A partnership is an association of two or more persons to carry on as co-owners a
business for profit.
The following are characteristics of a general partnership:
Mutual agency: Each partner can act as an agent on behalf of the other and can
bind the other to a contract sometimes to their detriment.
Right to dispose of interest: Partners have the right to sell their interest. It is a
personal asset; however the remaining partners have the right to refuse to admit
the new partner to management of the partnership.
Unlimited liability: Partners have unlimited liability that extends to their personal
Limited or uncertain life: Unlike corporations whose lives are indefinite and
independent of their owners, partnerships cease to exist when a partner dies or for
a variety of other reasons.
Not subject to tax or GAAP: Partnerships are not subject to tax. The income
earned by partners is taxed in the hands of partners.
Variations on a theme
There are numerous ways to organize a group of people for purposes of making a profit
of which the partnership is only one. Most of the variations result from tax laws that are
well outside the scope of this brief essay. In a nutshell, though, partnerships do not pay
income tax. Only the income that the partners earn is taxed. The dilemma has been that
partnerships have unlimited liability. Case in point: The 350 partners at Laventhol &
Horwath lost $47M of personal assets and partnership capital of $60M in 1991. The
question, therefore, is how can one structure an organization to achieve limited liability
but avoid double taxation.
An early attempt at this was the limited partnership in which the general partner had
unlimited liability but the other partners had only limited liability. A change in the tax
code meant that the latter partners who were deemed passive partners were unable to take
advantage of features in the new tax code.
Another approach has been to elect subchapter S of the tax code, which allows corporate
income to flow through to be taxed at the shareholder level. Another is to set up a limited
liability company (LLC), which has corporate characteristics but avoids double taxation
as it is called. A variation on this that has been popular with the accounting firms is the
limited liability partnership (LLP). In this structure, all partners are deemed active, so
avoiding the tax dilemma of the LP, but one’s personal assets are not at risk for the
negligence of other partners.
For more details on the niceties, one should consult a book on corporate tax and/or a
book on corporate law. Also, be aware that as the tax code changes so the advantages and
disadvantages of different corporate structures will change. The recent reduction in tax
rates, for instance, has made double taxation more advantageous in certain cases such as
professional service firms.
Tracking capital accounts
No matter the exact form of the partnership, the accounting system tracks the capital
accounts of individual partners with no use of a retained earning account. One uses a
drawing account for withdrawals, salaries etc and closes this at year-end to capital.
Partners’ salaries are typically treated like corporate dividends i.e., after net income.
Atypically they might be treated as an expense when they are handled no differently from
Example: A partner might begin the year with capital of $56, be allocated income of $24
and elect to draw $20 of that in cash. The drawing account would show $20 and the
capital account $60 after closing the drawing account and the income summary account
to A’s capital account.
Formation of partnership
Assets are generally contributed at fair value. Subsequently they may be revalued for
partnership accounting purposes, however their basis for tax purpose remains the original
cost. One must track and exclude any revaluations when preparing tax returns. Also, if
the partnership goes public, the SEC requires a return to historical cost i.e., to initial fair
Example: A contributes cash of $60 and B cash of $15 plus an asset with a book value of
$10 and a fair value of $25. The partnership will have assets of $100 and capital split $60
and $40 between the partners.
When one of the partners brings an intangible asset such a personal skills to the
partnership, they may elect to use one of two methods: the bonus method and the
goodwill method. Under the bonus method no intangible assets are recognized. One
simply reallocates the capital accounts.
Assume in the above example that B contributed $15 of cash and brought special skills to
the partnership that were valued at $25. Under the goodwill method one would record:
Dr Cash 75
Cr A Capital 60
B Capital 40
Under the bonus method one would record:
Dr Cash 75
Cr A Capital 45 = 60% x 75
B Capital 30 = 40% x 75
Allocation of net income
Income can be allocated on a wide variety of bases including:
A fixed ratio set in the articles
A ratio that depends on capital balances which can vary
A rate of interest on capital balances
Other arrangements set in articles
Some combination of the above
When salaries are expensed, computations remain the same
Example: A and B might elect to divide income in the ratio of 6:4, reflecting their
original capital. The capital might subsequently change as the partners withdraw monies,
but the profit would continue to be allocated in the ratio of 6:4.
Changes in partnerships
Changes are handled using either a so-called bonus or goodwill methods. Under the
bonus method no assets are revalued or goodwill recognized. One simply reallocates the
capital accounts. In making changes, one should distinguish cases when the incoming
partner makes payments to the partners in their personal capacities and when payments
are made to the partnership itself. The latter is in the nature of an investment.
Assume that A and B are partners with capital of $60 and $40 and income/loss sharing in
the same ratio of 6:4. Assume that A sells half her share to C for $36. In other words, C
gets a 30 percent share of the profits of the partnership. Since the monies are being
transferred outside of the partnership, there is no effect on the partnership itself. This is
like one investor selling shares to another investor.
Under the bonus method, all that happens is that the capital gets divided up 30%, 40%
and 30% or A30, B40, C30.
If A and B sell a 30 percent share to C, with each contributing 15 percent of their share
then one ends up, under the bonus method, with A45, B25, C30. There is no other change
in the affairs of the partnership. Alternatively they might decide to sell in proportion to
their original capital or their income ratio i.e., 18% and 12% respectively. The partners’s
capital would then end as A42, B28, C30.
