Characteristics of a partnership include the following: o
Moderately complex to form A partnership is often formed with a partnership agreement. – A partnership agreement includes matters such as amounts to be invested, limits on withdrawals, distributions of income and losses, and admission and withdrawal of partners.
No limitation on legal liability The partners are personally liable for any debts or legal claims against the partnership.
Not taxable For federal income tax purposes, a partnership is not taxed. Instead, the proprietorship’s income or loss is “passed through” to the partners’ individual income tax returns.
Limited life When the owner dies or retires, the partnership ceases to exist.
Characteristics of an LLC include the following: o
Moderately complex to form An LLC requires an agreement among the owners, who are called members. – The operating agreement includes matters such as amounts to be invested, limits on withdrawals, distributions of income and losses, and admission and withdrawal of partners.
Limited legal liability Only the members’ investments in the company are subject to claims of creditors.
Not taxable An LLC may elect to be treated as a partnership for tax purposes. Thus, income passes through the LLC and is taxed on the individual members’ tax returns.
Unlimited life Most LLC operating agreements specify continuity of life for the LLC, even when a member withdraws or new members join the LLC.
Moderate ability to raise capital (funds) Because of their limited liability, LLCs are attractive to many investors, thus allowing for greater access to capital (funds) than is normally the case in a partnership.
• In forming a partnership, the investments of each • • •
partner are recorded in separate entries. The assets contributed by a partner are debited to the partnership asset accounts. If any liabilities are assumed by the partnership, the partnership liability accounts are credited. The partner’s capital account is credited for the net amount.
• One method of dividing partnership income is based •
on the services provided by each partner to the partnership. These services are often recognized by partner salary allowances. o
Such allowances reflect differences in partners’ abilities and time devoted to the partnership. Such allowances are recorded as divisions of net income and are credited to the partners’ capital accounts.
Dividing Income: Services of Partners and Investments
• A partnership agreement may divide income based
upon interest on capital balances of each partner. In this way, partners with more invested in the partnership are rewarded by receiving more of the partnership income. One such method of dividing partnership income would be as follows: 1. 2. 3.
Partner salary allowances Interest on capital investments Any remaining income equally
• In some cases, the net income may be less than the total of the allowances. In this case, the remaining net income to divide is a negative amount. This negative amount is divided among the partners as though it were a net loss.
When a new partner is admitted by purchasing an interest from one or more of the existing partners, the total assets and the total owners’ equity of the partnership are not affected. The capital (equity) of the new partner is recorded by transferring capital (equity) from the existing partners. When a new partner is admitted by contributing assets to the partnership, the total assets and the total owners’ equity of the partnership are increased. The capital (equity) of the new partner is recorded as the amount of assets contributed to the partnership by the new partner.
Admitting a Partner: Purchasing an Interest from Existing Partners
• When a new partner is admitted by purchasing an
interest from one or more of the existing partners, the transaction is between the new and existing partners acting as individuals. The admission of the new partner is recorded by transferring owners’ equity amounts from the capital accounts of the selling partners to the capital account of the new partner.
• Before a new partner is admitted, the balances of a partnership’s asset accounts should be stated at current values. If necessary, the accounts should be adjusted. o
Any net adjustment (increase or decrease) in asset values is divided among the capital accounts of the existing partners, similar to the division of income. Failure to adjust the partnership accounts for current values before admission of a new partner may result in the new partner sharing in asset gains or losses that arose in prior periods.
If the partnership purchases the withdrawing partner’s interest, the assets and the owners’ equity of the partnership are reduced by the purchase price. The entry to record the purchase debits the capital account of the withdrawing partner and credits Cash for the amount of the purchase. o
If not enough partnership cash is available to pay the withdrawing partner, a liability may be created (credited) for the amount owed the withdrawing partner.
• When a partner dies, the partnership accounts should • •
be closed as of the date of death. The net income for the current period should then be determined and divided among the partners’ capital accounts. The asset accounts should also be adjusted to current values and the amount of any adjustment divided among the capital accounts of the partners.
• After the income is divided and any assets revalued, an entry is recorded to close the deceased partner’s capital account. The entry debits the deceased partner’s capital account for its balance and credits a liability account, which is payable to the deceased’s estate.
• When a partnership goes out of business, it sells the
assets, pays the creditors, and distributes the remaining cash or other assets to the partners. This winding-up process is called the liquidation of the partnership. When the partnership goes out of business and the normal operations are discontinued, the accounts should be adjusted and closed. o
The only accounts remaining open will be the asset, contra asset, liability, and owners’ equity accounts.
• The steps in the liquidation process are as follows: o
Step 1. Sell the partnership assets. This step is called realization. Step 2. Distribute any gains or losses from realization to the partners based on their income-sharing ratio. Step 3. Pay the claims of creditors, using the cash from the step 1 realization. Step 4. Distribute the remaining cash to the partners based on the balances in their capital accounts.