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Mark Hess Professor Preslar ACCT 523 December 7, 2012 Partnerships A partnership is the relationship existing between two or more persons who join to carry on a trade or business (Partnerships). Each person contributes money, property, labor or skill, and expects to share in the profits and losses of the business (Partnerships). There are nearly 3.6 million enterprises in the United States that are partnerships rather than the more commonly studied type of business; corporations (Hoyle, Schaefer, Doupnik). There are several advantages of partnerships with some disadvantages as well and also several types of different partnerships that will be covered. One of the most common reasons for the creation of partnerships is due to the ease of formation (Hoyle, Schaefer, Doupnik). To create a legally binding partnership, all that is needed is an oral agreement (Hoyle, Schaefer, Doupnik). Compared to the complexity of incorporation, this idea is very appealing to people looking to get into a business. People looking to start a business find the convenience and lesser costs of creating partnerships to be appealing features (Hoyle, Schaefer, Doupnik). According to the American Bar Association, The principle advantage of partnerships is the ability to make virtually any arrangements defining their relationship to each other that the partners desire.

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There is no necessity, as there is in a corporation, to have the ownership interest in capital and profits proportionate to the investment made; and losses can be allocated on a different basis from profits. It is also generally much easier to achieve a desirable format for control of the business in a partnership than in a corporation, since the control of a corporation, which is based on ownership of voting stock, is much more difficult to alter. Partnerships are taxed on a conduit or flow-through basis under subchapter K of the Internal Revenue Code. This means that the partnership itself does not pay any taxes. Instead the net income and various deductions and tax credits from the partnerships are passed through to the partners based on their respective percentage interest in the profits and losses of the partnership, and the partners include the income and deductions in their individual tax returns (Hoyle, Schaefer, Doupnik). Partnership revenue and expense items are to be assigned to the individual partners who pay income taxes each year (Hoyle, Schaefer, Doupnik). This avoids double taxation of profits that are earned by a business and then distributed to owners (Hoyle, Schaefer, Doupnik). Corporations are taxed when they earn the income and again when it is conveyed as a dividend and a partnership is only taxed at the time they initially earn it. Another tax advantage with partnerships is that operating losses can be used to reduce their personal taxable income directly (Hoyle, Schaefer, Doupnik). With corporations, the loss cannot be passed through the owners because it is viewed as a legally separate entity. The tax advantage

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of deducting partnership losses is limited. For tax purposes, ownership of a partnership is labeled as a passive activity unless the partner materially participates in the actual business activities (Hoyle, Schaefer, Doupnik). Normally, partnership losses cannot be used to reduce earned income such as salaries. Unless a taxpayer has significant passive activity income, losses reported by a partnership create little or no tax advantage unless the partner materially participates in the actual business activity (Hoyle, Schaefer, Doupnik). As with there being advantages to things, there are going to be disadvantages as well. With partnerships, the most severe disadvantage is that of the unlimited liability that each partner incurs (Hoyle, Schaefer, Doupnik). This means that each partners personal assets could be at risk to repay the debts of the company if they were to get into financial trouble. Unlimited liability goes hand-in-hand with mutual agency which is a legal term referring to the right that each partner has to incur liabilities in the name of the partnership (Hoyle, Schaefer, Doupnik). In order to help with a consistent application of these terms and legal aspects, the Uniform Partnership Act was created in 1914 and revised in 1997 (Hoyle, Schaefer, Doupnik). It has been adopted by each state in some capacity and it establishes uniform standards in such areas as the nature of a partnership, the relationship of the partners to outside parties, and the dissolution of the partnership (Hoyle, Schaefer, Doupnik). With partnerships, there have been alternative types of organizations that have been developed so that there can be a limit on the owners personal liability while providing the tax benefits of a partnership. A Subchapter S Corporation is a corporation which meets all the requirements of that form and has made a proper election to be taxed under Subchapter S of

