1. Chapter Nine Partnerships: Formation and Operation McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

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) 9-2

3. Economic Importance of Partnerships The Internal Revenue Service projects that by 2012, nearly 3.6 million partnership income tax returns will be filed in the United States (Source: www.irs.gov)www.irs.gov Rationale:  Reducing expenses, increasing expertise and expanding services  Tax benefits  Easily created by families and friends  Required by some professions (although these restrictions are fast disappearing) 9-3

4. Partnership Advantages Flexibility in defining relationships  Ownership interest and profit distribution may not be dependent on investment  Losses may be allocated differently than profits Ease of formation and dissolution Easier to implement a desired control format  Not based on ownership percentage of voting shares as with corporations Taxed on a “flow-through” (conduit) basis  The partnership itself does not pay income taxes  Income, deductions and tax credits are “passed through” to the partners, based on their respective percentage interests. The partners report these on their individual returns 9-4

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 9-5

6. 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. 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. 9-6

7. Alternative Legal Forms - Subchapter S Corporation Often referred to as an S-Corp... Has all the legal characteristics of a corporation.... Profit passes to owners just as with a partnership.... Ownership is limited to 75 stockholders. Owners limited to individuals, estates, and certain tax- exempt entities and trusts... Has all the legal characteristics of a corporation.... Profit passes to owners just as with a partnership.... Ownership is limited to 75 stockholders. Owners limited to individuals, estates, and certain tax- exempt entities and trusts 9-7

8. Alternative Legal Forms - Limited Partnership Tax benefits of a partnership without unlimited liability.... A number of “limited” partners who are not allowed to participate in management.... Losses are restricted to amount invested.... Must have one or more general partners who assume responsibility for all obligations.... A number of “limited” partners who are not allowed to participate in management.... Losses are restricted to amount invested.... Must have one or more general partners who assume responsibility for all obligations. 9-8

9. Alternative Legal Forms – Limited Liability Partnerships... Most of the characteristics of a general partnership. EXCEPT... Partners are liable only for their own acts and omissions, and the acts and omissions of those under their direct supervision.... Most of the characteristics of a general partnership. EXCEPT... Partners are liable only for their own acts and omissions, and the acts and omissions of those under their direct supervision. LLP laws differ from state to state. 9-9

10. Alternative Legal Forms – Limited Liability Companies... Classified as a partnership for tax purposes.... Owners only risk their own investments.... The number of owners is not usually restricted.... Classified as a partnership for tax purposes.... Owners only risk their own investments.... The number of owners is not usually restricted. LLC laws differ from state to state. 9-10

11. 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. 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

12. Articles of Partnership Put it in writing!!! Rights and responsibilities of partners Initial contribution to be made by each partner Method for settling a partner’s share upon withdrawal, retirement or death Profit/loss sharing percentages Method for dispute settlements Method for admitting new partners 9-12

13. Articles of Partnership Put it in writing!!! Life insurance provisions enabling survivor acquisition of decedent interest Method for valuing individual contributions Name and Address of Each Partner Name and Address of Each Partner Withdrawal limits BusinessLocationBusinessLocation Description of the Nature of the Business Description of the Nature of the Business 9-13

14. Accounting for Capital Contributions If the partners each contribute cash...... debit Cash.... credit individual Partner Capital accounts. 9-14

15. Accounting for Capital Contributions If the partners each contribute cash and other assets...... debit Cash & Contributed Assets for FV.... credit individual Partner Capital accounts. If the partners each contribute cash and other assets...... debit Cash & Contributed Assets for FV.... credit individual Partner Capital accounts. 9-15

16. Accounting for Capital Contributions Intangible assets, such as expertise, require special consideration Use either the Bonus Method or the Goodwill Method. Intangible assets, such as expertise, require special consideration Use either the Bonus Method or the Goodwill Method. Record the tangible assets contributed. Adjust the partner capital balances to reflect the relative value of the intangible asset. Record the tangible assets contributed. Adjust the partner capital balances to reflect the relative value of the intangible asset. 9-16

17. Prepare the journal entry to set up the partnership. Intangible Contributions - Bonus Method 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. 9-17

18. 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. 9-18

19. Intangible Contributions - Goodwill Method Record the tangible assets contributed. Record the tangible assets contributed. Record the contributed intangible asset as the difference between the contributed tangible assets and the implied value of the partnership. Record the contributed intangible asset as the difference between the contributed tangible assets and the implied value of the partnership. Record the tangible assets contributed. Record the tangible assets contributed. Record the contributed intangible asset as the difference between the contributed tangible assets and the implied value of the partnership. Record the contributed intangible asset as the difference between the contributed tangible assets and the implied value of the partnership. 9-19

