Reading: Lesson 5 - Partnerships

5.5.A - Partnerships

1. THE NATURE OF PARTNERSHIPS

1. Jennifer York, who operates the proprietorship mentioned earlier, is faced with a common management problem of expanding her business. She has run the business successfully for over ten years. She sees new opportunities in the community for increasing the scope of her business, but she does not wish to assume full responsibility for the undertaking. She realizes that the expansion of the business will entail considerable financial and managerial responsibilities. She also realizes that she needs additional capital to expand, but she does not want to borrow the money. Because of these reasons, she has decided that it would be wise to change her business from a proprietorship to a partnership, a business owned by two or more people.
   
2. Robert Burton operates an adjoining bakery, where he bakes fresh bread and pastries daily. He has proven to be honest and to have considerable management ability. Combining the two businesses could result in more customers for both groceries and baked goods. Customers who have been coming to the bakery may become grocery customers also. Moreover, those who have been buying at the grocery and fruit market may become customers of bakery products. A discussion between York and Burton leads to a tentative agreement to form a partnership if a third person can be found who will invest enough cash to purchase additional equipment and renovate space for the combined grocery and bakery. The financial statement for Burton’s business appears in the Figure below. 
   
   

   

3. The net worth of Burton’s business is $153,600. In other words, after deducting the amount of his liabilities ($7,200) from the total value of his assets ($160,800), his business is worth $153,600. According to Jennifer York’s balance, her business is worth $204,000. In order to have an equal investment in the partnership, Burton must invest an additional $50,400 in cash.
   

4. They find Lu Chan, a person with accounting experience, who has $144,000 and is able to borrow the remaining $60,000 to become an equal partner. York, Burton, and Chan draw up and sign a partnership agreement. A partnership agreement is a written agreement between two or more people identifying how the partners will add capital, labor, or other assets and divide any profits or share any losses.
   

5. Once the partnership is formed, a statement of financial position (balance sheet) must be prepared. This statement shows the total assets, liabilities, and capital of the owners at the start of the business. The partnership’s balance sheet appears in the Figure below. Each asset category on the combined balance sheet (merchandise, equipment, and land and buildings) as well as the accounts payable liability category represents the combined totals of these categories from Burton’s and York’s businesses. The cash category combines the cash from both businesses plus Chan’s cash investment of $204,000. 
   

   
   

6. A key factor in the success of a partnership is that the partners must clearly agree upon each person’s responsibilities. York, Burton, and Chan divide their duties: York supervises the grocery department, Burton supervises the bakery and meat departments, and Chan handles the finances, inventory, and records. During the year, the three partners combine the stores, remodel them, buy new equipment, and open for business.
   

1. Many businesses are organized as partnerships from the start. There are over 3 million businesses operating as partnerships in the United States, which is a small number in comparison to sole proprietorships. Though most partnerships have only two or three partners, there is no limit set on the number of partners. Some businesses have ten or more partners. Some management issues of partnerships are discussed below.
   
2. Expanded Management Input - A partnership is likely to be managed more effectively than a proprietorship, because a partnership can draw on the skills of two or more people instead of just one. One partner may propose a change in the business, and another partner may be able to point out disadvantages in the plan and suggest changes that were not initially apparent. Each partner of the business will take great interest in the firm; much of this is due to the greater financial responsibility each person has as a partner instead of an employee.
   
3. Capital - Often two or more people can supply more initial capital than an individual. When the business needs to expand, generally several partners can obtain the additional capital needed for the expansion more easily than an individual. The partnership usually has a better credit reputation than the sole proprietorship. This is true because more than one owner is responsible for the ownership and management of the business. It may be difficult for a partnership to obtain enough capital to operate a large business unless each member of the partnership is wealthy or unless there are many partners. Too many partners, however, may cause inefficient operations.
   
4. Efficiency - Two or more proprietors in the same line of business may become one organization by forming a partnership. This move may substantially decrease, or even eliminate, competition. It is often possible to operate more efficiently by combining two or more businesses. In such a case, certain operating expenses— such as advertising, supplies, equipment, fuel, and rent—can be reduced.
   
5. Tax Advantages - Partnerships usually have a tax advantage over corporations. Partnerships prepare a federal income tax return but do not pay a tax on their profits, as do corporations. However, each partner must pay a personal income tax on the individual share of the profit.
   