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the Internal Revenue Code (Hadzima). If the corporation meets certain regulations, it will be taxed essentially the same way a partnership is taxed (Hoyle, Schaefer, Doupnik). Granted they meet the regulations, the Subchapter S corporation pays no income taxes although any income and losses pass directly through to the taxable income of the individual owners (Hoyle, Schaefer, Doupnik). This form avoids double taxation and the owners do not face unlimited liability (Hoyle, Schaefer, Doupnik). In order for a corporation to qualify as a Subchapter S, the business can have only one class of stock and is limited to 100 stockholders and all owners must be individuals, estates, certain tax-exempt entities, or certain types of trusts (Hoyle, Schaefer, Doupnik). The biggest problem with this business form is that the growth potential is limited due to the restrictions (Hoyle, Schaefer, Doupnik). The next type of business covered is limited partnerships, also known as LPs. For limited partnerships, at least one of the owners is considered a general partner who makes business decisions and is personally liable for business debts (Pakroo). They also have at least one limited partner who invests money in the company and has minimal control over daily business decisions and operations (Pakroo). As stated, the limited partners do not play an active role in the business and also they are not personally liable and face slightly different tax rules than the general partners face because they do not have to pay self-employment taxes (Pakroo). Many limited partnerships were originally formed as tax shelters to create immediate losses (to reduce the taxable income of the partners) with profits spread out into the future (Hoyle, Schaefer, Doupnik).

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Another type of partnership is a limited liability partnership, also known as an LLP. It is similar to a limited partnership except that it significantly reduces the partners liability (Hoyle, Schaefer, Doupnik). Limited liability partnerships are most commonly professional groups such as lawyers and accountants and in some states they limit the LLPs to groups of professionals (Pakroo). A limited liability partnership protects each partner from debts against the partnership arising from professional malpractice lawsuits against another partner (Pakroo). Partners may lose their investment in the business and are responsible for the contractual debts of the business (Hoyle, Schaefer, Doupnik). The advantage of an LLP is created in connection with any liability resulting from damages where in these cases the partners are responsible for only their own acts or omissions plus the acts and omissions of individuals under their supervision (Hoyle, Schaefer, Doupnik). All of the Big 4 accounting firms are LLPs (Hoyle, Schaefer, Doupnik). The final type of partnership is a limited liability company. This is a new type of organization in the United States although it has long been used in Europe and other parts of the world (Hoyle, Schaefer, Doupnik). For tax purposes, it is classified as a partnership (Hoyle, Schaefer, Doupnik). Depending on the state laws in which the LLC is located, the owners risk only their own investments (Hoyle, Schaefer, Doupnik). It contrasts a Subchapter S corporation in the sense that the number of owners is not usually restricted so that growth is more easily accomplished (Hoyle, Schaefer, Doupnik). LLCs are not taxed as a separate business entity but rather all profits and losses are passed through the business to each member of the LLC (Limited Liability Company (LLC)).

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As shown through this paper, there are ways that you can be taxed as a partnership without technically being a partnership. They are easy to form, not subject to double taxation, and there are other tax advantages associated with them. The disadvantages are that there is an unlimited liability, unless you go the route of an LLP or LLC, and the concept of mutual agency is the other big disadvantage. There is a large number of partnerships in the United States, and the size of them is typically small.

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Works Cited Hadzima, Joseph G., Jr. "Subchapter S." Subchapter S. MIT, 2005. Web. 07 Dec. 2012. Hoyle, Joe B., Thomas F. Schaefer, and Timothy S. Doupnik. Advanced Accounting. 11th ed. New York, NY: McGraw-Hill, 2013. Print. "Limited Liability Company (LLC)." Limited Liability Company (LLC) | SBA.gov. SBA.gov, n.d. Web. 07 Dec. 2012. Pakroo, Peri. "Limited Partnerships and Limited Liability Partnerships." (LLPs). NOLO, n.d. Web. 07 Dec. 2012. "Partnerships." IRS, 8 Nov. 2012. Web. 7 Dec. 2012.