Partnerships and Limited Liability Companies

Accounting for Partnerships

Journal Entries for Formation of Partnerships and LLCs

During the formation of a partnership, each partner's investment in the business is recorded with a separate journal entry to establish each partner's individual equity in the business.

Generally, the journal entries and day-to-day transactions and activities of a partnership or LLC are the same as for any other organization. However, the elements that usually set these entities apart are the treatment of dissolution and liquidation of the partnership and the LLC, as well as the division of net income and net loss. During the formation of a partnership, each partner's investment is recorded in a separate journal entry to establish their individual equity in the business, known as their capital account. The assets are debited to the partnership, the liabilities are credited to the partnership, and the difference is credited to the capital account for that partner.

To illustrate, John Doe and Jane Smith are owners of Valley Company. John contributes to the partnership.

John Doe's Contributions to Valley Company Partnership

Cash $10,000 Equipment $5,000
Accounts Receivable $8,600 Allowance for Doubtful Accounts $1,000
Inventory $15,000 Accounts Payable $2,500

John Doe's Partner Assets and Liabilities Journal Entries

Date Description Debit Credit
Dec. 1 Cash $10,000
Accounts Receivable $8,600
Inventory $15,000
Equipment $5,000
Allowance for Doubtful Accounts $1,000
Accounts Payable $2,500
John Doe, Capital (Member's Equity*) $35,100
To record the contribution of assets and liabilities for John Doe to Valley Company
*

For an LLC, the capital account is referred to as member's equity.

In the event of the contribution of noncash assets, these types of assets are recorded in the partnership at values that have been agreed upon by the partners. These values are traditionally based on market values, which means that the prior book value of the asset usually differs from the value assigned to the asset upon recording it into the new partnership. For example, John Doe contributed equipment, a noncash asset. The partners, John and Jane, agreed that the equipment would be recorded at a value of $5,000, even though the prior book value of the equipment was $4,200.

Any contributions from Jane Smith would also be recorded in a journal entry similar to the one for John Doe.

Calculation of Partnership Income

There are two ways to divide partnership income, based on either services of the partner or services and investments of the partner.

Besides outlining the duties and responsibilities of the individual partners, a written partnership agreement determines how the partners will divide income as well as losses. Salaries paid to the partners, interest on capital balances, and share of partnership profit may be part of the partnership's net income. The stated conditions of the partnership agreement regarding the division of income and losses must be agreed upon by all the partners to deter future disagreements.

The two most commonly used methods for dividing the income from the partnership are services based, which is dependent upon the amount of time contributed, and services and investments based, which is dependent upon contributed time and financial investment in the partnership. However, if there is no specific agreement stipulated among partners, the income and losses from the business may be split equally among the partners.

Services of Partners

When distributing income based on the service of partners, the income is split depending on how much time the partner contributes to the partnership. Generally, this can be captured in the form of a salary allowance. Because partners are not employees, these allowances are recorded as a division of net income and therefore are credited to the partners' capital accounts. This usually takes place before the remaining income is divided based on the partnership's agreement amounts.

For example, partner John Doe's monthly salary allowance is $4,000, and partner Jane Smith's monthly salary allowance is $5,000. The remaining net income is then divided equally. If the net income for the period is $200,000, the division between partners is: John Doe $94,000 and Jane Smith $106,000.

Services-Based Net Income Split

J. Doe J. Smith Total
Annual Salary
(Monthly x 12)
$48,000 $60,000 $108,000
Remaining Income Distribution
[($200,000$108,000)÷2]\left[\left(\$200,000 - \$108,000\right)\div2\right]
$46,000 $46,000 $92,000
Net Income $94,000 $106,000 $200,000

Based on the services of the partners, Jane Smith will receive a higher share of the net income of the partnership even though the income is divided equally.

At the end of the period, the partnership makes two closing entries. First, the revenue and expense accounts for the period are closed into the partner's equity accounts; each partner's equity account will receive a credit equal to their share of the net income or a debit in the event of a net loss. Second, any withdrawals from the partnership by a partner are closed into that partner's equity account with closing entries.

Services-Based First Closing Journal Entries

Date Description Debit Credit
Dec. 31 Revenue $300,000
Expenses $100,000
John Doe, Capital (Member's Equity) $94,000
Jane Smith, Capital (Member's Equity) $106,000
To record first closing entry for Valley Company

In this example, the revenue and expenses are consolidated for simplicity, but traditionally each separate revenue and expense account receives its own debit or credit to properly close the accounts.

For the second entry to close the period for Valley Company, both owners withdraw their salary amounts.

Services-Based Second Closing Journal Entries

Date Description Debit Credit
Dec. 31 John Doe, Capital (Member's Equity $48,000
Jane Smith, Capital (Member's Equity) $60,000
John Doe, Cash $48,000
Jane Smith, Cash $60,000
To record second closing entry for Valley Company

Services of Partners and Investments

Another way that partners may divide income is based on how much time the partner contributes to running the business as well as the amount of the initial investment of the partner. For example, John Doe's monthly salary allowance is $4,000, and Jane Smith's monthly salary allowance is $5,000. However, there is an additional deposit of 10% to each partner's capital balance as of December 1. John's capital balance was $150,000, while Jane's capital balance was $170,000. The remaining net income is then divided equally.

Services and Investment-Based Net Income Split

J. Doe J. Smith Total
Annual Salary
(Monthly x 12)
$48,000 $60,000 $108,000
Interest Allowance
(Capital Balance x 10%)
$15,000 $17,000 $32,000
Remaining Income Distribution
[($200,000$108,000$32,000)÷2]\left[\left(\$200,000 - \$108,000 - \$32,000\right)\div2\right]
$30,000 $30,000 $60,000
Net Income $93,000 $107,000 $200,000

A closing entry for revenue and expense as well as for dividing the net income is recorded.

Services and Investment-Based Closing Journal Entries

Date Description Debit Credit
Dec. 31 Revenue $300,000
Expenses $100,000
John Doe, Capital (Member's Equity) $93,000
Jane Smith, Capital (Member's Equity) $107,000
To record the first closing entry for Valley Company

Allowances Exceeding Net Income

In the previous examples, the amount of net income enables the partners to take their salary allowance and their interest allowance while having additional income to split equally. But if the total amount of the allowances exceeds the amount of net income available, then the net income will be calculated so that the partners will share a deduction from their allowances equally and will not split the remaining net income. For example, the total amount of allowances exceeds the partner's net income, which is $125,000, so the division of income includes shared deducted allowances.

Division of Income with Deducted Allowances

J. Doe J. Smith Total
Annual Salary
(Monthly x 12)
$48,000 $60,000 $108,000
Interest Allowance
(Capital Balance x 10%)
$15,000 $17,000 $32,000
Deduct excess of allowances over income
[($125,000$108,000$32,000)÷2]\left[\left(\$125,000 - \$108,000 - \$32,000\right)\div 2\right]
($7,500) ($7,500) ($15,000)
Net Income $55,500 $69,500 $125,000

Thus, there is a closing entry for revenue and expense as well as for dividing the net income.

Closing Journal Entry for Revenue and Expense with Divided Net Income

Date Description Debit Credit
Dec. 31 Revenue $225,000
Expenses $100,000
John Doe, Capital (Member's Equity) $55,500
Jane Smith, Capital (Member's Equity) $69,500
To record the first closing entry for Valley Company