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15.2: Describe the Advantages and Disadvantages of Organizing as a Partnership

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  • A partnership is legal business structure consisting of an association of two or more people who contribute money, property, or services to operate as co-owners of a business. When discussing partnerships as a form of business ownership, the term personcan refer to individuals, corporations, or even other partnerships. However, in this chapter, all the partners are individuals.

    THINK IT THROUGH

    Choosing a Partner

    In some ways, a partnership is like a marriage; choosing a partner requires a great deal of thought. How do you know whether you and your potential partner or partners will be a good fit? A strong partnership agreement is one way to help settle future disagreements.

    But before you get that far, it is really important to take a hard look at future partners. How do they deal with stressful situations? What skills and assets do they possess that you do not, and vice versa? What work ethic do they exemplify? Do they procrastinate? Are they planners? Do they get along with others? Do the two of you work well with each other?

    All these questions and many more should be explored before choosing business partners. While you cannot predict the future or see all possible issues, doing your due diligence will help.

    What other questions can you think of that would help you decide whether someone will be a good business partner for you?

    Characteristics of a Partnership

    Just like a corporation, a partnership is a legal entity. It can own property and can be held legally liable for its actions. It is a separate entity from its owners, the partners. Partnerships have several distinct characteristics that set them apart from other entity types. The most common characteristics of a partnership are the following:

    • Formation by agreement. A partnership is formed by voluntary membership or association. The partners must have an agreement about who contributes assets or services, who performs what functions of the business, and how profits and losses and any additional compensation are shared. Ideally, this agreement should be in writing; however, if not, the Uniform Partnership Act or the Revised Uniform Partnership Act (RUPA) governs in areas of disagreement, depending on the state in which the partnership is located.
    • Defined or limited life. Typically, the life term of the partnership is established by agreement. Unlike corporations, which have an unlimited life, partnerships end when a new partner is accepted or a partner leaves (and a new partnership may be created), or the partnership dissolves.
    • Mutual agency. In a partnership, partners are considered agents of the entity. Mutual agency give each partner the ability to act as an agent for the partnership in dealing with outside entities such as vendors and lenders. The partnership is then bound by the actions of each partner acting within the scope of partnership activities.
    • Unlimited liability. Due to mutual agency, any partner has the ability to incur debt for the partnership. Regardless of who negotiated the debt, each partner is liable to pay it if the debt was incurred to further partnership activities. There are exceptions to this, but only for partners who meet limited partnership standards (which you will learn about later in this chapter). If you are considered a general partner, you are liable for the business’s debt.
    • Non-taxable income at partnership level. The net income of a partnership is not subject to federal taxation at the partnership level, despite the company’s being a separate legal entity from its partners. Instead, its income or loss is allocated among the partners based upon the partnership agreement and tax legislation, and the allocation is reported on each partner’s Tax Form K-1. The tax information on each partner’s K-1 is then incorporated into each partner’s individual tax return, and tax is paid at each individual partner’s relevant tax rate.
      Income tax is levied on the partners regardless of how much of that taxable income is actually withdrawn by the partner in a given year. For example, assume that a partner earned $20,000 in taxable income from a partnership in 2019 and withdrew $25,000 as a draw. The partner’s taxable income from the partnership for the year is $20,000. Draws are not considered taxable income. Instead, they are withdrawals from a partner’s capital account. However, the $25,000 draw in this example reduces the partner’s capital account by $25,000.
    • Co-ownership of property. In a partnership, assets are jointly owned by all partners. If a dissolution occurs, each partner retains a claim on the total assets proportional to that partner’s equity in the organization. The rule presented herein does not apply to specific assets.
    • Limited capital investment. Unlike a corporation, which is able to raise capital investments by issuing stock, partners do not have the ability to raise capital except by incurring additional debt or agreeing to contribute more of their personal assets. This limits the partnerships’ ability for rapid expansion.
    • Participation in both income and loss. The net income or loss of the partnership is distributed as specified in the partnership agreement. If the arrangement is not specified in the partnership agreement, all partners participate equally in net income or losses.

    IFRS CONNECTION

    Partnerships and IFRS

    You’ve learned how partnerships are formed, and you will soon learn how partnership capital and income can be allocated and what happens to the capital structure when a partner is added or subtracted. But how does a partnership account for normal day-to-day business transactions?

