CHAPTER 20

1. CHAPTER 20 PARTNERSHIPS: FORMATION AND OPERATION

2. 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

3. 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.

4. 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).

5. Types of Partnerships • Limited Liability Partnerships (LLPs): • A partner’s personal assets are at risk only for: • His or her OWNnegligence and wrongdoing. • The negligence and wrongdoing of those under his or her control. • This form of organization has not been tested in the courts.

6. 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.

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

12. 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.

13. 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. • Liabilitiesassumed by a partnership.

14. 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.

15. 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.

16. Review Question #1 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 D. $43,000

17. Review Question #1With Answer 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

18. End of Chapter 20(Appendix 20A follows) Time to Clear Things Up—Any Questions?

19. Appendix 20A: Income Taxes Appendix 20A • A partnership interest is acapital 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.

20. Appendix 20A: Income Taxes Appendix 20A • 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 thetaxable gain or loss to be reported onthe disposal of the partnership interest.

21. Appendix 20A: Income Taxes Appendix 20A • 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.

22. Appendix 20A: Income Taxes Appendix 20A • What is the most important thing to ignore for tax reporting purposes?ANSWER:A partner’s general ledgercapital balance—it is totally irrelevant.

23. Review Question #20A-1 Appendix 20A 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

24. Review Question #20A-1With Answer Appendix 20A 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

25. Review Question #20A-2 Appendix 20A 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 D. $8,000 E. $9,000

26. Review Question #20A-2With Answer Appendix 20A 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