Chapter 9: Partnerships: Formation and Operation Flashcards
What are the advantages of operating a business as a partnership rather than as a corporation? What are the disadvantages?
- The advantages of operating a business as a partnership include the ease of formation and the avoidance of the double taxation effect that inherently reduces the profits distributed to the owners of a corporation. In addition, Because the losses of a partnership pass, for tax purposes, directly through to the owners, partnerships have historically been used (especially in certain industries) to reduce or defer income taxes.Several disadvantages also accrue from the partnership format. Each general partner, for example, has unlimited liability for all debts of the business. This potential liability can be especially significant in light of the concept of mutual agency, the right that each partner has to create liabilities in the name of the partnership. Because of the risks created by unlimited liability and mutual agency, the growth potential of most partnerships is severely limited. Few people are willing to become general partners in an organization unless they can maintain some day to day contact and control over the business.
How does partnership accounting differ from corporate accounting?
- Specific partnership accounting problems center in the equity (or capital) section of the balance sheet. In a corporation, stockholders’ equity is divided between earned capital and contributed capital. Conversely, for a partnership, each partner has an individual capital account that is not differentiated according to its sources. Virtually all accounting issues encountered purely in connection with the partnership format are related to recording and maintaining these capital balances.
What information do the capital accounts found in partnership accounting convey?
- The balance in each partner’s capital account measures that partner’s interest in the book value of the business’ net assets. This figure arises from contributions, earnings, drawings, and other capital transactions.
Describe the differences between a Subchapter S corporation and a Subchapter C corporation.
- A Subchapter S corporation is formed legally as a corporation so that its owners enjoy limited legal liability and easy transferability of ownership. However, if a company qualifies and becomes a Subchapter S Corporation, it will be taxed in virtually the same manner as a partnership. Hence, income will be taxed only once and that is to the owners at the time that it is earned by the corporation.Use of this designation is quite restricted. To qualify as a Subchapter S Corporation, a company can only have one class of stock and must have no more than 100 owners. These owners can only be individuals, estates, certain tax-exempt entities, and certain types of trusts. Most corporations that do not qualify as Subchapter S Corporations are automatically Subchapter C Corporations. These entities are also corporations but they pay income taxes when the income is earned. Additionally, the owners are liable for a second income tax when dividends are distributed to them. Thus, the income earned by a Subchapter C Corporation faces the double taxation effect commonly associated with corporations.
A company 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 each of these legal forms?
- In a general partnership, each partner can have unlimited liability for the debts of the business. Therefore, a partner may face a significant risk, especially in connection with the actions and activities of other partners. However, general partnerships are easy to form and often serve well in smaller businesses where all partners know each other. The major advantage of a general partnership is that all income earned by the business is only taxed once when earned by the business so that no second tax is incurred when distributions are made to owners.A limited liability partnership (LLP) is very similar to a general partnership except in the method by which a partner’s liability is measured. In an LLP, the partners can still lose their entire investment and be held responsible for all contractual debts of the business such as loans. However, partners cannot be held responsible for damages caused by other partners. For example, if one partner carelessly causes damage and is sued, the other partners are not held responsible.A limited liability company can now be created in certain situations. This type of organization is classified as a partnership for tax purposes so that the double-taxation effect is avoided. However, the liability of the owners is limited to their individual investments like a Subchapter C Corporation. Depending on state law, the number of owners is not restricted in the same manner as a Subchapter S Corporation so that there is a greater potential for growth.
What is an articles of partnership agreement, and what information should this document contain?
- The Articles of Partnership is a legal agreement that should be created as a prerequisite for the formation of a partnership. This document defines the rights and responsibilities of the partners in relation to the business and in relation to each other. Thus, it serves as a governing document for the partnership. The Articles of Partnership may contain any number of provisions but should normally specify each of the following:
a. Name and address of each partner
b. Business location
c. Description of the nature of the business
d. Rights and responsibilities of each partner
e. Initial investment to be made by each partner along with the method to be used for valuation
f. Specific method by which profits and losses are to be allocated
g. Periodic withdrawals to be allowed each partner
h. Procedure for admitting new partners
i. Method for arbitrating partnership disputes
j. Method for settling a partner’s share in the business upon withdrawal, retirement, or death
What valuation should be recorded for noncash assets transferred to a partnership by one of the partners?
