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Advantages and Disadvantages of Partnerships
A partnership is one of the forms of business ownership structures. It is the same as the proprietorship, with the only difference being that the business has at least two owners. According to Horngren et al. (2012), the partnership comprises an association of at least two people who form a for-profit business as co-owners. The majority of businesses uses the partnership structure, especially service and small retail businesses. Moreover, many professionals such as accountants, investors, lawyers, and physicians often structure their practices in the form of partnerships. Partnerships are a crucial type of business structure since they provide particular advantages due to their distinctive features. Some of the unique features associated with partnerships include voluntary association, partnership agreement, limited life, taxation, mutual agency, unlimited liability, and property co-ownership (Jeter, Chaney, & Bline, 2010).
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When accounting for partnerships, a number of important factors should be taken into account. First, the partnership is considered a separate business entity. Second, accounting for partnerships allows the use of modified cash basis of accounting, cash basis accounting, and accrual accounting (Horngren et al., 2012). This paper discusses the advantages and disadvantages associated with partnerships, the Financial Accounting Standards (FAS) governing the creation, operation, and liquidation of partnerships, and the tax consequences of partnerships.
There are unique advantages and disadvantages associated with partnerships as a form of business structure. Prior to delving into the benefits and drawbacks of partnerships, it is imperative to know how this business structure operates, which in turn results in its pros and cons (Needles, Powers, & Crosson, 2013). The partnerships often take the form of an agreement of at least two people having an objective of financing and operating a business. In a general partnership, the losses and profits are filed in the tax returns of the partners. Moreover, partnerships are structured such that the partners have an equal authority and responsibility with respect to running the business. In addition, Reimers (2014) points out that all partners must participate in the daily operations of the business and engage in managerial decision-making. Furthermore, any partner can legally represent the business without seeking the consent of other partners, which means that the actions undertaken by one partner are binding to all the other members (Warren, Reeve, & Duchac, 2011). For instance, when one partner enters into a contractual agreement on behalf of the business, then all other members, as well as the general partnership, are liable for that contract.
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Establishing a partnership appears the most suitable option in certain instances, such as when forming a small business likely to have a low turnover (Needles et al., 2013). The manner in which the partnership is formed, ran, governed, and taxed usually makes it the most attractive form of business structure. Nevertheless, there are certain scenarios wherein the partnership is not an ideal form of business structure. The concept of shared ownership associated with partnerships has both advantages and disadvantages. Establishing partnerships is an easy process; nevertheless, Warren et al. (2011) underline the importance of taking sufficient time to develop the partnership agreement, including the manner in which the business will be funded, the allocation of responsibilities, as well as the next course of action in case of the death of a partner and partnership dissolution. In the partnership, partners share decision-making, liabilities, and profits, which is one of the important advantages associated with this business structure, especially in cases where partners have diverse skills and can cooperate effectively (Reimers, 2014). Even so, some problems are likely. There are numerous documented cases where partnerships have been dissolved due to partners’ disagreement because of business and personal reasons, which is one of the key problems associated with this business structure. Therefore, it is imperative to balance the advantages and disadvantages of partnerships to ensure their viability in the long-term.
One of the benefits associated with partnerships is the availability of capital. Partners often finance the business using a start-up capital; hence, when there are more partners, it implies more availability of the capital to be invested in the business (Jeter et al., 2010). Capital availability facilitates better flexibility, as well as the potential for the business growth. In addition, the availability of capital increases the potential profit that will be shared amongst the business partners.
The second advantage associated with partnerships stems from the flexibility of the structure (Jeter et al., 2010). This is because forming, managing, and running the partnership is relatively easy. There are fewer strict regulations targeting partnerships when compared to the laws that govern companies, especially with respect to the formation. In addition, since only partners have a say regarding the running of the business and there is no shareholders’ interference, they enjoy more flexibility in managing the business, provided there is agreement among the partners (Jeter et al., 2010).
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The third benefit of partnerships stems from the shared responsibility. Partnerships are structured in such a way that the responsibility of managing the business is shared among the partners. According to Horngren et al. (2012), the shared responsibility in partnerships allows partners to exploit their abilities. Instead of dividing the management responsibility equally, partners may divide the work in accordance to their skills. In such an arrangement, a partner who is good at accounting might be tasked with bookkeeping whereas another partner good at selling may be in charge of sales (Jeter et al., 2010). Moreover, such an arrangement makes partnerships cost-effective since they specialize in the particular aspects of the business that they are good at.
