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Accounting for Partnerships and Limited Liability Corporations (Part A)
by
Charles Lamson
If you were to start up any type of business, you would want to separate the business affairs from your personal affairs. Keeping business transactions separate from personal transactions aids business analysis and simplifies tax reporting. For example, if you provided freelance photography services, you would want to keep a business checking account for depositing receipts for services rendered and writing checks for expenses. At the end of the year, you would have a basis for determining the earnings from your business and the information necessary for completing your tax return. In this case, forming the business would be as simple as establishing a name and a separate checking account. As a business becomes more complex, the form of the business entity becomes an important consideration. The entity form has an impact on the owner's legal liability, taxation, and the ability to raise capital. The four major forms of business entities that we will discuss in the next several posts are the proprietorship, corporation, partnership, and limited liability corporation.
Alternate Forms of Business Entities A variety of legal forms exist for forming and operating a business. The four more common legal forms are proprietorships, corporations, partnerships, and limited liability corporations. In this post, we describe the characteristics of each of these business entities. Proprietorships As we discussed in part 1, a proprietorship is a business enterprise owned by a single individual. Internal Revenue Service (IRS) data indicate that proprietorships comprise more than 73% of the business tax returns filed but only 7.7% of all business revenues (bigideasforsmallbusiness.com). This statistic suggests that proprietorships, although numerous, consist mostly of small businesses. The most common type of proprietorships are professional service providers, such as lawyers, architects, realtors, and physicians. A proprietorship is simple to form. Indeed, you may already be a proprietor. For example, a person providing childcare services for friends of the family is a proprietor. There are no legal restrictions or forms to file in forming a proprietorship. The ease of forming a proprietorship is one of its main advantages. In addition, the individual owner can usually make business decisions without consulting others. This ability to be one's own boss is a major reason why many individuals organize their businesses as proprietorships. .jpg) A proprietorship is a separate entity for accounting purposes, and when the owner dies or retires, the proprietorship ceases to exist. For federal income tax purposes, however, the proprietorship is not treated as a separate taxable entity. The income or loss is said to "pass through" to the owner's individual income tax return. Thus, the income from a proprietorship is taxed only at the individual level. A primary disadvantage of a proprietorship is the difficulty in raising large amounts of capital. Investment in the business is limited to the amount that the owner can provide from personal resources, plus any additional amounts that can be raised through borrowing. In addition, the owner is personally liable for any debts or legal claims against the business. In other words, if the business fails, creditors have rights to the personal assets of the owner, regardless of the amount of the owner's actual investment in the enterprise. Corporations The major benefits of the corporate form are its ability to provide limited liability to its owners and its potential for raising large amounts of capital through issuing stock. For these reasons, most large businesses use the corporate form of entity. However, corporations also have disadvantages. Forming a corporation requires legal filings to and approvals by state regulatory agencies. In addition, corporations are more complex to manage and must be operated in accordance with the corporate bylaws. Corporations are taxed as a separate entity. Thus, when earnings are distributed to shareholders in the form of dividends, they are also taxed again at the individual level.  To avoid the double taxation of dividends a business may organize an S corporation. Under an S corporation, the IRS allows income to pass through the corporation to the individual stockholders without the corporation having to pay taxes on the income. However, the S corporation has a number of legal imitations, including a limitation on the number of stockholders. In recent years, the S corporation has become less popular due to the emergence of the limited liability corporation and its many advantages, which we will discuss later in this post.
