THEME: PARTNERSHIPS. By John W. Day. The following is a definition of a Partnership from The Tax Book page 20-2:

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1 THEME: PARTNERSHIPS By John W. Day ACCOUNTING TERM: Partnership The following is a definition of a Partnership from The Tax Book page 20-2: An unincorporated organization with two or more members is a partnership by default for federal tax purposes if its members carry on a trade, business, or financial operation and divide profits. General partnership. A general partnership is composed of only general partners. A general partner is a partner who is personally liable for partnership debts. Limited partnership. A limited partnership is formed under a state limited partnership law and composed of at least one general partner and one or more limited partners. A limited partner is a partner whose personal liability is limited. A limited partner cannot assume any management duties. FEATURE ARTICLE: Bread and Butter Partnerships It is often said that partnerships are like a marriage - easy to get into and hard to get out of. They even start out with a honeymoon period just like a marriage. As time goes by the partners discover each other s idiosyncrasies. Unless some good channels of communication are established along the way, divorce sometimes is the only solution. Although it is not required, a written partnership agreement may be the best and only way to part company in an amiable fashion. Why choose a partnership business entity in the first place? One very good reason is that it is so easy. All you and your partner need to do is to open the doors and start doing business. At the end of the year you file 1065 federal income tax form and you are a partnership. Another good reason is that it is comparatively inexpensive. There is no paperwork required or state fees to be paid. Furthermore, when the state partnership return is filed (at least in California) there is no tax to be paid. Of course, there will be a cost If you have an attorney draw up a partnership agreement. But why form a general partnership and be personally responsible for your share of the partnership debts when you could be protected by forming a corporation or Limited Liability Company? That is a good question that should be researched before making your decision. Sometimes corporations don t shield you from liability as in the case of service businesses such as doctors, accountants, attorneys, and the like. Copyright 2008 John W. Day 1

2 One s first line of defense should always be adequate insurance no matter what type of business organization is chosen. It s the simplicity that makes partnerships attractive. In addition, they are pass-through entities meaning that the profit or loss of the business flows directly to the partners and is reported on their individual tax returns on a K-1 form. The most common partnerships are simple ones and are referred to as bread and butter partnerships. It is true that partnerships can become very complex depending on the number of partners, the special agreements between the partners and the nature and amount of assets they have contributed that constitutes their ownership basis. Bread and butter partnerships usually have a few partners who have contributed specific amounts of capital and don t require many special allocations. The accounting for partnerships differs only slightly from other business entities. In the equity section, individual partner capital accounts are set up. Here is an example of how it might look: Partner A Capital Account Partner B Capital Account Partner C Capital Account Partner s Clearing Net Profit or <Loss> Each partner s capital account keeps track of the original contribution, i.e., money paid into the partnership for a share of ownership, increases from profits and additional contributions of capital, decreases from losses and capital draws. The balance of the partner s capital account represents his/her inside basis. A partner s actual basis may be different from his/her inside basis. A partner may have bought out another partner and paid that partner directly outside of the partnership. Therefore, partners must keep track of their actual or outside basis for their own tax purposes. The Partner Clearing account is used to distribute the profit or loss to the partner capital accounts. Most computer systems are not sophisticated enough to close the year end profit or loss into more that one account. Therefore, the Partner Clearing account is the account the total profit or loss is closed into. As you may know, the Net Profit or Loss account is not a regular general ledger account. It simply reflects the Net Profit or Loss amount coming from the Income and Expense Statement. It is closed into a general ledger account such as Retained Earnings for a corporation, or Owner s Equity for a sole proprietorship. However, you can designate whatever account you want and that is what we are doing with the Partner s Clearing account. Once the Net Profit or Loss is transferred into the Partner Clearing account, it is easy to write a general journal entry to allocate the total into the appropriate partner capital accounts. For Copyright 2008 John W. Day 2

