Chapter Fourteen Partnerships: Formation and Operation McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Partnership Advantages Flexibility in defining relationships Profits and losses, and management operating decisions, may be shared independent of ownership percentages Ease of formation and dissolution Taxes flow-through the partnership (conduit) to the partners, and are taxed to the individuals (no double- taxation). 14-2

Partnership Disadvantages Unlimited liability incurred by each partner (they are jointly and severally liable) Mutual agency (each partner has the right to incur liabilities in the name of the partnership) Inability to participate in various corporate tax benefits 14-3

Alternative Legal Forms - Subchapter S Corporation Legal characteristics of a corporation. Ownership limited to 100 stockholders. Owners limited to individuals, estates, and certain tax-exempt entities and trusts (no corporate owners allowed). Profit passes to owners as a partnership Often referred to as an S-Corp

Alternative Legal Forms - Limited Partnership A number of limited partners who are not allowed to participate in management. Losses are restricted for limited partners to the amount invested. Must have one or more general partners who assume responsibility for all obligations Tax benefits of a partnership without unlimited liability.

Alternative Legal Forms – Limited Liability Partnerships 14-6 Many characteristics of a general partnership, and classified as a partnership for tax purposes. The number of owners is not usually restricted. HOWEVER…Owners only risk their own investments, and are liable only for their own acts and omissions, and those of the individuals they directly supervise. LLP laws differ from state to state.

Partnerships - Capital Accounts The equity section of a partnership consists of capital balances for each partner. Profits/losses for each period are allocated to each partners capital account. Withdrawals by partners reduce their capital accounts. 14-7

Articles of Partnership Partnerships can exist even in the absence of a written partnership agreement. The Uniform Partnership Act establishes standards and rules for partnerships. A written agreement will supersede the UPA standards. Partnerships can exist even in the absence of a written partnership agreement. The Uniform Partnership Act establishes standards and rules for partnerships. A written agreement will supersede the UPA standards. 14-8

Accounting for Capital Contributions Intangible assets contributed, such as expertise, require special consideration Use either the Bonus Method or the Goodwill Method for recording contributed intangible assets.

Allocation of Income The allocation of income is not necessarily based on the relative capital balances. It is a separately negotiated item. Allocated compensation Bonuses Remaining income Interest on beginning capital balances Items to be allocated:

Legal Dissolution Any alteration in the specific individuals composing a partnership results in legal dissolution Departures Retirement Death Admission (including promotion) of a New Partner Frequently this leads to the immediate formation of a new partnership as the business continues Can lead to termination and liquidation 14-11

These two rights can be sold (unless restricted by the articles of partnership) This right cannot be sold without the other partners approval. Admission of a New Partner - The Rights of a Partner An individual partners ownership rights include: The right to co- ownership in the business property. The right to share in profits and losses as specified in the partnership agreement The right to participate in the management of the business

Admission of a New Partner - Purchase of a Current Interest A new partner can purchase partnership interest directly from the existing partners. The cash goes to the partners, not the partnership. Two methods are available to account for the transfer of ownership: Book Value Approach Goodwill (Revaluation) Approach 14-13

Admission of a New Partner - Contribution to the Partnership The new partner can also gain partnership interest by contributing cash to the partnership. Remember that the new cash will increase the partnerships net assets. Two methods are: Bonus Approach Goodwill Approach 14-14

Withdrawal of a Partner The Withdrawing Partner is paid out in accordance with the Partnership Agreement. Using the Bonus Method, any amount paid in excess of that partners capital account is allocated against the remaining partners capital accounts. Using the Goodwill Method, the books are first adjusted to FMV, with a proportion of the increase allocated to each partners account. The withdrawing partner is then paid based on the balance in the individual capital account. The Withdrawing Partner is paid out in accordance with the Partnership Agreement. Using the Bonus Method, any amount paid in excess of that partners capital account is allocated against the remaining partners capital accounts. Using the Goodwill Method, the books are first adjusted to FMV, with a proportion of the increase allocated to each partners account. The withdrawing partner is then paid based on the balance in the individual capital account