Partnerships A partnership is an association of two or more persons who own and manage a business for profit. Partnerships have several characteristics with accounting implications. A partnership has a limited life. A partnership dissolves whenever a partner ceases to be a member of the firm. For example, a partnership is dissolved if a partner withdraws due to bankruptcy, incapacity, or death. Likewise, admitting a new partner dissolves the old partnership. When a partnership is dissolved, the remaining partners must form a new partnership if operations of the business are to continue. In most partnerships, the partners have unlimited liability. That is, each partner is individually liable to creditors for debts incurred by the partnership. Thus, if a partnership becomes insolvent, the partners must contribute sufficient personal assets to settle the debts of the partnership.  Partners have co-ownership of partnership property. The property invested in a partnership by a partner becomes the joint property of all the partners. When a partnership is dissolved, the partners claims against the assets are measured by the amount of the balances in their capital accounts. Another characteristic of a partnership is mutual agency. This means that each partner is an agent of the partnership. The acts of each partner bind the entire partnership and become the obligations of all partners. For example, any partner can enter into a contract on behalf of all the members of the partnership. This is why partnerships should be formed only with people you trust. An important right of partners is participation in income of the partnership. Net income and net loss are distributed among the partners according to their agreement. A partnership , like a proprietorship, is a nontaxable entity and thus does not pay federal income taxes. However, revenue and expense and other results of partnership operations must be reported annually to the Internal Revenue Service. The partners must, in turn, report their share of partnership income on their personal tax returns. A partnership is created by a contract, known as the partnership agreement or articles of partnership. It should include statements regarding such matters as amounts to be invested, limits on withdrawals, distribution of income and losses, and admission and withdrawal of partners.  A variant of the regular partnership is a limited partnership. A limited partnership is a unique legal form that allows partners who are not involved in the operations of the partnership to retain limited liability. In such a form at least one general partner must operate the partnership and retain unlimited liability. The remaining partners are considered limited partners The partnership form is less widely used than the proprietorship and corporate forms. For many business purposes, however, the advantages of the partnership form are greater than its disadvantages. A partnership is relatively easy and inexpensive to organize, requiring only an agreement between two or more persons. A partnership has the advantage of bringing together more capital, managerial skills, and experience than does a proprietorship. Since a partnership is a non-taxable entity, the combined income taxes paid by the individual partners may be lower than the income taxes that would be paid by a corporation, which is a taxable entity. A major disadvantage of the partnership is the unlimited liability feature for partners. Other disadvantages of a partnership are that its life is limited, and one partner can bind the partnership to contracts. Also, raising large amounts of capital is more difficult for a partnership than for a corporation. To overcome these limitations, other hybrid forms of organization, such as limited liability corporations (LLCs), have been replacing partnerships as a means of organization.  Limited Liability Corporations A limited liability corporation (LLC) combines the advantages of the corporate and partnership forms. Many features of a partnership are retained in an LLC. The owners of an LLC are termed "members" rather than "partners" the members must create an operating agreement, which is similar to a partnership agreement. For example, the operating agreement normally indicates how income is to be distributed to the members. Thus, unlike a corporation, income need not be distributed according to the number of shares owned by each member. Instead, income might be distributed according to the amount of time each member devotes to the business. For tax purposes, an LLC may elect to be treated as a partnership. In this way, income passes through the LLC and is taxed on the individual members' tax returns. Plus, the LLC may avoid the double taxation characterized by the corporate form. Unless specified in the operating agreement, LLCs have a limited life and must dissolve when a member withdraws. In addition, the members may elect to operate the LLC as a "member-managed" entity, which allows individual members to legally bind the LLC, like partners bind a partnership. LLCs also have some features of a corporation. One of the most important corporate features is that LLCs provide limited liability for the members, even if they are active participants in the business. Thus, members' personal assets are not subject to claims by creditors of the LLC.  Like a corporation, LLCs file "articles of organization" with state governmental authorities. In addition, the LLC may elect to be "manager-managed" rather than "member-managed." In a "manager-managed" structure, only authorized members may legally bind the LLC. This allows members to share in the income of the LLC without being concerned about managing the business, much like stockholders of a corporation. Comparison of Alternate Identity Characteristics You can't make an assumption that one form is better than another. Generally, the corporate form will be preferred if the business is risky and requires access to capital. Otherwise, the other three forms all have their advantages. Depending on the need for simplicity, liability limitation, flexibility, and tax considerations.  *WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 518-521* end |
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