Introduction
For a partnership to exist there must be a business agreement, established in a contract, in which 2 or more persons commit to an economically productive activity. These partners are owners of the business. Partnerships are attractive because of the possibility to combine administrative capabilities, experience and capital. When a partnership is formed, the contract that binds the entity must state exactly how income and losses are divided amongst partners, the responsibilities of each owner, investments, and the what the business will do.
Partnership’s Characteristics
Partnerships have certain distinctive characteristics. For example, partnerships have limited lifetimes. This means that a partnership’s life is submitted to the life of its members. If a member dies, the contract must be amended to establish the new conditions. The entity’s responsibility towards its owner’s personal finance is unlimited, unless the member is a silent partner, in this case the responsibility is bound to the member’s investment. Each member has the right to use the partnership’s assets. Each member shares income and losses. Partnerships are non-taxable entities, taxes are paid individually by the owner’s. The IRS must be informed annually of the entity’s financial activities, and the payments made to the owner’s.
Advantages and Disadvantages
The advantages of partnerships include the combination of member’s capital, administrative and creative capabilities, and experience. Starting a partnership is relatively easy and less expensive in comparison to corporations. There are less government regulations and they are non-taxable.
A partnership’s disadvantages include its owner’s unlimited financial responsibility and its limited lifetime. A strong set back is that the ability to raise funds and capital is limited to its member’s personal assets. On the other hand, corporations can sell stock.
Accounting- Investing in Partnerships
When partnerships take in a new member, a monetary value is assigned to each asset invested. Accounting measures are taken to establish this value to each asset that is not cash. Only the realizable value of accounts receivable is accounted for. The debt of the new partner is also accounted for, and now forms part of the partnership’s finances. The partnership’s asset accounts are debited, liability accounts are credited and the remainder is credited to the new partner’s capital account.
Unless otherwise stated, earnings are shared equally among partners. Partners regularly receive salaries and interest allowances. Any net income at the end of the financial period is shared as stated in the contract. Losses are divided in the same way.
Liquidating a Partnership
The death or retirement of a partner dissolves the partnership. Conditions may remain as they are only if the remaining partners buy the parted partner’s share. When a partnership is liquidated or dissolved, assets and liabilities must be taken care of correctly. Assets are sold and all debt must be paid. Cash is distributed among its members. Difficulties may arise because the proceeds from the sale of assets rarely equal the value stated in the books of the partnership. In this case, gains or losses are recorded to the Gain and Loss on Realization account. The net gain or loss represents a change in equity, and is divided among partners according to the income-sharing agreement.
S Corporations
The corporation must be a domestic, small business corporation of no more than 35 shareholders. Only natural persons can be shareholders, no nonresident alien shareholders. Only one class of stock and voting rights do not create second class of stock. The corporate must be an eligible corporation. Shareholder cannot be member of an affiliated group. Financial institution, foreign corporations, insurance companies and domestic international sales corporations (DISC) or former DISC are not eligible. The corporation must make a proper and timely-filed S-Corporation election.
Tax Advantages of S-Corp Election
There are three primary tax advantages to be gained form becoming an S-Corp. The most important benefit is the ability to avoid double taxation. The next has to do with differences between corporate versus individual income tax rates. Currently, the top Federal individual rate is 31% as compared with respect to state tax rates (although not all states recognized S-Corp. concept). Thus, election of S-Corp. status for profitable companies can mean an immediate tax savings in many cases. In addition, the pass-through of corporate income or loss directly to the corporation’s owners provides each shareholder with a wide range of planning opportunities in minimizing the tax bite on corporate earnings. For example, a shareholder may be able to reduce the overall tax burden on S-Corp earnings by shifting income to family members. This can be accomplished by transferring stock to minor children over the age of 13. Typically, such minor children will be in a lower tax bracket and will thus pay a lesser amount of tax than would the parent.
Yet another advantage of S-Corp. treatment relates to the utilization of corporate net operating losses. A shareholder may be able to offset S-Corp. losses against personal taxable income from other sources. A shareholder mush have sufficient “basis” in the S-Corp to enable the use of losses to offset other income. Basis is obtained through by the corporation.
Disadvantages of S-Corp. Status
S-Corporations are limited in choosing a “permitted tax year”. Normally an S-Corp. must use a calendar year in filing its tax returns. This may present a dilemma for government contractors who have historically chosen to use a fiscal year end, such as September 30. The election of S-Corp. Another disadvantage relates to multistage tax filing. Because contract operations may be relatively far-flung, even small government contractors are often required to file in as many as five or more states. Since some states do not recognize S-Corp. status, the process of complying with the various state filing requirements for both the corporation and its shareholder can become unwieldy and expensive.
Conclusions
In the process of forming a business, there are a few options that may apply in giving the entity financial structure. Partnerships are ideal if members wish to maintain a closed and private style of operating. Partnerships are easily formed and are less expensive. Filing tax reports are easier because partners submit their personal taxes individually. Corporations, on the other hand, must submit financial statements on a regular basis, and shareholders must also file their tax reports individually. Corporations have the advantage of being able to raise funds easily in the sale of stock. In corporations, personal financial responsibility is limited. Each has its pros and cons, in the end, deciding which financial structure will depend on the nature of the business, its vision, and the motives of its members.
References
1992 Friedman & Fuller, P.C., Published March 31, 2009 http://www.morebusiness.com/running_your_business/taxtalk/scorp.brc
UMET Class, Prof. Relon Acosta-Toro, MA, MBA. oct-nov 2009
by Héctor Millán
Nov 28, 2009
