CHAPTER 20

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 agreed-

upon 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 with 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 #1Dee 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

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

Review Question #1With Answer

End of Chapter 20(Appendix 20A follows)

Time to Clear Things Up—Any Questions?

Appendix 20A: 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 20A

Appendix 20A: 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 onthe disposal of the partnership interest.

Appendix 20A

Appendix 20A: 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 20A

Appendix 20A: 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 20A

Review Question #20A-1Dee 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 20A

Review Question #20A-1With 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 20A

Review Question #20A-2Use 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 20A

Review Question #20A-2With 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

Appendix 20A