- To give fair recognition to noncash contributions, all assets donated by the partners (such as land or inventory) should be recorded by the partnership at their fair values at the date of investment. However, for taxation purposes, the partner’s book value is retained.
If a partner is contributing attributes to a partnership such as an established clientele or a particular expertise, what two methods can be used to record the contribution? Describe each method.
- In forming a partnership, one or more of the partners may be contributing some factor (such as an established clientele or an expertise) which is not viewed normally as an asset in the traditional accounting sense. In effect, the partner will be receiving a larger capital balance than the identifiable contributions would warrant.The bonus method of recording this transaction is to value and record only the identifiable assets such as land and buildings. The capital accounts are then aligned to recognize the proportionate interest being assigned to each partner’s investment. If, for example, the capital balances are to be equal, they are set at identical amounts that correspond in total to the value of the identifiable assets.As an alternative, the amounts contributed along with the established capital percentages can be used to determine mathematically the implied total value of the business and the presence of any goodwill brought into the business. This goodwill is recognized at the time that the partnership is created so that the amount can be credited to the appropriate partner.
What is the purpose of a drawing account in a partnership’s financial records?
- The Drawing account measures the amount of assets that a particular partner takes from the business during the current period. Often, only regularly allowed distributions are recorded in the Drawing account with larger, more sporadic withdrawals being recorded as direct reductions to the partner’s capital balance.
At what point in the accounting process does the allocation of partnership income become significant?
- At the end of each fiscal year, when revenues and expenses are closed out, some assignment must be made of the resulting income figure Because a partnership will have two or more capital accounts rather than a single retained earnings balance. This allocation to the capital accounts is based on the agreement established by the partners preferably as a part of the Articles of Partnership.
What provisions in a partnership agreement can be used to establish an equitable allocation of income among all partners?
- The allocation process can be based on any number of factors. The actual assignment of income should be designed to give fair and equitable treatment to each of the partners. Often, an interest factor is used to reward the capital investment of the partners. A salary allowance is utilized as a means of recognizing the amount of time worked by an individual or a certain degree of business expertise. The allocation process can be further refined by a ratio that is either divided evenly among the partners or weighted in favor of one or more members.
If no agreement exists in a partnership as to the allocation of income, what method is appropriate?
- If agreement as to the allocation of income has not been specified, an equal division among all partners is presumed. If an agreement has been reached for assigning profits but no mention is made concerning losses, the assumption is made that the same method is intended in either case.
What is a partnership dissolution? Does dissolution automatically necessitate the cessation of business and the liquidation of partnership assets?
- The dissolution of a partnership is the breakup or cessation of the partnership. Many reasons can exist for a partnership to dissolve. One partner may withdraw, retire, or die. A new partner may be admitted to the partnership. The original partnership terminates whenever the identity of the individuals serving as partners has changed.
Dissolution, however, does not necessarily lead to the liquidation of the business. In most cases, but not all, a new partnership is formed which takes over the business. Such dissolutions are no more than changes in the composition of the ownership and should not affect operations.
By what methods can a new partner gain admittance into a partnership?
- A new partner can join a partnership by acquiring part or all of the interest of one or more of the present partners. This transaction is carried out with the individual partners directly and not with the partnership. A new partner may also enter through a contribution to the business. In such cases, the investment is made to the partnership rather than to the individuals.
When a partner sells an ownership interest in a partnership, what rights are conveyed to the new owner?
- In selling an interest in a partnership, three rights are conveyed to the new owner:
a. The right of co ownership of the business property;
b. The right to a specified allocation of profits and losses generated by the partnership’s business; and
c. The right to participate in the management of the business.
No problem exists in selling or assigning the first two of these rights. However, the right to participate in management decisions can only be transferred with the consent of all partners.