The shared decision-making is also another advantage associated with partnerships as a form of business ownership structure. In this regard, the decision-making responsibility is shared among the partners (Reimers, 2014). Having a larger number of partners implies the diversity of ideas, which can be helpful in solving any potential problems that might be encountered when running the business. Needles et al. (2013) assert that partnerships offer moral support, as well as facilitate more creative brainstorming when compared to sole proprietorships. Partnerships also facilitate the pooling together of assets, knowledge, and experience, which can contribute to the success of the business. Other advantages associated with partnerships include the sharing of risk and the relative ease at which the business structure can be changed when needed following the growth of the business (Horngren et al., 2012).
Despite the previously mentioned advantages, partnerships have inherent disadvantages. The first drawback associated with this form of business structure is disagreements. The likelihood of disagreements among business partners forms one of the most significant problems that affect partnerships (Reimers, 2014). People tend to differ in terms of running the business, the allocation of responsibility, and the best interests of the business. Such differences can result in disputes and disagreements that are detrimental to not only the existence of the business itself but also the relationship of the partners. The shared decision-making increases the likelihood of disagreements. For this reason, Reimers (2014) recommends drafting a partnership deed when establishing the partnership in order to make sure that every partner is informed of the procedures that will be initiated in the event of a disagreement among partners and the dissolution of the partnership.
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The need for agreement among partners presents another hurdle in partnerships. As partnerships are run collectively, there is a need to ensure that all partners are in agreement with the manner in which the business operations are conducted (Horngren et al., 2012). This implies less freedom for partners with respect to managing the business. In comparison to sole proprietorships, partners may enjoy less freedom. Nevertheless, partnerships are characterized by more freedom when compared with limited companies wherein the directors’ actions are influenced by the shareholders.
The issue of liability is another problem associated with partnerships. In this respect, ordinary partnerships have unlimited liability; thus, the financial risks and liability of the business are shared among all partners (Horngren et al., 2012). This limitation can be offset by establishing a limited liability partnership that has the advantages enjoyed by limited liability companies while, at the same time, enjoying the flexibility accorded by the partnership ownership structure.
Another major disadvantage associated with the partnership model is taxation. In this respect, taxation laws stipulate that partners have the tax liability as sole traders; thus, each partner must file tax returns (Needles et al., 2013). Additionally, partners must register as being self-employed. If the partnership business, as well as the partners, earns beyond a particular level, their personal tax liability exceeds their liability if they have used a limited company structure (Reimers, 2014). Therefore, in most cases, forming a limited liability company might be more beneficial because of the favorable taxation laws.
Profit sharing is yet another disadvantage of partnerships. In partnerships, profits are shared equally, which can result in an inconsistency in situations whereby some partners are not making an adequate effort to manage the business while still receiving the same rewards as those who put forth more effort (Needles et al., 2013). Apart from equal profit sharing, another drawback of partnerships is that partners are individually and collectively liable for the actions undertaken by other partners. Other disadvantages associated with the partnership include having a limited life following a partner’s death or withdrawal; limitations that might hinder it from growing into a large business; and the possibility of personal liability, leading to the use of personal assets to settle partnership debts (Horngren et al., 2012).
The FAS Governing Accounting for Partnerships
Partnerships essentially follow the Generally Accepted Accounting Principles (GAAP) for accounting. Specialized or small partnerships might use either tax-basis or cash basis counting (Horngren et al., 2012). For internal reporting, partnerships are allowed not to use the GAAP methods; hence, their financial reports might be presented in the format that is different from the one demanded by the GAAP. However, when issuing general-purpose financial statements for outside users, partnerships are required to use the GAAP. The Financial Accounting Standards Board (FASB) Codification Topic 323-30 outlines the guidelines for partnership accounting, including the formation, operation, and liquidation (Horngren et al., 2012). During the establishment of the partnership, the FAS requires assigning proper value to non-cash liabilities and assets that each partner has contributed. In addition, it requires distinguishing between the loans and the capital contributed by the individual partners to the partnership. Also, the FAS requires distinguishing between the tangible assets under the ownership of the partnership and the specific assets placed under the ownership of the individual partners, although utilized by the partnership (Jeter et al., 2010). According to the FASB Statement No 157, assets contributed by the partners should be assessed at their fair values, which might need other valuation or appraisal techniques. Additionally, any liability that the partnership business assumes must be valued at the present value of residual cash flows. The FAS also requires the individual partners to reach an agreement regarding the percentage of equity that each partner will have in the partnership’s net assets (Jeter et al., 2010). Usually, each partner computes the capital balance using the proportionate share of the capital contribution.
