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Partnership characteristics reviewed.

In 1977 Wyoming became the first state to pass legislation permitting Limited Liability Companies (LLCs). Since then, an additional 24 states have passed similar legislation. LLCs have often been compared to regular partnerships. It now seems appropriate to review the rules about partnerships.

A partnership is defined as an association of individuals who agree to carry on as co-owners of a business for profit. Merely owning property together doesn't constitute a partnership. The owners must provide a service or otherwise function as a business. While oral or "handshake agreements" are sufficient to bind partners together, a written agreement should be drawn between the partners. This contract should spell out what the firm will do and who the partners are, what each partner contributes, how profits and losses will be distributed and what to do when the partnership changes.

Partnerships are relatively easy to form and to run and allow individuals to amass greater amounts of talent and capital than an individual could alone. Its primary value is that the firm itself is not taxed. All income is passed through to the partners on the business return.

Characteristics of Partnerships

There are four primary characteristics of a partnership, three of which are considered disadvantages of this business form! A partnership is a separate economic entity and as such its assets, liabilities and transactions are kept distinct from those of the owners. Once assets are transferred from the owners to the partnership the assets are co-owned by all the partners. While each partner has a claim against assets of the firm equal to the balance in his/her capital account, that claim is not related to a specific asset.

Mutual agency allows any partner to bind the partnership to a contract as long as the act is within the scope of the partnership's field of business. Thus, a partnership whose business it is to build boats would be obligated to honor a contract to build a sailboat entered into by one of the partners (even if that action exceeded the authority of that partner) while a partnership of veterinarians would not be bound to the same contract.

The lifetime of a partnership is limited by the lifetime of each of the partners. So long as the original partners continue to be bound by the partnership agreement, the partnership lives. However, once a new partner is accepted or a partner withdraws or dies, the partnership is dissolved.

Another characteristic of partnerships is that of unlimited liability. Each partner is personally liable for all partnership liabilities. While some states allow for limited partners whose liability is confined to the amount of the investment in the firm, there must always be at least one general partner whose liability is unlimited. The advantage of LLCs is to provide such general partners with a limited liability.

The assets and liabilities brought to a partnership by each owner at its formation are valued at fair market value on the date of investment. The owner's equity of that partner is the difference between assets and liabilities thus contributed.

For example, Hilda Gaard brings to her new partnership venture assets worth $25,000, a building valued at $100,000 with a $72,000 mortgage and current liabilities of $13,000. Her initial capital investment in the firm is $40,000.

If all the original partners agree, new partners can be brought into the firm. If the new partner purchases an interest from one of the original partners, the capital account is simply transferred to the new partner. The new partner might also contribute assets to the firm in return for an equity share. If the partnership is very attractive, the new individual may be willing to pay more than the actual equity share received in the partnership. In this case, a bonus is given to the original partners, divided according to their profit/loss ratios.

A struggling partnership may wish to entice a new partner with talent or resources into the firm and offer a capital interest greater than the dollars invested by the new partner. In this case, the bonus is from the old partners to the new, divided in the same manner.

According to the Uniform Partnership Act, partnership agreements that are silent with regard to profits and losses will share equally in both. If the agreement discusses profits but not losses, the losses will be shared in the same manner as profits. Generally profits and losses are allocated using some ratio that may be in proportion to amounts contributed to the firm or amount of time actually worked. Partners can be apportioned a "salary" or "interest" on their investment. These are not expenses as we usually think of salaries and interest but are merely tools that assist in a rational apportionment of the profits. Salaries and interest must be distributed, even if the result is to require the subsequent distribution of a negative amount.

It is the final result of these distribution techniques that is shown as the partner's share and passed through the partnership to the individual owner. This amount needn't correspond to what the partner actually took out of the firm during the year.

Below is an opportunity to refresh your skills on partnership formation and income distribution. The answers will be published in next month's issue!

September Quiz

Meg A. Byte and CD Romm formed a partnership on January 1, 1991, to operate a computer software store. Meg contributed cash totalling $116,000 and equipment valued at $84,000 to the firm. CD transferred cash of $56,000, land valued at $36,000 and a building valued at $300,000. The partnership assumed the $232,000 mortgage on the building.

In the partnership agreement, the owners specified that income and losses would be distributed by allowing 10% interest on initial capital balances, salaries of $20,000 to Meg and $48,000 to CD, with the remaining amount divided using a 3:2 ratio. For the first year, the store reported a loss of $16,000.

On January 1, 1992, the partners brought Tex Packedge, an accounting software expert, into the business. Tex invested $56,000 into the the partnership for a 20% interest. The new partnership agreement required the same 10% interest on beginning capital balances for the year, salaries of $20,000, $48,000 and $60,000 for Meg, CD and Tex respectively, with the balance to be divided equally. During 1992, the company earned $108,000.

Prepare journal entries to record the partnership activities described above.
COPYRIGHT 1993 National Society of Public Accountants
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Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Accounting Scene
Author:Winicur, Barbara
Publication:The National Public Accountant
Date:Sep 1, 1993
Words:1084
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