PARTNERSHIPS: LIQUIDATIONS CHAPTER 22 PARTNERSHIPS: LIQUIDATIONS

FOCUS OF CHAPTER 22 Fundamental Procedures in Liquidation Lump-Sum Liquidations Installment Liquidations

Sharing of Gains & Losses During Liquidation Gains and losses incurred on the realization of noncash assets during liquidation are: Allocated among the partners in the profit-and-loss sharing ratio (such as 4:3:1). UNLESS agreed to otherwise by the partners.

Consequences of A Partner Being Personally Insolvent A partner having a capital account deficit may be able to eliminate the deficit by: Capital contribution. Setoff. A deficit that cannot be eliminated, is allocated to: The remaining partners who have POSITIVE capital balances (using their P/L sharing ratio).

Consequences of A Partner Being Personally Insolvent A partner that winds up absorbing some or all of another partner’s capital deficit has: Legal recourse against that partner. Because that partner has broken the terms of the partnership agreement.

Sharing Profits and Losses: In The Ratio of Capital Balances Is one of the most important safeguards used in partnership agreements. Results in no partner EVER having a capital account deficit balance until the losses incurred in liquidation exceed the TOTAL partnership capital. Thus ALL partners go into a deficit position SIMULTANEOUSLY.

The Rule of Setoff A deficit balance in a partner’s capital account can be eliminated to the extent that such partner has a loan to the partnership. Note Payable Capital, to Jones Jones Balances before setoff....... $30,000 $(11,000) Apply rule of setoff........ (11,000) 11,000 Balances after setoff....….. $19,000 $ -0-

No More “Marshaling of Assets” In liquidation: PARTNERSHIP CREDITORS have first priority as to PARTNERSHIP ASSETS. PERSONAL CREDITORS of an insolvent partner do NOT have first priority as to PERSONAL ASSETS of that partner. They share on a pro rata basis with partnership creditors.

Installment Liquidations: Priority In Distributing Cash No cash distributions are made to partners until creditors have been paid in full (100%). This holds true for BOTH: Lump-sum liquidations. Installment liquidations.

Installment Liquidations: Different Strokes For Different Folks The amount to be distributed to each partner at any point in time can be determined by preparing either of the following items: Schedules of safe payments at each cash distribution date. Will have to be done several times. A cash distribution plan at the beginning of the liquidation process. Need be done only once. #1 #2

Installment Liquidations The EFFECT of distributing cash to partners based on either (a) schedules of safe payments or (b) cash distribution plans, is to: Bring the capital balances into the profit-and-loss sharing ratio. “CONVERGENCE”

Installment Liquidations: Loss Absorption Potentials Conceptually, the first cash distribution to partners goes to that partner who has: THE HIGHEST LOSS ABSORPTION POTENTIAL. This is NOT necessarily the partner that has the highest capital balance.

Installment Liquidations: Loss Absorption Potentials—Calculating The loss absorption potential of each partner is calculated by: Dividing the partner’s capital balance by his or her profit-and-loss sharing percentage. Capital balance of Jones............ $80,000 = $400,000 Jones’ P/L sharing percentage.. 20% Loss Absorption Potential

Installment Liquidations: Loss Absorption Potentials—Implications Consequences of Having the Highest Loss Absorption Potential: He or she will be: The first partner to receive cash. The partner that could suffer the greatest inequity in relation to his or her capital balance. It is NOT a good thing to have the highest loss absorption potential.

Installment Liquidations: Loss Absorption Potentials—Loans “To” In calculating a partner’s loss absorption potential, a partner’s loan to the partnership is ADDED TO the partner’s capital balance. Capital balance, Jones................ $80,000 Note payable to Jones............... 10,000 Total.......................................... $90,000 = $450,000 Jones’ P/L sharing percentage... 20% Loss Absorption Potential PLUS

Installment Liquidations: Loss Absorption Potentials—Loans “From” In calculating a partner’s loss absorption potential, a partner’s loan from the partnership is SUBTRACTED FROM the partner’s capital balance. Capital balance, Jones................ $80,000 Note receivable from Jones...... (5,000) Total.......................................... $75,000 = $375,000 Jones’ P/L sharing percentage... 20% Loss Absorption Potential MINUS

The Statement of Realization and Liquidation The STATEMENT OF REALIZATION AND LIQUIDATION is A historical statement. It portrays what actually happened in the past (during the liquidation process). Income statements are not prepared during this period.

The Schedule of Safe Payments In contrast to the Statement of Realization and Liquidation, the SCHEDULE OF SAFE PAYMENTS is A pro forma (what if) statement. It portrays what could happen in the future—on a worst-case basis.

Review Question #1 In liquidation, cash distributions to partners are determined based on: A. Who has the highest capital balance. B. How profits and losses are shared. C. Partners’ loans to the partnership having priority over partners’ capital balances. D. The marshalling of assets principle. E. The rule of setoff. F. None of the above.

Review Question #1 With Answer In liquidation, cash distributions to partners are determined based on: A. Who has the highest capital balance. B. How profits and losses are shared. C. Partners’ loans to the partnership having priority over partners’ capital balances. D. The marshalling of assets principle. E. The rule of setoff. F. None of the above. (Loss absorption potential)

Review Question #2 In liquidation, Kelly (who shares in 25% of profits and losses) was given equipment having a carrying value of $10,000 and a fair value of $14,000. Kelly’s capital account is debited: A. $10,000 B. $11,000 C. $13,000 D. $14,000 E. $15,000

Review Question #2 With Answer In liquidation, Kelly (who shares in 25% of profits and losses) was given equipment having a carrying value of $10,000 and a fair value of $14,000. Kelly’s capital account is debited: A. $10,000 B. $11,000 C. $13,000 ($14,000 - [$4,000 x 25%]) D. $14,000 E. $15,000

Time to Clear Things Up—Any Questions? End of Chapter 22 Time to Clear Things Up—Any Questions?