Further, the FAS outlines the guidelines that can be used in partnership operations, including partner’s accounts and the allocation of profits or losses to the partner. The partners’ accounts comprise capital, drawing, and loan accounts (Horngren et al., 2012). The capital accounts are utilized for recording a partner’s initial investment, contributions to capital, loss and profit distributions, and capital withdrawals. The deficiencies are often eliminated using additional capital contributions. The drawing accounts are used for recording periodic withdrawals made by a partner and shifting them to the capital account of the partner when the trading period ends (Horngren et al., 2012). The valuation of non-cash drawings is determined using the market values at the withdrawal date. Loan accounts are used to show the partner’s loan that is payable as indicated on the partnership’s books. The partnership has an obligation to pay the interest that the loan accrues unless the partners agree otherwise. With respect to the allocation of profits and losses to partners, they are allocated at the end of the trading period as outlined in the partnership agreement. In the event that there is no agreement, the partners are supposed to share the profits equally (Warren et al., 2011). The profit distribution plans that can be used include bonuses and salaries given to partners, interests on the capital balance, and pre-agreed ratio. The FAS requires the recording of the profit or loss allocation with a closing entry at the end of every trading period. The expenses and revenue must be closed into either the partners’ capital accounts or the income summary account (Jeter et al., 2010).
The FAS also provides accounting guidelines for partnership liquidation, which include membership changes and dissociation of a partner. Regarding membership changes, present members must unanimously approve any new members followed by public announcements. The new members do not have any liability incurred by the partnership before their admission (Jeter et al., 2010). The withdrawal or retirement of a partner also results in membership changes; however, this does not imply that the partnership will be dissolved. The partnership might opt to purchase the leaving partner’s interest; therefore, such partners have a liability to the partnership for any damages likely to be attributed to wrongful dissociation.
The partnership is considered as a separate entity from individual members with the respect to the use of GAAP, as well (Horngren et al., 2012). Thus, the partnership is supposed to account for a membership change in the same way the company will account for a change in its investors. The FASB 142 and FASB 144 outline the standards for membership changes (Jeter et al., 2010).
Tax Consequences of Partnerships
Partnerships are considered a pass-through entity; hence, they are not liable for income taxes. Contrary to irrevocable trusts and corporations, the partnership is not considered a tax paying entity. According to Horngren et al. (2012), it is supposed to file a yearly informational tax return that specifies its expenses and income but is not taxed on its net income. Rather, the proportionate income/loss share of each individual partner is passed through the business partnership as an entity to the individual. Thus, all individual partners are supposed to report their income share when filing their tax returns. This is crucial in avoiding double taxation, which is always the case with a C Corporation structure. Moreover, Horngren et al. (2012) underline that the taxation of partnerships is cumbersome and lengthy and that property transfers out of and into the partnership might not result in tax consequences. In the event when losses exceed the profits, the partners can deduct the losses in their investment amounts. Another important tax consequence is that general partners are required to pay self-employment taxes as opposed to limited partners.
Partnerships have diverse advantages, including the availability of capital; the flexibility of the structure; shared responsibility; shared decision-making; the relative ease at which the business structure can be changed when needed following the growth of the business; and the sharing of risk. Despite these benefits, partnerships also have disadvantages, including disagreements; tax liability as sole traders; profit sharing; a limited life following a partner’s death or withdrawal; limitations that might hinder them from growing into large businesses; and the possibility of personal liability leading to the use of personal assets to settle partnership. The FASB Codification Topic 323-30 specifies the guidelines for partnership accounting, including the formation, operation, and liquidation, which spell out the GAAP requirements for partnership activities. Regarding taxation, partnerships enjoy the benefit of pass-through taxation wherein the profits and losses of partners are passed through and reported on the individual tax returns instead of being taxed at the business level. This helps in preventing the double taxation of partners.
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