the book value of the net assets of the business. •Does not differentiate between sources of ownership capital. •Equity section of the balance sheet composed solely of capital accounts affected by: contributions from and distributions to partners, earnings, and equity transactions.

Alternative Legal Forms—Limited Liability Corporation (L L C)

•Relatively new type of organization in the United States. •Long used in Europe and other areas of the world. •Classified as a partnership for tax and court purposes. •Depending on state laws, owners risk only their own investments. •Similar to a Subchapter S, L L C provides liability protection for its owners and managers. •In contrast to a Subchapter S corporation, the number of owners is not usually restricted so that growth may be easier to accomplish.

Withdrawals

•Retirement. •Death. •Admission (including promotion) of a new partner. •Immediate formation of a new partnership.

Articles of partnership should always clearly describe the: (cont)

•Specific method by which profits and losses are to be allocated. •Periodic withdrawal of assets by each partner. •Procedure for admitting new partners. •Method for arbitrating partnership disputes. •Life insurance provisions enabling remaining partners to acquire the interest of any deceased partner. Method for settling a partner's share in the business upon withdrawal, retirement, or death.

Alternative Legal Forms—Limited Partnership (L P)

•Tax benefits of a partnership. •Partners do not want to work in partnership or have unlimited liability. •Number of limited partners invest money as owners but are not allowed to participate in company's management. •Partners can incur a loss on their investment, but it is restricted to what has been contributed. •To protect creditors, one or more general partners must be designated to assume responsibility for all obligations created in the name of the business.

Additional Capital Contributions

•These investments can be made to stimulate expansion or to assist the business in overcoming working capital shortages or other problems. •Regardless, the contribution is again recorded as an increment in the partner's capital account based on fair value. •If a partner invests additional cash in partnership, the partner's capital account balance is increased by the amount to reflect a transfer to the partnership.

The partnership form of business has significant disadvantages.

•Unlimited liability that each partner automatically incurs. •Any partner can be held personally liable for all debts. •Potential risk is significant when coupled with mutual agency, the right each partner has to incur liabilities in the name of partnership. •Partners acting within the normal scope of the business have the power to obligate the company for any amount. If the partnership fails to pay the debts, creditors can seek satisfactory remuneration from any partner they choose.

Bonus

•—amount paid in excess of that partner's capital account is allocated against remaining partners' capital accounts. —

Partnership

"an association of two or more persons to carry on a business as co-owners for profit."

Assume that Carter invests $50,000 in cash to begin the previously discussed partnership and Green contributes these assets: inventory, land, and building.

After the contribution, Green holds no more right to the assets than Carter does; they now belong to the partnership.

the Uniform Partnership Act (U P A) was created

To provide consistent application across state lines in regard to many legal aspects of a partnership

Contributed intangible assets require

• special consideration.

The number of different allocation procedures that could be employed is

limited solely by the partners imagination

Partnership revenue and expense items (as defined by the tax laws)

must be assigned directly each year to the individual partners who pay the income taxes.

A method

must be devised for assignment of income.

Articles of partnership should always clearly describe the:

•Name and address of each partner. •Business location. •Description of the nature of the business. •Rights and responsibilities of each partner. •Initial contribution to be made by each partner and method to be used for valuation.

Alternative Legal Forms—Subchapter S Corporation

•Has all legal characteristics of a corporation. •Taxed in virtually the same way as a partnership. •Ownership limited to 100 stockholders. •Owners limited to individuals, estates, certain tax-exempt entities, and trusts. •Growth potential limited due to restriction on number and type of owners.

An individual partner's ownership rights include:

1.The right of co-ownership in the business property. The right to share in profits and losses as specified in the partnership agreement

Over the life of a partnership, these figures serve in a number of important capacities:

1.Totals in individual capital accounts influence assignment of profits and losses to partners. 2.Capital account balance is usually one factor in determining final distribution to be received by a partner at withdrawal or retirement. 3.Ending capital balances indicate allocation to be made of assets that remain following liquidation of a partnership.

These two rights can be sold (unless restricted by the articles of partnership).

3.The right to participate in the management of the business.•This right cannot be sold without the other partners' approval.

Passing income balances through to partners

avoids double taxation of profits earned and distributed to owners.

In the present illustration, Joyce invested $10,000 cash—$60,000 less than James—

but receives an equal amount of capital according to the partnership agreement.

The assignment process

is merely a series of mechanical steps reflecting change in each partner's capital balance resulting from provisions of the partnership agreement.

A corporation

is viewed as legally separate from its owners, so losses cannot be passed through to them.

Partnership income is taxed

only at the time the business initially earns it

Income is taxable to partners as the business earns it

operating losses reduce their personal taxable income directly if they materially participated in the business.

Articles of partnership allow withdrawals as a reward for

ownership or as compensation for work performed

New partner acquires partnership interest by:

purchasing it from other partners or making a contribution to the partnership

dissolution can be a preliminary step in the

termination or liquidation of the business

•One method of gaining admittance to a partnership is by

the purchase of a current interest.

Limited Partnership (L L P)- Limited Liability Partnership

•Has most characteristics as a general partnership but it significantly reduces the partners' liability. •Partners may lose investment in the business. •Responsible for contractual debts of the business. •The advantage is in connection with any liability resulting from damages. •Partners are responsible for only their acts or omissions and those of individuals under their supervision.

•One or more partners can choose

to sell their portion of the business to an outside party.

Distributions are recorded initially

• in a separate drawing account that is closed into the individual partner's capital account at year-end.

Alternative Legal Forms

•Due to possible owner liability, partnerships experience difficulty in attracting large amounts of capital. •Potential partners frequently prefer to avoid the risk that is a basic characteristic of a partnership. •Tax benefits of avoiding double taxation is a strong pull. •A number of alternative types of organizations have been developed depending on state laws as well as applicable tax laws. •Purpose is to limit the owners' personal liability while providing the tax benefits of a partnership.

Uniform Partnership Act

•First proposed in 19 14 (and revised in 19 97), the Act has been adopted by all states in some form.

the popularity of partnerships derives from several advantages inherent to this type of organization.

•For formation, only an oral agreement is necessary to create a legally binding partnership. •Depending on specific state laws, incorporation requires filing a formal application and completing various other forms and documents. •Operators of small businesses may find convenience and reduced cost involved in creating a partnership to be an especially appealing characteristic.