    Partnership organizations can be very small, very large, or any size in between. What type of accounting rules do partnerships use to record their daily business activities? Partnerships can choose among various forms of accounting. The options broadly include using a cash basis, a tax basis, and a full accrual basis to track transactions. When choosing to use the full accrual basis of accounting, partnerships apply U.S. GAAP rules in their accounting processes. But you may be surprised to learn that some non-publicly traded partnerships in the United States can use IFRS, or a simpler form of IFRS known as IFRS for Small and Medium Sized Entities (SMEs). In 2008, the AICPA designated IFRS and IFRS for SMEs as acceptable sets of generally accepted accounting principles. However, it is up to each State Board of Accountancy to determine whether that state will allow the use of IFRS or IFRS for SMEs by non-public entities incorporated in that state.

    Despite the use of size descriptors in the title, qualifying as a small- or medium-sized entity has nothing to do with size. A SME is any entity that publishes general purpose financial statements for public use but does not have public accountability. In other words, the entity is not publicly traded. In addition, the entity, even if it is a partnership, cannot act as a fiduciary; for example, it cannot be a bank or insurance company and use SME rules.

    Why might a partnership want to use IFRS for SMEs? First, IFRS for SMEs contains fewer and simpler standards. IFRS for SMEs is only about 300 pages in length, whereas regular IFRS is over 2,500 pages long and U.S. GAAP is over 25,000 pages. Second, IFRS for SMEs is modified only every three years, whereas U.S. GAAP and IFRS are modified more frequently. This means entities using IFRS for SMEs don’t have to adjust their accounting systems and reporting to new standards as frequently. Finally, if a partnership transacts business with international businesses or hopes to attract international partners, seek capital from international sources, or be bought out by an international company, having its financial statements in IFRS form can make these transactions easier.

    Advantages of Organizing as a Partnership

    When it comes to choosing a legal structure or form for your business, the most common options are sole proprietorships, partnerships, and different forms of corporations, each with advantages and disadvantages. Partnerships have several advantages over other forms of business entities, as follows:

    • Exemption from taxation at the partnership level. A significant advantage to forming a partnership is the exemption from taxation as a business entity. In other words, although the individual partners are taxed at the individual level, the partnership itself (as a business unit) is not subject to income tax. The tax characteristics of a partnership “flow through” to the individual partners.
    • Ease and lower cost of formation. Most business regulations tend to be written for corporations, which is to be expected given the complexities of many such companies. Partnerships, on the other hand, are simpler and have to comply with fewer regulations. Also, without shareholders, partnerships have fewer reporting requirements. The partnership formation paperwork also tends to be less cumbersome than that for other entities in most states. Overall, partnerships are simple to form, alter, and terminate.
    • Combined skills and financial resources. Combining business acumen and financial assets can give a partnership an advantage over sole proprietorships.
    • Flexibility in managing and running the business. Partnerships are often simpler to manage and run than other business structures (except for most sole proprietorships), and they can offer more management flexibility as well if the partners generally agree on management issues. Since there is no board of directors overseeing operations, partnerships can be nimble and make speedy changes—again, as long as the partners agree.
    • Easily changed business structure. It is a relatively easy process to convert a partnership to a corporation in the future. With no shareholders to consider, a partnership’s capital can be converted to shares of common stock.
    • Informality. Unlike publicly traded corporations, partnerships do not need to prepare articles of incorporation, write bylaws, issue stock certificates to owners, document minutes or board meetings, pay incorporation fees to states, or file quarterly financial statements with the SEC. However, it is advised that partners create a written document detailing decision on issues such as profit sharing, dispute resolution procedures, partnership changes, and other terms that the partners might agree upon to prevent future complications.

    YOUR TURN

    All in the Family

    Family partnerships are frequently utilized to allow family members to pool resources for investment purposes and to transfer assets in a tax-efficient manner. In what ways can you imagine using a family partnership?

    Solution

    Cash can be combined to purchase income-producing properties or other investments without having to sell assets, thus keeping costly investments all in the family. Through a family partnership, it becomes possible for those in high net worth tax brackets to transfer assets and wealth to younger generations in a way that reduces potential estate and gift taxes. For example, a family partnership can be formed by a grandparent who owns an apartment building. Children and grandchildren can be partners to share in profits of the building. As they earn the income from the building while living, this can be a very tax efficient way to transfer wealth.