6. Liability - According to the law, each member of the partnership has an unlimited financial liability for all the debts of the business. If the business fails and some of the partners are unable to pay a share of the debt, one partner may have to cover those partners’ shares. Each partner is bound by the partnership agreement to honor contracts made by any partner if such contracts apply to the ordinary operations of the business. If one partner commits to a contract in the name of the partnership, all partners are legally bound by it, whether or not they think the contract is good for the business. Disagreements can eventually lead to partnership failure.
   
7. Agreement Between Partners - The decision process between partners must be managed properly or there is the danger of disagreement. The majority of the partners may want to change the nature of the business but are unable to do so because one partner refuses. For example, a partnership may have been formed to conduct a retail business selling mobile phones. After a while, the majority of the partners may think it wise to add tablets to their line of merchandise. The change may benefit the business. However, as long as one partner disagrees, the partnership agreement may stop the change from happening. Furthermore, partners sometimes believe that they are not properly sharing in the management. This situation may cause disagreements that could hurt the business. Such a condition may be avoided if the partnership agreement clearly states the duties of each partner.
   
8. Uncertain Life - The life of a partnership is uncertain. Sometimes when partners draw up a partnership contract, they specify a definite length of time, such as ten years, for the existence of the business. Should one partner die, however, the partnership ends. The deceased partner may have been the primary manager, and because of his or her death, the business may suffer. The heirs of the deceased partner may demand an unfair price from the surviving partners for the share of the deceased partner. On the other hand, the heirs may insist on ending the partnership quickly to obtain the share belonging to the deceased partner. In the latter case, the assets that are sold may not bring a fair price; as a result, all the partners suffer a loss. A partnership can carry insurance on the life of each partner to provide money to purchase the share of a partner who dies. Under the laws of most states, two other causes may suddenly terminate a partnership. The first is the personal bankruptcy of any partner; the other is the addition of a new partner.
   
9. Division of Profits - Sometimes the partnership profits are not divided equally according to the contributions of the individual partners. Partners should agree up front on how to divide profits according to the amount of labor, expertise, and capital each partner contributes. The partnership should then specify the agreed-upon division in the partnership agreement, such as 60 percent to one partner and 40 percent to another. If no provision is made in the agreement, the law requires an equal division of the profits. If one partner later contributes more time, expertise, or labor to the business than do the others, this partner may feel that he or she deserves more than an equal share of the profit. If a partner wishes to sell his or her interest in the business, it may be difficult to do so. Even if a buyer is found, the buyer may not be acceptable to the other partners.
   
10. In an ordinary (general) partnership, each partner is personally liable for all the debts incurred by the partnership. The laws of some states, however, permit the formation of a limited partnership. A limited partnership is a partnership with at least one general partner who has unlimited liability and at least one limited partner whose liability is limited to his or her investment. In many states, the name of a limited partner cannot be included in the firm name.
    
11. Under the Uniform Limited Partnership Act, states have created similar regulations for controlling limited partnerships. For example, the law requires that a certificate of limited partnership be filed in a public office of record and that proper notice be given to each creditor with whom the limited partnership does business. If these requirements are not fulfilled, the limited partners have unlimited liability in the same manner as a general partner.
    
12. The limited partnership is a useful form of business organization in situations where one person wishes to invest in a business but does not have the time or interest to participate actively in its management. Any business that can be formed as a proprietorship can usually be formed as a limited partnership.
    
13. The partnership form of organization is common among businesses that furnish more than one kind of product or service. Each partner usually looks after a specialized phase of the business. For example, car dealers often have sales and service departments. One partner may handle the sale of new cars, and another partner may be in charge of servicing and repairing cars. Another partner could be in charge of used-car sales or coordinate the accounting and financial side of the business. Similarly, if a business operates in more than one location, each partner can be in charge of a specific location. Businesses that operate extended hours each day may find the partnership organization desirable, as each partner can lead a different shift of employees.
    
14. Partnerships are also common in the same types of businesses that are formed as proprietorships, particularly those that sell goods and services to consumers. They are especially popular among those offering professional services, such as lawyers, doctors, accountants, and financial consultants. Internet businesses have been formed as partnerships as well. Good faith, together with reasonable care in the exercise of management duties, is required of all partners in a business.