CHAPTER 20 PARTNERSHIPS FORMATION AND OPERATION FOCUS OF

CHAPTER 20 PARTNERSHIPS: FORMATION AND OPERATION

FOCUS OF CHAPTER 20 • Types of Partnerships • Major Features of the Partnership Form of Business • Formation of a Partnership • Methods to Share Profits and Losses • Financial Reporting Issues • Income Tax Aspects

Definition of a Partnership • A partnership is an association of two or more persons who: – Are co-owners of a business. – Share profits and losses in an agreedupon manner. • A person can be: – An individual. – A corporation. – Another partnership.

Types of Partnerships • General Partnerships: – All partners have unlimited liability. – Thus creditors can go after the personal assets of any or all of the partners. – Since 1993, many accounting firms have abandoned this form of organization in favor of limited liability partnerships (LLPs).

Types of Partnerships • Limited Liability Partnerships (LLPs): – A partner’s personal assets are at risk only for: • His or her OWN negligence and wrongdoing. • The negligence and wrongdoing of those under his or her control. – This form of organization has not been tested in the courts.

Types of Partnerships • Limited Partnerships: – Certain partners have limited liability to partnership creditors if the partnership is unable to pay its creditors. • Usually the partner’s risk is limited to the partner’s capital invested. • Thus personal assets are not at risk. – At least 1 of the partners must be a general partner.

Partnership Form of Organization: Advantages & Disadvantages • Advantages: – Ease of formation. – Lack of formality. – A closer sense of bonding among partners. – Single taxation (see following slide). • Disadvantages: – Unlimited liability (for general partnerships). – Difficulty of disposing of interest.

Partnership Form of Organization: Income Tax Reporting • Single Taxation of Partnership Earnings: – Partnerships only report their earnings— they are not taxed at the business entity level (as are corporations). • Partnerships file IRS Form 1065, which shows the allocation of profits among partners. • Partners report their share of profits on their individual IRS Form 1040 return.

The Uniform Partnership Act (UPA) • Each state has laws governing the conduct of partnerships. • Most states have adopted the RUPA or a variation thereof. The RUPA covers: – Relations of partners to one another. – Relations of partners to persons dealing with the partnership. – Dissolution and winding up of the partnership.

The Partnership Agreement • The Partnership Agreement: A written expression of what the partners have agreed to. Examples of areas addressed are: – Manner of sharing profits. – Limitations on withdrawals. – Rights of partners. – Settling withdrawing partners. – Expulsion of partners. – Conflicts of interest.

General Matters • SEPARATENESS: The business of a partnership should always be accounted for separately from the partners’ personal transactions. • GAAP: Partnerships—unlike public corporations—do not have to follow GAAP; often they do not. • FOCUS: The accounting focus is achieving equity (fairness) among the partners.

Partners’ Accounts • Each partner can have: – A capital account. – A drawing account (a contra capital account—closed out at year-end). – A loan account (loans usually earn interest—a partnership expense). • Partnerships do NOT use: – A retained earnings account.

Recording the Capital Contributions • Two Fundamental Principles for Achieving Equity among the Partners: – Current values should be used to value: • Noncash assets contributed to a partnership. • Liabilities assumed by a partnership.

Methods to Share Profits and Losses • Partners can share profits and losses in any way they choose. Possible ways include: – Ratios. – Salary allowances and ratios. – Imputed interest on capital, salary allowances, and ratios. – Capital balances only. – Performance methods.

Methods to Share Profits and Losses: Order of Priority Provision • When an “order of priority” provision exists: – The exact sequence for sharing profits and losses specified in the partnership agreement must be followed. – The next lower level method of sharing can be reached if and only if there is still unallocated profit remaining after dealing with the current level.

Review Question #1 Dee and Jay created a partnership (D&J) on 12/31/05 (sharing profits 50 -50). Dee contributed equipment from her sole proprietorship having a carrying value of $5, 000 and a fair value of $9, 000. In 2006, D&J had profits of $88, 000 and borrowed $20, 000 from a bank. In 2006, Dee withdrew $30, 000 cash. Dee’s Y/E capital balance is: A. $13, 000 B. $19, 000 C. $23, 000 D. $43, 000

Review Question #1 With Answer Dee and Jay created a partnership (D&J) on 12/31/05 (sharing profits 50 -50). Dee contributed equipment from her sole proprietorship having a carrying value of $5, 000 and a fair value of $9, 000. In 2006, D&J had profits of $88, 000 and borrowed $20, 000 from a bank. In 2006, Dee withdrew $30, 000 cash. Dee’s Y/E capital balance is: A. $13, 000 B. $19, 000 C. $23, 000 ($9, 000 + $88, 000/2 - $30, 000) D. $43, 000

End of Chapter 20 (Appendix 20 A follows) Time to Clear Things Up—Any Questions?

Appendix 20 A: Income Taxes • A partnership interest is a capital asset —it is the equivalent of owning shares of common stock in a corporation. – Individuals keep track of their cost basis of shares owned in corporations.

Appendix 20 A: Income Taxes • Tax Basis: A partner’s cost basis in the partnership—commonly referred to merely as “basis. ” – Each partner keeps track of his or her own tax basis. – Tracking is needed to determine the taxable gain or loss to be reported on the disposal of the partnership interest.

Appendix 20 A: Income Taxes • Items That Increase Tax Basis: – Profits. – Capital contributions. – An increase in partnership liabilities (shared in the profit and loss sharing ratio). • Items That Decrease Tax Basis: – Losses. – Capital withdrawals (distributions). – A decrease in partnership liabilities.

Appendix 20 A: Income Taxes • What is the most important thing to ignore for tax reporting purposes? ANSWER: A partner’s general ledger capital balance—it is totally irrelevant.

Appendix 20 A Review Question #20 A-1 Dee and Jay created a partnership (D&J) on 12/31/06 (sharing profits 50 -50). Dee contributed equipment from her sole proprietorship having (1) a carrying value of $5, 000, (2) a tax basis of $6, 000, and (3) a fair value of $9, 000. Dee’s tax basis in D&J is: A. $5, 000 B. $6, 000 C. $7, 000 D. $8, 000 E. $9, 000

Appendix 20 A Review Question #20 A-1 With Answer Dee and Jay created a partnership (D&J) on 12/31/06 (sharing profits 50 -50). Dee contributed equipment from her sole proprietorship having (1) a carrying value of $5, 000, (2) a tax basis of $6, 000, and (3) a fair value of $9, 000. Dee’s tax basis in D&J is: A. $5, 000 B. $6, 000 C. $7, 000 D. $8, 000 E. $9, 000

Appendix 20 A Review Question #20 A-2 Use the information in the preceding question, but also assume that (1) Dee contributed a $2, 000 liability to D&J and (2) D&J borrowed $4, 000 from a bank on 12/31/06? What is Dee’s tax basis in D&J? A. $5, 000 B. $6, 000 C. $7, 000 D. $8, 000 E. $9, 000

Appendix 20 A Review Question #20 A-2 With Answer Use the information in the preceding question, but also assume that (1) Dee contributed a $2, 000 liability to D&J and (2) D&J borrowed $4, 000 from a bank on 12/31/06? What is Dee’s tax basis in D&J? A. $5, 000 B. $6, 000 C. $7, 000 ($6, 000 - [$2, 000 x 50%] + [$4, 000 x 50%]) D. $8, 000 E. $9, 000