    Disadvantages of Organizing as a Partnership

    While partnerships carry some clear advantages, there are also several disadvantages to consider. For example, due to unlimited liability, each partner in a general partnership is equally and personally liable for all the debts of the partnership. Following are some of the disadvantages of the partnership form of business organization:

    • Difficulty of ownership transfer. Since a partnership dissolves when there is a change in ownership, it tends to be difficult to transfer ownership. It is a complicated process when a new partner is added or a partnership interest is sold, requiring asset valuation and negotiation of previously agreed upon partnership operating terms.
    • Relative lack of regulation. You learned, for example, that a partnership’s informal agreement not need be in writing. But this could lead to legal disputes between partners and expose them to unlimited liability, something individuals in corporations do not need to worry about (they are liable only for the amount of their investment in the corporation’s stock).
    • Taxation subject to individual’s tax rate. Individual partners often have other sources of income outside the partnership; this can make their allocated partnership income taxable at a higher rate than if the partnership were liable for the income taxes instead.
    • Limited life. The partnership ends when a new partner is accepted into the partnership, a partner leaves, a partner dies, or the partnership dissolves. Therefore, most partnerships tend to have limited lives.
    • Unlimited liability. Unlimited liability is the legal obligation of all general partners for the partnership’s debts regardless of which partner incurred them. This liability can extend to the partners’ personal assets.
    • Mutual agency and partnership disagreements. Mutual agency is the right of all partners to represent the business and bind the partnership to contracts and agreements. This rule applies regardless of whether all the partners agree with the contract or agreement. Mutual agency could cause tension among the partners, since any of them can bind the partnership and make everyone liable as long as the action is taken in the interest of furthering the partnership.
    • Limited ability to raise capital. A partnership is often limited in its ability to raise capital or additional funds, whether from the individual partners themselves or from a financial institution making a loan.

    CONCEPTS IN PRACTICE

    Sports Memorabilia Store

    Farah and David decide to form a sports memorabilia retail partnership. They have known each other since business graduate school and have always worked well together on various projects. The business is doing well but cash flow is very tight. Farah takes several calls from vendors asking for payment. He believed David had been paying the bills. When he asks about this, David admits to embezzling from the partnership. What liability does Farah face as a result of the theft?

    Table 15.1 summarizes some of the main advantages and disadvantages of the partnership form of business organization.

    Advantages and Disadvantages of Forming a Partnership

    Potential Advantages Potential Disadvantages
    • No taxation at the partnership level
    • Ease and lower cost of formation
    • Combined skills and financial resources
    • Flexibility in managing and running the business
    • Easily changed business structure
    • Informality
    • Difficulty of ownership transfer
    • Relative lack of oversight/regulation
    • Number of partners needed
    • Taxation subject to individual’s tax rate
    • Limited life
    • Unlimited liability
    • Mutual agency and potential for partnership disagreements
    • Limited ability to raise capital

    Table15.1

    Types of Partnerships

    A general partnership is an association in which each partner is personally liable to the partnership’s creditors if the partnership has insufficient assets to pay its creditors. These partners are often referred to as general partners. A limited partnership (LP) is an association in which at least one partner is a general partner but the remaining partners can be limited partners, which means they are liable only for their own investment in the firm if the partnership cannot pay its creditors. Thus, their personal assets are not at risk.

    Finally, the third type is a limited liability partnership (LLP), which provides all partners with limited personal liability against another partner’s obligations. Limited liability is a form of legal liability in which a partner’s obligation to creditors is limited to his or her capital contributions to the firm. These types of partnerships include “LLP” or partnership in their names and are usually formed by professional groups such as lawyers and accountants. Each partner is at risk however, for his or her own negligence and wrongdoing as well as the negligence and wrongdoing of those who are under the partners’ control or direction. Table 15.2summarizes the advantages and disadvantages of different types of partnerships.

    Advantages and Disadvantages of Types of Partnerships

    Type of partnership Advantages Disadvantages
    General partnership Business is simple to form All partners have personal liability
    Limited partnership (LP) Limited partners have limited liability General partners are personally liable
    Limited liability partnership (LLP) Partners are protected from other partners’ malpractice Some partners remain personally liable

    Table15.2

    LINK TO LEARNING

    Arthur Andersen was one of the “Big 5” accounting firms until it was implicated in the Enron scandal. Arthur Andersenhad been formed as an LLP. Read this CNN Money article about the Arthur Andersen case to see how courts can hold partners liable.

    Dissolution of a Partnership

    Dissolution occurs when a partner withdraws (due to illness or any other reason), a partner dies, a new partner is admitted, or the business declares bankruptcy. Whenever there is a change in partners for any reason, the partnership must be dissolved and a new agreement must be reached. This does not preclude the partnership from continuing business operations; it only changes the document underlying the business. In some cases, the new partnership may also require the revaluation of partnerships assets and, possibly, their sale. Ideally, the partnership agreement has been written to address dissolution.