Chapter Nine

Partnerships: Formation and Operation

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

9-2

Partnerships
A partnership is defined as an association of two or more persons to carry on a business as co-owners for profit. (Section 6 of Uniform Partnership Act)

9-3

Economic Importance of Partnerships

The IRS projects that by 2012, nearly 3.6 million partnership U.S. income tax returns will be filed, compared to 7.3 million corporation income tax returns. (Source: www.irs.gov) Why do people form partnerships? Reduce expenses, increase expertise and expand services Tax benefits Easily created by families and friends Some professions have historically not permitted incorporation

9-4

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).

9-5

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

9-6

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.

9-7

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.

9-8

Alternative Legal Forms Limited Liability Partnerships

Many characteristics of a general partnership, and classified as a partnership for tax purposes.

The number of owners is not usually restricted. HOWEVEROwners only risk their own investments, and are liable only for their own acts and omissions, and those of the individuals they directly supervise.

9-9

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.

9-10

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.

9-11

Articles of Partnership
Method for dispute settlements Method for settling a partners share upon withdrawal, retirement or death Profit/loss sharing percentages Method for admitting new partners Initial contribution to be made by each partner

PUT IT IN WRITING!!
Rights and responsibilities of partners

9-12

Articles of Partnership
Name and Address of Each Partner

Withdrawal limits
Description of the Nature of the Business

Life insurance provisions enabling survivor acquisition of decedent interest

PUTitIT IN Put in writing!!! WRITING!!

Business Location

Method for valuing individual contributions

9-13

Accounting for Capital Contributions

If the partners each contribute cash . . . . . . debit Cash. . . . credit individual Partner Capital accounts.

Partnership Journal
Date Description

Page
Debit

##
Credit

Cash Capital - Partner A Capital - Partner B

$$$ $$$ $$$

9-14

Accounting for Capital Contributions

If the partners each contribute cash and other assets . . . . . . debit Cash & Contributed Assets for FV. . . . credit individual Partner Capital accounts.
Partnership Journal
Date Description

Page
Debit

##
Credit

Cash Contributed Assets (FV) Capital - Partner A Capital - Partner B

$$$ $$$ $$$ $$$

9-15

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.

9-16

Intangible Contributions -Bonus Method

Record the tangible assets contributed. 2) Adjust the partner capital balances to reflect the relative value of the intangible asset.
1)

On 2/15/08, Cookie and Bijou form a partnership. They agree to equal capital balances. Cookie contributes $80,000 cash. Bijou contributes land valued at $40,000, and brings years of experience to the new business. What is the journal entry to set up this partnership, using the Bonus Method?

9-17

Intangible Contributions Bonus Method

Total tangible assets for the partnership are $120,000. The partners have agreed to have equal capital balances, based on the contributed assets, even though Bijou only contributed land worth $40,000. Essentially, Cookie has given Bijou a $20,000 bonus.

Partnership Journal
Date Description

Page
Debit

##
Credit

15-Feb Cash Land Capital - Cookie Capital - Bijou

80,000 40,000 60,000 60,000

9-18

Intangible Contributions -Goodwill Method

Record the tangible assets contributed. 2) Record the intangible asset as the difference between the tangible assets and the implied value of the partnership.
1)

On 2/15/08, Cookie and Bijou form a partnership. They agree to equal capital balances. Cookie contributes $80,000 cash. Bijou contributes land valued at $40,000, and brings years of experience to the new business. What is the journal entry to set up this partnership, using the Goodwill Method?

9-19

Intangible Contributions Goodwill Method

Cookie's Tangible Contributed Assets $ 80,000 Cookie's Capital % 50% Implied Value of the Partnership $ 160,000

Implied Value of the Partnership Total Tangible Contributed Assets Goodwill Attributed to Bijou

$ 160,000 120,000 $ 40,000

9-20

Intangible Contributions Goodwill Method

Cookies capital account is credited for the tangible contribution of $80,000. Bijous capital account is credited for the tangible contribution of $40,000, plus the intangible contribution valued at $40,000.

Partnership Journal
Date Description

Page
Debit

##
Credit

15-Feb Cash Land Goodwill Capital - Cookie Capital - Bijou

80,000 40,000 40,000 80,000 80,000

9-21

Allocation of Income
Items to be allocated:
Interest on beginning capital balances Allocated compensation

The allocation of income is not necessarily based on the relative capital balances. It is a separately negotiated item.
Remaining income

Bonuses

9-22

Allocation of Income -Example

Mushon and Gee, a retail partnership selling pet products, has beginning of period capital balances of $50,000 and $70,000, respectively. Net income for the period is $100,000. Both are credited with 10% interest on their beginning capital balance. Mushon is credited with a $20,000 bonus per the partnership agreement. They share income 40:60 (Mushon:Gee). What are the ending capital balances for each partner?

9-23

Allocation of Income Example

Mushon Beginning capital balances Interest on capital balances Bonus to Mushon Allocation of remaining income Capital Balances 50,000 5,000 20,000 Gee 70,000 7,000 Total 120,000 12,000 20,000

27,200 40,800 68,000 $ 102,200 $ 117,800 $ 220,000

( 100,000 - 12,000 - 20,000 ) = $68,000

9-24

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

9-25

Admission of a New Partner The Rights of a Partner

These two rights can be sold (unless restricted by the articles of partnership) This right cannot be sold without the other partners approval.

An individual partners ownership rights include: The right to coownership 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.

9-26

Partnership Dissolution Admission of a New Partner

When the makeup of the partnership changes, the partnership is dissolved. A new partnership is immediately formed. New partner acquires partnership interest by: Purchasing it from the other partners, or Making a contribution to the partnership.