3 example, let s say that the year end profit of the business was $12,000. this is what happens when the year end closing takes place: Net Profit or Loss 12,000 Partner Clearing 12,000 The next step is to do the allocation: Partner Clearing 12,000 Partner A Cap Acct 4,000 Partner B Cap Acct 4,000 Partner C Cap Acct 4,000 The only other general ledger accounts that are unique to a partnership are called guaranteed payments. These accounts are found in the operating expense section of the income and expense statement. Working partners don t take a salary as in a formal payroll system. They take a draw and the amount is recorded in the guaranteed payments account. This is a partnership deduction and reduces the net profit of the business. This way the compensation differences for work performed by the partners can be recorded accurately. The important thing to remember is that when the partners receive their K-1 form it will show the amount of the guaranteed payments received plus their share of the profit or loss. The entirety of this income is subject to self-employment tax (social security). If there is a profit, the partner s capital accounts will be increased. If there is a loss, the partner s capital accounts will be decreased. The partners have to report profit on their K-1 regardless if they receive a capital distribution (draw) from their capital accounts. Sometimes is happens that the business needs money for other things and can t pay the partners for the amount of their profit. It doesn t matter. The taxes still have to be paid. On the other hand, if the business sustains a loss, that loss will decrease the amount of the guaranteed payments that have to be recorded as income. Furthermore, if there are so many losses that it reduces a partner s capital account to zero (or a partner s basis to zero) then the partner cannot deduct any losses beyond a zero basis. Losses beyond zero have to be claimed as income and taxes paid accordingly. However, in a partnership, all debt is considered basis since the general partners are personally liable for it. So when figuring whether a loss can be taken, a partner s share of partnership debt must be added into the equation. This is where it starts getting tricky and why it is highly recommended that you consult a qualified tax professional for advice. Copyright 2008 John W. Day 3

4 QUESTION: What Happens When Partners Contribute Unequal Amount To The Partnership? They say there are different ways to skin a cat. If you want to keep your partnership simple you might try this: Let s say you have two partners who want to have a 50/50 partnership. Partner A has $5,000 and partner B has $500. An easy way to deal with this is to have them both contribute $500. Now it is 50/50. The remaining $4,500 can be set up as a loan to the partnership from partner A. The partners can agree on how quickly the $4,500 will be paid back. Cash 5,500 Part A Capital Acct 500 Part B Capital Acct 500 Due to Partner A 4,500 Maybe partner B will be able to come up with $1,000 in six months. Once partner B puts in the $1,000, partner A can take $1,000 from the loan and contribute it. For instance: Cash 1,000 Part B Capital Acct Due to Partner A 1,000 Part A Capital Acct 1,000 Another scenario might be that partner B will contribute labor for the $4,500 difference. There should a very clear agreement as to exactly what partner B will do. The $4,500 will be construed as a guaranteed payment to partner B and considered as taxable income just as though the payment came in the form of cash. The guaranteed payment is deductible by the partnership. The accounting would work like this: Cash 5,500 Guaranteed Pymnt (B) 4,500 Partner A Capital Acct 5,000 Partner B Capital Acct 5,000 The idea is to keep things simple so the partners know exactly where they stand with each other. If one partner works and the other doesn t it is imperative that the partners agree on the compensation package for the working partner. The Copyright 2008 John W. Day 4

5 working partner could believe that he/she is underpaid and continue to take increasing amounts. The non-working partner might never see any profit for his/her investment. No matter how you cut it, it s a marriage. Tip: Some Things to Keep in Mind About Partnerships If it is agreed that partners are required to pay for partnership expenses that will not be reimbursed by the partnership, make doubly sure that this is stated in the partnership agreement. Because, if there is not a provision for this in the partnership agreement, those expenses will not be deductible on the partner s personal tax return. A partnership is considered terminated if at least 50% of the total interest in partnership capital and profits is sold or exchanged within a 12-month period, including a sale or exchange to another partner. This is one that can sneak up on you. It can be a big hassle to find out that you didn t close the books on the old partnership and open up new books on the new partnership. Sometimes when a business hasn t been very profitable, partners have been able to take losses on their tax returns due to a large amount of debt basis in the partnership. If a partner dies, that partner is responsible for his/her share of that debt. Be sure that the partnership agreement is real clear about who will be responsible for the partner who dies liabilities. Will it be the partner s estate or spouse? After all, it is a debt just like any other debt. It would be best to have the partner s spouse sign an acknowledgement of this beforehand. John W. Day, MBA is the author of two courses in accounting basics: Real Life Accounting for Non-Accountants (20- hr online) and The HEART of Accounting (4-hr PDF). Visit his website at to download his FREE e-book pertaining to small business accounting and his monthly newsletter on accounting issues. Ask John questions directly on his Accounting for Non-Accountants blog Copyright 2008 John W. Day 5