Chapter Fourteen Partnerships: Formation and Operation Copyright © 2015 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education Partnerships A partnership is defined as “an association of two or more persons to carry on a business as co-owners for profit.” (Section of Uniform Partnership Act) The IRS projects that by 2016, nearly 4.7 million partnership U.S income tax returns will be filed, compared to 8.1 million corporation income tax returns (Source: www.irs.gov) 14-2 Learning Objective 14-1 Explain the advantages and disadvantages of the partnership versus the corporate form of business 14-3 Partnership Advantages Advantages: Flexibility in defining relationships Profits and losses, and management operating decisions, shared independent of ownership percentages Ease of formation and dissolution Taxes “flow-through” to the partners Disadvantages: Unlimited liability incurred by each partner (they are “jointly and severally” liable) Mutual agency (each partner has right to incur liabilities in the name of the partnership) Inability to participate in various corporate tax benefits 14-4 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 14-5 Alternative Legal Forms Limited Partnership (LP) Limited partners 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 Limited Liability Partnership (LLP) Owners: Risk their own investments Are responsible for contractual debts of the business Are liable only for their own acts and omissions, and those of individuals they directly supervise 14-6 Alternative Legal Forms – Limited Liability Company (LLC) LLC’s are a new type of organization for U.S They have long been used in Europe and other areas They are classified as partnerships for tax purposes In contrast to Sub Chapter S Corporations, the number of owners is not usually restricted Owners only risk their own investments 14-7 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 partner’s capital account Withdrawals by partners reduce their capital accounts 14-8 Learning Objective 14-2 Describe the purpose of the articles of partnership and list specific items that should be included in this agreement 14-9 Articles of Partnership The Uniform Partnership Act establishes standards and rules for partnerships but a written agreement will supersede the UPA standards Articles of partnership should always clearly describe the: • Name and address of each partner • Business location • Nature of the business • Rights and responsibilities of each partner • Initial contribution to be made by each partner and the method to be used for valuation 14-10 Admission of a New Partner The Rights of a Partner An individual partner’s ownership rights include: The right to co-ownership in the business These two rights can be sold (unless restricted by the articles of partnership) 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 This right cannot be sold without the other partners’ approval 14-34 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 14-35 Admission of a New Partner - Purchase of a Current Interest Assume Scott, Thompson, and York formed a partnership, and subsequently, York decides to leave the partnership He offers to sell his interest to Morgan Although York may transfer the right of property ownership as well as the specified share of future profits and losses, the partnership does not automatically admit Morgan York legally remains a partner until such time as both Scott and Thompson agree to allow Morgan to participate in the management of the business 14-36 Admission of a New Partner Purchase of a Current Interest Book Value Approach Instead of York selling his interest to Morgan, each of these three partners elects to transfer a 20 percent interest to Morgan for a total payment of $30,000 in a simple capital reclassification The money is paid directly to the owners 14-37 Admission of a New Partner - Purchase of a Current Interest Goodwill Approach Scott, Thompson, and York is transferring all assets and liabilities to the partnership of Scott, Thompson, York, and Morgan The goodwill method recognizes the transaction as occurring between two separate reporting entities that necessitates the complete revaluation of all assets and liabilities 14-38 Learning Objective 14-9 Prepare journal entries to record a new partner’s admission by a contribution made directly to the partnership 14-39 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 partnership’s net assets Two methods are: Bonus Approach Goodwill Approach 14-40 Admission of a New Partner Contribution to the Partnership An outsider may be admitted to a partnership by contributing directly to the business Assume King and Wilson maintain a partnership and presently report capital balances of $80,000 and $20,000, respectively According to the articles of partnership, King is entitled to 60 % of all profits and losses with the remaining 40% credited each year to Wilson Goldman can enter the partnership for $20,000 cash with the money going into the business Goldman receives an initial 10 percent interest in partnership property 14-41 Admission of a New Partner Contribution to the Partnership Bonus Credited to Original Partners Goodwill Credited to Original Partners 14-42 Admission of a New Partner Contribution to the Partnership Hybrid Method 14-43 Admission of a New Partner Contribution to the Partnership Bonus or Goodwill Credited to New Partner 14-44 Learning Objective 14-10 Prepare journal entries to record the withdrawal of a current partner 14-45 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 partner’s 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 partner’s account The withdrawing partner is then paid based on the balance in the individual capital account 14-46 Withdrawal of a Partner Bonus Method Applied Goodwill Method Applied 14-47 Withdrawal of a Partner Hybrid Method Applied 14-48 ... 14-3 Prepare the journal entry to record the initial capital investment made by a partner 14-12 Accounting for Capital Contributions Assume that Carter and Green form a business to be operated... Green invests $20,000 The initial journal entry to record the creation of the partnership: 14-13 Accounting for Capital Contributions If one or more of the partners transfers noncash assets, fair... to begin the previously discussed partnership and Green contributes the following assets 14-14 Accounting for Capital Contributions Green’s building is encumbered by a $23,600 mortgage that the