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CHAPTER 24
PARTNERSHIPS:
FORMATION AND OPERATION
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FOCUS OF CHAPTER 24
 Types of Partnerships
 Major Features of the Partnership
Form of Business
 Formation of a Partnership
 Methods to Share Profits and Losses
 Financial Reporting Issues
 Income Tax Aspects
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Definition of a Partnership
 A partnership is an association of two or more
persons who:
 Are co-owners of a business.
 Share profits and losses in
an agreed-upon manner.
 A person can be:
 An individual.
 A corporation.
 Another partnership.
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Types of Partnerships
 General Partnerships:
 All
partners have unlimited
 Thus
liability.
creditors can go after the personal
assets of any or all of the partners.
 Since 1993, many accounting firms have
abandoned this form of organization in
favor of limited liability partnerships (LLPs).
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Types of Partnerships
 Limited Liability Partnerships (LLPs):
 A partner’s personal assets are at risk only
for:



His or her OWN negligence and
wrongdoing.
The negligence and wrongdoing of
those under his or her control.
This form of organization has not been
tested in the courts.
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Types of Partnerships
 Limited Partnerships:
 Certain partners have limited liability to
partnership creditors if the partnership is
unable to pay its creditors.
 Usually the partner’s risk is limited to
the partner’s capital invested.
 Thus personal assets are not at risk.
At
least 1 of the partners
must be a general partner.
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Partnership Form of Organization:
Advantages & Disadvantages
 Advantages:
 Ease of formation.
 Lack of formality.
 A closer sense of bonding among partners.
 Single taxation (see following slide).
 Disadvantages:
 Unlimited liability (for general partnerships).
 Difficulty of disposing of interest.
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Partnership Form of Organization:
Income Tax Reporting
 Single Taxation of Partnership Earnings:
 Partnerships only report their earnings-they are not taxed at the business entity
level (as are corporations ).
 Partnerships file IRS Form 1065, which
shows the allocation of profits among
partners.
 Partners report their share of profits on
their individual IRS Form 1040 return.
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The Uniform Partnership Act (UPA)
 Each state has laws governing
the conduct of partnerships.
 Most states have adopted the RUPA or a
variation thereof. The RUPA covers:
 Relations of partners to one another.
 Relations of partners to persons dealing
with the partnership.
 Dissolution and winding up of the
partnership.
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The Partnership Agreement
 The Partnership Agreement: A written
expression of what the partners have agreed
to. Examples of areas addressed are:
 Manner of sharing profits.
 Limitations on withdrawals.
 Rights of partners.
 Settling with withdrawing partners.
 Expulsion of partners.
 Conflicts of interest.
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General Matters
 SEPARATENESS: The business of a
partnership should always be accounted for
separately from the partners’ personal
transactions.
 GAAP: Partnerships--unlike public
corporations--do not have to follow GAAP;
often they do not.
 FOCUS: The accounting focus is achieving
equity (fairness) among the partners.
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Partners’ Accounts
 Each partner can have:
 A capital account.
 A drawing account (a contra capital
account--closed out at year-end).
 A loan account (loans usually earn interest-a partnership expense).
 Partnerships do NOT use:
A
retained earnings account.
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Recording the Capital Contributions
 Two Fundamental Principles for
Achieving Equity
among the Partners:
 Current values should be used to value:
 Noncash assets contributed to a
partnership.
 Liabilities assumed by a partnership.
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Methods to Share Profits and Losses
 Partners can share profits and losses in any
way they choose. Possible ways include:
 Ratios.
 Salary allowances and ratios.
 Imputed interest on capital, salary
allowances, and ratios.
 Capital balances only.
 Performance methods.
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Methods to Share Profits and Losses:
Order of Priority Provision
 When an “order of priority”
provision exists:
 The exact sequence for sharing profits
and losses specified in the partnership
agreement must be followed.
 The next lower level method of sharing can
be reached if and only if there is still
unallocated profit remaining after dealing
with the current level.
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Review Question #1
 Dee and Jay created a partnership (D&J) on
12/31/03 (sharing profits 50-50). Dee contributed
equipment from her sole proprietorship having a
carrying value of $5,000 and a fair value of $9,000. In
2004, D&J had profits of $88,000 and borrowed
$20,000 from a bank. In 2004, Dee withdrew $30,000
cash. Dee’s Y/E capital balance is:
A. $13,000
B. $19,000
C. $23,000
D. $43,000
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Review Question #1--With Answer
 Dee and Jay created a partnership (D&J) on
12/31/03 (sharing profits 50-50). Dee contributed
equipment from her sole proprietorship having a
carrying value of $5,000 and a fair value of $9,000. In
2004, D&J had profits of $88,000 and borrowed
$20,000 from a bank. In 2004, Dee withdrew $30,000
cash. Dee’s Y/E capital balance is:
A. $13,000
B. $19,000
C. $23,000 ($9,000 + $88,000/2 - $30,000)
D. $43,000
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End of Chapter 24
(Appendix material follows)
Time to Clear Things Up-Any Questions?
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
Appendix A: Income Taxes
A partnership interest is a
capital asset--it is the
equivalent of owning shares of
common stock in a corporation.
 Individuals keep track of their
cost basis of shares owned in
corporations.
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Appendix A: Income Taxes
 Tax Basis: A partner’s cost basis in the
partnership--commonly referred to
merely as “basis.”
 Each partner keeps track of
his or her own tax basis.
Tracking is needed to determine the
taxable gain or loss to be reported on
the disposal of the partnership interest.
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Appendix A: Income Taxes
 Items That Increase Tax Basis:
 Profits.
 Capital contributions.
 An increase in partnership liabilities
(shared in the profit and loss sharing ratio).
 Items That Decrease Tax Basis:
 Losses.
 Capital withdrawals (distributions).
 A decrease in partnership liabilities.
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Appendix A: Income Taxes
What is the most important
thing to ignore for tax
reporting purposes?
ANSWER: A partner’s general
capital balance--it
ledger
is
totally irrelevant.
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Review Question #1A
 Dee and Jay created a partnership (D&J) on
12/31/03 (sharing profits 50-50). Dee contributed
equipment from her sole proprietorship having
(1) a carrying value of $5,000, (2) a tax basis of
$6,000, and (3) a fair value of $9,000. Dee’s tax
basis in D&J is:
A. $5,000
B. $6,000
C. $7,000
D. $8,000
E. $9,000
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Review Question #1A--With Answer
 Dee and Jay created a partnership (D&J) on
12/31/03 (sharing profits 50-50). Dee contributed
equipment from her sole proprietorship having
(1) a carrying value of $5,000, (2) a tax basis of
$6,000, and (3) a fair value of $9,000. Dee’s tax
basis in D&J is:
A. $5,000
B. $6,000
C. $7,000
D. $8,000
E. $9,000
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Review Question #2A
 Use the information in the preceding question,
but also assume that (1) Dee contributed a
$2,000 liability to D&J and (2) D&J borrowed
$4,000 from a bank on 12/31/03? What is Dee’s
tax basis in D&J?
A.
B.
C.
D.
E.
$5,000
$6,000
$7,000
$8,000
$9,000
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Review Question #2A--With Answer
 Use the information in the preceding question,
but also assume that (1) Dee contributed a
$2,000 liability to D&J and (2) D&J borrowed
$4,000 from a bank on 12/31/03? What is Dee’s
tax basis in D&J?
A.
B.
C.
D.
E.
$5,000
$6,000
$7,000 ($6,000 - [$2,000 x 50%] + [$4,000 x 50%])
$8,000
$9,000
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