20. Prepare the journal entry to set up the partnership. Intangible Contributions - Goodwill Method 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. 9-20

21. Intangible Contributions - Goodwill Method ÷ 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. 9-21

22. Intangible Contributions - Goodwill Method Cookie’s capital account is credited for the tangible contribution of $80,000. Bijou’s capital account is credited for the tangible contribution of $40,000, plus the intangible contribution valued at $40,000. Cookie’s capital account is credited for the tangible contribution of $80,000. Bijou’s capital account is credited for the tangible contribution of $40,000, plus the intangible contribution valued at $40,000. 9-22

23. Allocation of Income The allocation of income is not necessarily based on the relative capital balances.  It is a separately negotiated item. Items to be allocated: Allocated compensation Bonuses Remaining income Interest on beginning capital balances 9-23

24. 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 partners are credited with 10% interest on their beginning capital balance. In addition, Mushon is credited with a bonus of $20,000 per the partnership agreement. They share income 40:60 (Mushon:Gee). What are the ending capital balances for each partner? 9-24

25. Allocation of Income Example 9-25

26. Allocation of Income Example 9-26

27. Allocation of Income Example 9-27

28. Allocation of Income Example 9-28

29. Legal Dissolution Any alteration in the specific individuals composing a partnership automatically leads to “legal dissolution”  Departures  Retirement  Death  Admission of a New Partner Promotions Buy-ins Frequently this leads to the immediate formation of a new partnership as the business continues Can lead to termination and liquidation 9-29

30. These two rights can be sold (unless restricted by the articles of partnership ) This right cannot be sold without the other partners’ approval. 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 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. An individual partner’s ownership rights include: The right to co-ownership 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. 9-30

31. Partnership Dissolution - Admission of a New Partner When the makeup of the partnership changes, the partnership is dissolved. When the makeup of the partnership changes, the partnership is dissolved. A new partnership is immediately formed. A new partnership is immediately formed. New partner acquires partnership interest by: New partner acquires partnership interest by:  Purchasing it from the other partners, or  Making a contribution to the partnership. When the makeup of the partnership changes, the partnership is dissolved. When the makeup of the partnership changes, the partnership is dissolved. A new partnership is immediately formed. A new partnership is immediately formed. New partner acquires partnership interest by: New partner acquires partnership interest by:  Purchasing it from the other partners, or  Making a contribution to the partnership. 9-31

32. Admission of a New Partner - Purchase of a Current Interest A new partner can purchase partnership interest directly from the existing partners. A new partner can purchase partnership interest directly from the existing partners.  The cash goes to the partners, not to the partnership. Two methods are available to account for the transfer of ownership: Two methods are available to account for the transfer of ownership:  Book Value Approach  Goodwill (Revaluation) Approach A new partner can purchase partnership interest directly from the existing partners. A new partner can purchase partnership interest directly from the existing partners.  The cash goes to the partners, not to the partnership. Two methods are available to account for the transfer of ownership: Two methods are available to account for the transfer of ownership:  Book Value Approach  Goodwill (Revaluation) Approach 9-32

33. Book Value Example Mare, Mic and Roma have a partnership. Using the Book Value Approach, prepare the entry assuming Nia pays $60,000 directly to the other partners for a 20% partnership interest. Admission of a New Partner - Purchase of a Current Interest 9-33

34. Admission of a New Partner - Purchase of a Current Interest Book Value Example The cash goes to Mare, Mic and Roma, NOT to the partnership. Each partner gives up 20% of their existing capital. Book Value Example The cash goes to Mare, Mic and Roma, NOT to the partnership. Each partner gives up 20% of their existing capital. Prepare the journal entry to admit Nia to the partnership. 9-34

35. Admission of a New Partner Purchase of a Current Interest Book Value Example The cash goes to Mare, Mic and Roma, NOT to the partnership. Each partner gives up 20% of their existing capital. Book Value Example The cash goes to Mare, Mic and Roma, NOT to the partnership. Each partner gives up 20% of their existing capital. 9-35

36. Goodwill (Revaluation) Example Mare, Mic and Roma have a partnership. Using the Goodwill Approach, prepare the entry assuming Nia pays $60,000 directly to the other partners for a 20% partnership interest. Goodwill (Revaluation) Example Mare, Mic and Roma have a partnership. Using the Goodwill Approach, prepare the entry assuming Nia pays $60,000 directly to the other partners for a 20% partnership interest. Admission of a New Partner - Purchase of a Current Interest 9-36