The argument can be made, however, that if AB’s demand for $36 from C for a 30%
share in the partnerships suggests that the old partnership was worth $120 ($36/30%) not
$100. This might be because the old partnership had assets that were worth $20 more
than book. One possibility then is to write these assets up, crediting the difference to AB
in the ratio of 6:4.
Dr Asset 20
Cr A 12
C now receives $36 of this revalued partnership, reducing A and B by $18 each, if shared
equally, to a capital division of A54 (60 + 12 – 18), B30 (40 +8 – 18), C36 (18 + 18),
Alternatively, the partnership might elect to record goodwill of $20. Aside from
recording the $20 as a revaluation gain to a specific, identifiable asset and recording it as
goodwill, there is no difference in the subsequent method.
Investing in a partnership
Now assume that C is to receive a one-third interest in the partnership in exchange for an
investment of a certain amount of cash or assets that might include goodwill in the form
of skills and talents. There are two methods to account for this – the bonus method in
which no goodwill is recognized and the goodwill method in which an asset is either
revalued or goodwill recognized.
In the bonus method, the assets of the partnership remain unchanged except for the
addition of cash and/or assets from the new partner. Consider by way of example an
existing partnership in which A has capital of $40,000 and B has capital of $30,000. The
share profits in the ratio 6:4. Now consider three cases.
This example is drawn from Jeter & Chaney, Advanced Accounting.
In the first case, C offers to invest $35,000 to get a one-third share of the partnership.
This will mean that the partnership will be worth $105,000 of which C will have one-
third or $35,000. One simple entry is all that is required:
Dr Cash 35,000
Cr C Capital 35,000
In the second case, C offers to invest $50,000. This will mean that the book value of the
new partnership is $120,000 of which C will have one-third or $40,000. To achieve this,
C give up $10,000 to AB in proportion to their 6:4 profit ratio.
Dr Cash 50,000
Cr A Capital 6,000
B Capital 4,000
C Capital 40,000
The resulting shares are A46, B34, C40. C’s willingness to pay $50,000 for a one-third
share registered as $40,000 capital suggests that C perceives that the partnership has
value above its book value.
In the third case, C offers to invest $20,000. This will mean that the book value of the
new partnership is $90,000 of which C will have one-third or $30,000. The old partners
are presumably willing to take C in a something less than book value because of skills
that C possesses. They transfer some of their capital to make this possible/
Dr Cash 20,000
A Capital 6,000
B Capital 4,000
Cr C Capital 30,000
Note that under the bonus method there is no revaluation of assets, only the passage of
capital between partners.
Valuing a partnership
There are two ways to value a partnership – use either the percentage owned by the new
partner or the percentage owned by the old partner’s. The general rule is to take the larger
of the two. For example going back to an earlier example:
C’s offer divided by C’s share is one measure i.e., $36/30% = $120
AB’s capital divided by their share is another i.e., $70/70% = $100
In general, but not always, one takes the larger of the two namely $120 as the value of the
Computing negotiated goodwill
Sometimes it is necessary to compute the goodwill implicit in the detail. To do this
assume that AB are the old partners with capital of $70,000 and that C is the new partner
who wants to invest $50,000.
C payment/C share e.g., $50/(1/3) = $150 implied value
AB capital/AB share e.g., $70/(2/3) = $105 implied value
If we value the new partnership at the higher of these two numbers, namely $150, then
we have goodwill of $30,000. We see this from this computation:
AB original capital + C’s payment e.g., $70 + 50 = $120
The difference between the implied value of $150 and the historical value of $120 is the
goodwill of $30. The goodwill, in this case, was generated by the old partnership.
Dr Goodwill 30,000
Cr A Capital 18,000
B Capital 12,000
Dr Cash 50,000
Cr C Capital 50,000
The end result is A58, B42 and C50 totaling $150,000.
Assume now that C is being asked to contribute $35,000 for a one-third share.
$35,000/(1/3) = $105,000
In other words, the new partnership is worth the amount being invested i.e.,
$70,000 + 35,000 = $105,000
One simple entry is all that is needed:
Dr Cash 35,000
Cr C Capital 35,000
Finally assume that C is being asked to contribute $20,000 for a one-third share. Now we
20,000/(1/3) = $ 60,000
70,000/(2/3) = $105,000
If we assume the first number, then we are assuming that the old partnership has assets
that need to be written down.
Dr AB Capital 10,000
Cr Assets 10,000
Dr Cash 20,000
Cr C Capital 20,000
In which case C has one-third of a shrunken partnership.
The other possibility is that the partnership is really worth $105,000 and that C is
bringing skills into the partnership along with some cash. In this event the entry is:
Dr Cash 20,000
Cr C Capital 30,000
To summarize: Under the bonus method, there are no revaluations and no insertion of
goodwill. Partners’ capital is shuffled to arrive at the desired ownership interest. Under
the goodwill method, one has first to determine the implied value of the partnership.
Goodwill must then be recognized and/or assets valued up or down to arrive at the
implied value of the partnership. The new partner’s capital account then shows the
desired percentage of the total capital.