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APPENDIX B Partnerships Partnerships and Related Forms of Business

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APPENDIX B Partnerships Partnerships and Related Forms of Business Appendix B 11/20/06 10:38 AM Page B-2 APPENDIX Partnerships B artnerships differ in many ways from sole proprietorships and corpo- Prations. Here, we describe their characteristics and those of related forms of business. We also examine management and accounting issues pertaining to the formation, dissolution, and liquidation of partnerships, as well as the division of income among partners. Because of the special characteristics of partnerships, individuals who engage in them should choose as partners people who have high ethical standards. LEARNING OBJECTIVES LO1 Describe the characteristics of partnerships and related forms of business. LO2 Record partners’investments of cash and other assets when a partnership is formed. LO3 Use stated ratios, capital balance ratios, and partners’salaries and interest to compute the income or losses that partners share. LO4 Record a person’s admission to or withdrawal from a partnership. LO5 Compute and record the distribution of assets to partners when they liquidate their partnership. B-2 Appendix B 11/9/06 4:30 PM Page B-3 DECISION POINT A USER’S FOCUS ERNST & YOUNG ● How does a firm as large as Ernst & Young organize to accomplish its objectives? ● How does a partnership account for its partners’ interests? ● What happens when partners enter or withdraw from a partnership? Many people think of partnerships as relatively small businesses, and usually they are right. However, some partnerships—among them law firms, invest- ment companies, real estate companies, and accounting firms—are very large. One example is Ernst & Young, an organization with offices in 140 countries and revenues of almost $17 billion. Ernst & Young provides a wide range of services, including accounting and auditing services, tax reporting and operations, business risk services, and technology and security risk serv- ices. With over 2,000 partners and 108,000 employees (23,000 in the United States), it is one of the largest partnerships in the world.1 Appendix B 11/9/06 4:30 PM Page B-4 B-4 | APPENDIX B Partnerships Partnerships and Related Forms of Business LO1 Describe the characteristics of partnerships and related forms of business. he Uniform Partnership Act, which most states have adopted, defines a partnership as “an association of two or more persons to carry on as co- Towners of a business for profit.” Partnerships are treated as separate enti- Partnerships and sole ties in accounting, but legally there is no economic separation between them proprietorships are not legal and their owners. Here, we describe their characteristics and the management entities; corporations are. All three, issues involved in forming and operating them. We also describe variations on however, are considered accounting entities. the partnership form of business. Characteristics of Partnerships A partnership is easy to form; two or more persons simply agree to be partners in a business venture. Because a partnership is a voluntary association rather than a legal entity, a partner is responsible under the law not only for the debts of the business, but also for the actions of other partners within the scope of the business. However, a partner can choose the people who join the partner- ship and in doing so should select persons who share his or her business objectives and ethical standards. Partnerships have several advantages: They are not only easy to form, but also easy to change; all that is required is agreement among the partners. They facilitate the pooling of capital resources and individual talents. They have no corporate tax burden. Because partnerships are not legal enti- ties, they do not have to pay a federal income tax, as corporations do; how- ever, they must file an informational return. There is no federal income tax on partnerships; partners are taxed at They allow the partners a certain amount of freedom and flexibility in oper- their personal rates. However, ating the business. The hierarchy and structures usually found in corpora- partnerships must file an tions are not a necessary characteristic of partnerships. informational return with the IRS, and some state and local Partnerships also have certain disadvantages: governments levy taxes on them. The life of a partnership is limited. One partner can bind the partnership to a contract (a characteristic called mutual agency). The partners have unlimited personal liability for the debts of the business. Partnerships have more difficulty than corporations in raising large amounts of capital, and transfer of ownership is also more difficult. To maximize the advantages of a partnership and minimize the disadvan- tages, the partners must have a carefully planned partnership agreement that covers various contingencies. Although this agreement does not have to be in writing, good business practice calls for a written document that clearly states the details of the arrangement. A partnership agreement should include the following: Name, location, and purpose of the business Names of the partners and their respective duties Investments of each partner Appendix B 11/9/06 4:30 PM Page B-5 Partnerships and Related Forms of Business | B-5 The advantages of partnerships are that they are easy to form and change, they facilitate the pooling of capital resources and talents, they pay no corporate taxes, and partners have a certain freedom and flexibility in operating the business. Because of these advantages, many people form partnerships with siblings or spouses. The husband and wife shown here are partners in a bakery enterprise. Method of distributing income and losses Procedures for the admission and withdrawal of partners, withdrawal of assets allowed each partner, and the liquidation (termination) of the business Important considerations in drafting a partnership agreement are limited life, mutual agency, unlimited liability, co-ownership of property, participation in income or losses, and terms of dissolution and liquidation. Limited Life Because a partnership is formed by an agreement between partners, it has a limited life. In contrast, a corporation, which is chartered by a state, has an unlimited life. A partnership is dissolved when a partner is admit- ted, withdraws, goes bankrupt, is incapacitated (to the point that he or she can- not perform as obligated), retires, or dies, or when the terms of the partnership agreement are met (e.g., when the project for which the partnership was formed is completed). The partnership agreement can be written in a way that allows the partnership to continue under any of these circumstances. For example, the agreement can state that if a partner dies, the remaining partner or partners must purchase the deceased partner’s capital at book value from the heirs. Mutual Agency Each partner is an agent of the partnership within the scope of the business. Because of this mutual agency, any partner can bind the partnership to a business agreement as long as it is within the scope of the company’s normal operations. For example, partners in a used-car business can bind the partnership to a contract that involves the purchase or sale of used cars. But they cannot bind the partnership to a contract for buying chil- dren’s clothing or any other goods unrelated to the used-car business. Because of mutual agency, it is very important that the persons admitted to a partner- ship have integrity and share the business objectives of the other partners. For example, an unscrupulous partner could engage the partnership in a question- able business deal without the knowledge of the other partners. Unlimited Liability Each partner has unlimited liability (i.e., personal responsibility) for all the debts of the partnership. If a partnership cannot pay Appendix B 11/9/06 4:30 PM Page B-6 B-6 | APPENDIX B Partnerships its debts, creditors must first satisfy their claims from the assets of the busi- ness. If those assets are not enough to pay all debts, the creditors can seek payment from the personal assets of each partner. If one partner’s personal assets are used up before the debts are paid, the creditors can claim the per- sonal assets of the other partners. The only way a partner can avoid this liabil- ity is by declaring personal bankruptcy. (As discussed below, some states allow a partnership to be formed under a limited liability partnership law that pro- tects the personal assets of partners in most situations.) Co-Ownership of Property When people invest property in a part- nership, they give up the right to their separate use of the property. The prop- erty becomes an asset of the partnership and is owned jointly by the partners. Participation in Income or Losses Each partner has the right to share in the firm’s income and the responsibility to share in its losses. The part- nership agreement should state the method of distributing income and losses to each partner. If the agreement describes how income should be shared but does not mention losses, then losses are distributed in the same way as income. If the agreement does not describe the method of income and loss distribution, then the partners must by law share income and losses equally. Dissolution and Liquidation The partnership agreement should con- sider the financial consequences of a partner’s entering or withdrawing from the firm, which will result in the dissolution or liquidation of the partnership. If the agreement does not specify how these issues are to be resolved, state laws will prevail, and the result may adversely affect one or more partners. Special Types of Partnerships In the sections that follow, we discuss special types of partnerships that over- come some of the disadvantages of the basic form. Limited Partnerships As we have noted, the potential loss of all part- ners in an ordinary partnership is limited only by personal bankruptcy laws.
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