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Unformatted text preview: CHAPTER 14 PARTNERSHIPS: FORMATION AND OPERATION Answers to Questions 1. The advantages of operating a business as a partnership include the ease of formation and the avoidance of the double taxation effect that inherently reduces the profits distributed to the owners of a corporation. In addition, since the losses of a partnership pass, for tax purposes, directly through to the owners, partnerships have historically been used (especially in certain industries) to reduce or defer income taxes. Several disadvantages also accrue from the partnership format. Each general partner, for example, has unlimited liability for all debts of the business. This potential liability can be especially significant in light of the concept of mutual agency, the right that each partner has to create liabilities in the name of the partnership. Because of the risks created by unlimited liability and mutual agency, the growth potential of most partnerships is severely limited. Few people are willing to become general partners in an organization unless they can maintain some day-to-day contact and control over the business. Further discussion of these issues can be found in the Answer to the first Discussion Question that appears above. 2. Specific partnership accounting problems center in the equity (or capital) section of the balance sheet. In a corporation, stockholders' equity is divided between earned capital and contributed capital. Conversely, for a partnership, each partner has an individual capital account that is not differentiated according to its sources. Virtually all accounting issues encountered purely in connection with the partnership format are related to recording and maintaining these capital balances. 3. The balance in each partner's capital account measures that partner's interest in the book value of the business net assets. This figure arises from contributions, earnings, drawings, and other capital transactions. 4. A Subchapter S corporation is formed legally as a corporation so that its owners enjoy limited legal liability and easy transferability of ownership. However, if a company qualifies and becomes a Subchapter S Corporation, it will be taxed in virtually the same manner as a partnership. Hence, income will be taxed only once and that is to the owners at the time that it is earned by the corporation. Use of this designation is quite restricted. To qualify as a Subchapter S Corporation, a company can only have one class of stock and must have no more than 100 owners. These owners can only be individuals, estates, certain tax-exempt entities, and certain types of trusts. Most corporations that do not qualify as Subchapter S Corporations are automatically Subchapter C Corporations. These entities are also corporations but they pay income taxes when the income is earned. Additionally, the owners are liable for a second income tax when dividends are distributed to them. Thus, the income earned by a Subchapter C Corporation faces the double taxation effect commonly associated with corporations. 5.5....
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- Spring '11