9-27

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

9-28

Admission of a New Partner Purchase of a Current Interest

Book Value Example Mare, Mic and Roma have a partnership.
Partner Capital Balance Mare $ 30,000 Mic $ 50,000 $ 60,000 Roma

Profit & Loss Ratio 40% 25% 35%

Using the Book Value Approach, prepare the entry assuming Nia pays $60,000 directly to the other partners for a 20% partnership interest.

9-29

Admission of a New Partner Purchase of a Current Interest

Book Value Example Each partner gives up 20% of their capital. No revaluation of assets or liabilities is required.
Date Description

$30,000 x $50,000 x $60,000 x

20% = $6,000 20% = $10,000 20% = $12,000

Partnership General Journal

31-Dec Partner Capital - Mare Partner Capital - Mic Partner Capital - Roma Partner Capital - Nia

Page
Debit

18
Credit

6,000 10,000 12,000 28,000

9-30

Admission of a New Partner Purchase of a Current Interest

Goodwill (Revaluation) Example Mare, Mic and Roma have a partnership.
Partner Capital Balance Mare $ 30,000 Mic $ 50,000 $ 60,000 Roma

Profit & Loss Ratio 40% 25% 35%

Using the Goodwill Approach, prepare the entry assuming Nia pays $60,000 directly to the other partners for a 20% partnership interest.

9-31

Admission of a New Partner Purchase of a Current Interest

Goodwill (Revaluation) Example The implied fair value of the partnership is $300,000
$60,000 20% = $300,000

Current book value is inferred from the combined capital balances of the existing partners,
$30,000 + $50,000 + $60,000 = $140,000.

First, compute the Goodwill

$300,000 - $140,000 = $160,000

9-32

Admission of a New Partner Purchase of a Current Interest

Goodwill (Revaluation) Example Allocate the $160,000 of Goodwill to the existing partners, based on their income sharing percentage. (40:25:35)

Partnership General Journal

Date Description

Page
Debit

18
Credit

Goodwill Partner Capital - Mare Partner Capital - Mic Partner Capital - Roma

160,000 64,000 40,000 56,000

9-33

Admission of a New Partner Purchase of a Current Interest

Goodwill (Revaluation) Example The new balances for Mare, Mic and Roma appear as follows:
Mare Capital 30,000 64,000 94,000 Mic Capital 50,000 40,000 90,000 Roma Capital 60,000 56,000 116,000

Next, allocate 20% from each of the existing partners to Nia.

9-34

Admission of a New Partner Purchase of a Current Interest

Revaluation Example Note that after allocation from the current partners, Nias balance equals the contribution made of $60,000.
Date Description

$94,000 x 20% = $18,800 $90,000 x 20% = $18,000 $116,000 x 20% = $23,200

Partnership General Journal

31-Dec Partner Capital - Mare Partner Capital - Mic Partner Capital - Roma Partner Capital - Nia

Page
Debit

18
Credit

18,800 18,000 23,200 60,000

9-35

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

9-36

Admission of a New Partner Contribution to the Partnership

Bonus Example Mare, Mic and Roma have a partnership.
Partner Capital Balance Mare $ 30,000 Mic $ 50,000 $ 60,000 Roma

Profit & Loss Ratio 40% 25% 35%

Using the Bonus Approach, prepare the entry assuming Nia pays $60,000 to the partnership for a 20% partnership interest.

9-37

Admission of a New Partner Contribution to the Partnership

Bonus Example Determine the new net assets of the partnership.

Partnership net assets of $140,000 + $60,000

contribution = $200,000

Nia will own 20% of new net assets

$200,000 x 20% = $40,000

The remainder of the $60,000 contribution is allocated to the other partners.

9-38

Admission of a New Partner Contribution to the Partnership

$20,000 x $20,000 x $20,000 x 40% = $8,000 25% = $5,000 35% = $7,000

The remainder of the $60,000 contribution is allocated to the other partners.

Date Description

Debit

Credit

Cash Partner Partner Partner Partner

60,000 Capital - Nia Capital - Mare Capital - Mic Capital - Roma 40,000 8,000 5,000 7,000

9-39

Admission of a New Partner Contribution to the Partnership

Goodwill Example Mare, Mic and Roma have a partnership.
Partner Capital Balance Mare $ 30,000 Mic $ 50,000 $ 60,000 Roma

Profit & Loss Ratio 40% 25% 35%

Using the Goodwill Approach, prepare the entry assuming Nia pays $60,000 to the partnership for a 20% partnership interest.

9-40

Admission of a New Partner Contribution to the Partnership

Goodwill Example Net assets after the contribution are $200,000. Implied value of the partnership is $300,000.
$60,000 20% = $300,000

Goodwill to be recorded is $100,000

300,000 - 200,000 = $100,000

Date

Description

Debit

Credit

Goodwill Partner Capital - Mare Partner Capital - Mic Partner Capital - Roma

100,000 40,000 25,000 35,000

9-41

Admission of a New Partner Contribution to the Partnership

Goodwill Example After allocating the goodwill to the original partners, record Nias cash contribution and credit Nias capital account.
Date Description Debit Credit

Cash Partner Capital - Nia

60,000 60,000

Prepare the journal entry to admit Flatt to the partnership.

9-42

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.

9-43

Summary
A partnership is defined as an association of two or more persons to carry on a business as co-owners for profit. This form of business organization is popular for many reasons, primarily ease of formation and organization. There are tax benefits as a result of their flow-through nature. Disadvantages include unlimited liability and mutual agency.

9-44

Possible Criticisms

Because corporations can be considered persons for purpose of partnership formation, some critics contend that this form of business organization can be easily manipulated for fraudulent intent. Others argue that unlimited liability and mutual agency provisions are too strict and unduly limit commerce. WHAT DO YOU THINK????