Partnership

A partnership is the relationship existing between two or more persons who join to carry on a trade or business. Each person contributes money, property, labor or skill, and expects to share in the losses of the business.

A partnership must file an annual information return to report the income, deductions, gain, losses, etc. from its operations, but it does not pay income tax. Instead, it "passes through" any profits or losses to its partners. Each partner includes his or her share of the partnership's income or loss on his or her tax return.

Partner are not employees and should not be issued a Form W-2. The partnership must furnish copies of Schedule K-1 (Form 1065) to the partners by the date Form 1065 is required to be filed, including extensions

The partnership agreement may specify that partners should be compensated for services they provide to the partnership and for capital by partners.

For example, one partner contributed more of the assets, and works full time in the partnership , while the other partner contributed a smaller amount of assets and does not provide as much services to the partnership.

Compensation for services is provided in the form of salary allowance. Compensation for capital is provided in the form of interest allowance. Amount of compensation is added to the capital account of the partner.

Formation Requirements


A partnership's FORMATION REQUIREMENTS are satisfied when two or more parties agree to join forces for the common purpose of  earning a profit within a business environment. The parties to a partnership must simply agree to enter into a partnership. If, at a later date, the partners should decide not to continue the relationship, they can just easily terminate the association.

Agency Relationship

It is important that the selection of partners in a partnership be made with great care. Each partner has the power and right to act as an agent of the partnership.

Co-ownership of Assets

Assets are contributed to the partnership by the individual partners. Once contributed, the asset is said to be owned by the partnership, and the value of the asset given is reflected in the capital account of the contributing partner. Once the asset is contributed, it no longer belongs to the person who gave it. The partner's right is only to the value of the capital resulting from the contribution. This is known as the CO-OWNERSHIP OF ASSETS. in the event of a discontinuance of the partnership, individual partners have no rights to the specific assets they previously contributed, but merely to the dollar value of their investment in the business as evidenced by their capital balance.

Limited Life

In a sole proprietorship, if the owner becomes disabled or dies, the organization comes to an end. In a partnership, one of two possible changes may occur to the partnership. A DISSOLUTION is said to occur as a result of any change in the composition of a partnership, and a LIQUIDATION takes place if the partnership is terminated. Either event is an example of the partnership's LIMITED LIFE. A partnership may dissolve upon the death of a partner, the withdrawal of a partner, the incapacity of a partner, partnership bankruptcy, or even the admission of a new partner. Dissolution only extends to a liquidation in the case of bankruptcy.

Unlimited Liability

The profits or losses of a sole proprietorship are the sole pleasure or burden of the owner. In the case of a partnership, the same is true. The concepts UNLIMITED LIABILITY applies equally to both forms of businesses, but it may have a more serious effect on the partners of a partnership. The creditors who owed money by a partnership are not concerned with who pays the obligation; they are primarily concerned with being paid. The individual partner is said to be held liable for the debts of the partnership both collectively (jointly) and severally (individually). If the other partners are unable to contribute toward the liquidation of the debt, it becomes the obligation of the solvent partner to pay the entire obligation.

Participating in Profit and Losses

Participating in profits and losses comes about through a partnership agreement, and if there is no agreement, then any profit recognized or losses incurred are distributed equally. If an agreement exists that states how profits are to be distributed, but is silent as to losses, these losses, should they occur, are divided in the same manner as the agreed-upon profit distribution. Participation agreements as to profits and losses are recognized by the courts, assuming there was no undue influence or illegality in the making of the agreement.

The distribution of profits or losses is usually determined according to what is known as the PROFIT AND LOSS SHARING RATIO. This ratio is assumed to be equal unless there is a n agreement as to the distribution. If there is an agreement, that is the sole criterion for the determination of participation in profits or losses by the individual partners. Partner A may willingly accept 40% of the profits and 60% of the losses, As long as A agrees to this arrangement, it is perfectly valid.

Articles of Partnership

Participation in the profits or losses is determined by a court if there is no evidence of an agreement. It should be obvious that the rights and responsibilities of the partners in a partnership should be written form. This will serve to eliminate any disputes that may arise from an oral agreement. Such a written agreement is a contract and is referred to as the ARTICLES OF PARTNERSHIP. While there is no legal or governmental requirement that a partnership agreement be in written form, the existence of such a document outlines the obligations of the partners, their specific duties, and the effect on the partnership of such occurrences as the death of  a partner. Other provisions that should be made a part of the articles are the amount of the investment by each partner, the limitations on the withdrawal of funds, the policy with regard to the admissions or withdrawal of partners, and any other contingencies that can be anticipated at the time that the articles are prepared.

See the following example:

Exercise 1