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CHAPTER 13 UNDERSTANDING THE ISSUES 1. Partnerships are generally less formal than oth- er types of organizations and yet it is important to consider a number of factors in a partnership agree- ment. Individual partners have more legal exposure in a partnership because, unlike a corporation, part- nerships are characterized by unlimited liability. However, limited partners, limited liability corpora- tions, and limited liability partnerships provide for a significant reduction in such liability. Partnerships of- fer significant tax advantages over a corporation in that they are not taxed as a separate entity and therefore, avoid double taxation issues. However, other types of tax option organizations are also avail- able that avoid double taxation. 2. The use of a salary or bonus as a means of al- locating profits would be appropriate when there is a desire to reward partners for personal services or significant personal time commitments to the part- nership. The use of interest on capital as a means of allocating profits would be appropriate when the business is capital intensive versus labor intensive or if the partners are not significantly involved in the day-to-day operations. 3. For tax purposes, a partnership is not viewed as a separate distinct entity but rather as consisting of separate distinct individuals. Therefore, assets contributed to the partnership are considered to have the same tax basis as they had in the hands of the individual taxpayer. This tax basis is generally different from fair value. 4. A partnership is not a taxable entity, and there- fore, its balance sheet will show no liability for in- come taxes and the income statement will have no tax expense. On the other hand, a corporation is typ- ically a taxable entity and its financials will show the impact of taxes. Therefore, taxes are incurred at the corporate level on earnings and also at the individual shareholder level when after-tax earnings of the cor- poration are distributed to shareholders. It is import- ant to note that individual shareholders will not incur a tax liability until such earnings are distributed. Tax- ation at both of these levels is referred to as double taxation. On the other hand, the partnership, not be- ing a taxable entity, does not incur income taxes and pretax earnings are allocated directly to individual partners. The allocated pretax earnings of the part- nership are taxed to individual partners upon alloca- tion. It is important to remember that the allocation of partnership earnings is not always accompanied by a distribution of partnership earnings. Therefore, it is possible for an individual to incur a personal income tax liability on such allocated earnings without ne- cessarily having adequate resources from the part- nership to satisfy the tax obligation. If a partnership incurs losses, these losses are also passed through to individual partners and, therefore, may provide more immediate tax benefit than if a corporation in- curred such losses. Recognizing that the “passing
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This note was uploaded on 04/07/2008 for the course ACCT. 3533 taught by Professor Jahanian during the Spring '08 term at Temple.

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