37. Admission of a New Partner - Purchase of a Current Interest Goodwill (Revaluation) Example The implied value of the partnership is $300,000  $60,000 ÷ 20% = $300,000 First, compute the Goodwill Goodwill (Revaluation) Example The implied value of the partnership is $300,000  $60,000 ÷ 20% = $300,000 First, compute the Goodwill 9-37

38. 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 %. (40:25:35) Goodwill (Revaluation) Example Allocate the $160,000 of Goodwill to the existing partners, based on their income sharing %. (40:25:35) Prepare the journal entry to allocate goodwill to Mare, Mic and Roma. 9-38

39. 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 %. (40:25:35) Goodwill (Revaluation) Example Allocate the $160,000 of Goodwill to the existing partners, based on their income sharing %. (40:25:35) 9-39

40. Admission of a New Partner - Purchase of a Current Interest Goodwill (Revaluation) Example The new balances for Mare, Mic and Roma appear as follows: Next, allocate 20% from each of the existing partners to Nia. Goodwill (Revaluation) Example The new balances for Mare, Mic and Roma appear as follows: Next, allocate 20% from each of the existing partners to Nia. 9-40

41. Admission of a New Partner - Purchase of a Current Interest Revaluation Example Note that Nia’s balance, after allocation from the current partners, equals Nia’s contribution of $60,000. Revaluation Example Note that Nia’s balance, after allocation from the current partners, equals Nia’s contribution of $60,000. 9-41

42. Admission of a New Partner - Contribution to the Partnership The new partner can gain partnership interest by contributing cash to the partnership. The new partner can gain partnership interest by contributing cash to the partnership. Remember that the new cash will increase the partnership’s net assets. Remember that the new cash will increase the partnership’s net assets. Two methods are: Two methods are:  Bonus Approach  Goodwill Approach The new partner can gain partnership interest by contributing cash to the partnership. The new partner can gain partnership interest by contributing cash to the partnership. Remember that the new cash will increase the partnership’s net assets. Remember that the new cash will increase the partnership’s net assets. Two methods are: Two methods are:  Bonus Approach  Goodwill Approach 9-42

43. Bonus Example Mare, Mic and Roma have a partnership. Using the Bonus Approach, prepare the entry assuming Nia pays $60,000 to the partnership for a 20% partnership interest. Admission of a New Partner - Contribution to the Partnership 9-43

44. Bonus Example Net assets after the contribution are $200,000. Nia gets credit for 20% of net assets ($200,000 x 20%). The remainder of the $60,000 contribution is allocated to the other partners. Bonus Example Net assets after the contribution are $200,000. Nia gets credit for 20% of net assets ($200,000 x 20%). The remainder of the $60,000 contribution is allocated to the other partners. Note that the $200,000 results from the net assets of the partnership of $140,000 + Nia’s $60,000 contribution. Prepare the journal entry. Admission of a New Partner - Contribution to the Partnership 9-44

45. Note that the $200,000 results from the net assets of the partnership of $140,000 + Flatt’s $60,000 contribution. Prepare the journal entry. Bonus Example Net assets after the contribution are $200,000. Nia gets credit for 20% of net assets ($200,000 x 20%). The remainder of the $60,000 contribution is allocated to the other partners. Bonus Example Net assets after the contribution are $200,000. Nia gets credit for 20% of net assets ($200,000 x 20%). The remainder of the $60,000 contribution is allocated to the other partners. Admission of a New Partner - Contribution to the Partnership 9-45

46. Goodwill Example Mare, Mic and Roma have a partnership. Using the Goodwill Approach, prepare the entry assuming Nia pays $60,000 to the partnership for a 20% partnership interest. Goodwill Example Mare, Mic and Roma have a partnership. Using the Goodwill Approach, prepare the entry assuming Nia pays $60,000 to the partnership for a 20% partnership interest. Admission of a New Partner - Contribution to the Partnership 9-46

47. 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) 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) Prepare the journal entry to allocate goodwill to Mare, Mic and Roma. 9-47

48. 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) 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) 9-48

49. Admission of a New Partner - Contribution to the Partnership Goodwill Example After allocating the goodwill to the original partners, record Nia’s cash contribution and credit Nia’s capital account. Prepare the journal entry to admit Nia to the partnership. 9-49

50. Admission of a New Partner - Contribution to the Partnership Goodwill Example After allocating the goodwill to the original partners, record Nia’s cash contribution and credit Nia’s capital account. Prepare the journal entry to admit Flatt to the partnership. 9-50

51. 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 9-51

52. 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???? 9-52