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Business Entity Formation and Taxable Income Case Study

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Updated: Jun 9th, 2022

A partnership form of business has several advantages over a corporation. The first advantage is that a partnership lacks a specific governing structure. A partnership business has the freedom of operating like private arrangements without reporting their activities to any authority. Therefore, they come up with ways of managing their own organization unlike the corporation which have to operate within specific laws. The second advantage is that a partnership form of business is not a separate legal entity. Therefore, there is free flow of assets in and out of the business. For instance, the owners can easily add or withdraw funds, property, goods, and services from the business without any restrictions. On the other hand, a corporation lacks this fluidity because they are separate legal entities. Therefore, it may not be easy to transfer property and funds in and out of a corporation. The third advantage is that a partnership business does not pay taxes unless the partners specifically chose to file tax returns like a corporation. In a partnership, the profits and losses at the end of the year are shared among the partners in the ratio of their capital contribution. The partners then incorporate them into their personal income tax. Therefore, filing tax returns is easy because there is no need for a separate tax return for the business. This eliminates the issue of double taxation that is evident in the case of corporations. The fourth advantage is that a partnership is easy to form, manage and run unlike corporations. They lack the extensive legal formation requirements that are evident in corporations. Finally, a partnership, business allows the owners to share responsibilities in running the business. Therefore, the partners can split responsibilities according to their area of specialization. Finally, a partnership form of business will allow the members to share profits and losses unlike corporations. Bill and Kerry should form a partnership business because it will grant them a lot of flexibility in their operations.

In this business, one partner (Bill) has contributed $70,000 while the second partner (Kerry) has contributed skills in accounting to the business. Therefore, their contributions will be regarded as equal despite the fact that one partner did not contribute cash. The partners can share profit, losses, liabilities, and management authority in equal proportions. Thus, each of them will have a 50% stake in the business. With the 50% stake for each partner, they should consider forming a general partnership business because each one of them has equal rights and responsibilities. A limited liability partnership would have been suitable if one partner has less liability, and does not participate in management decisions.

Based on the discussion above, it is recommended that they open a general partnership business. Further, they will share the profit and losses in equal proportions. The calculation of profit and loss for each partner is presented below.

Memo Appropriation account
Bill Kerry Dr. Cr.
Loss for the year $35,000
Salaries 0 0 0
Interest on capital 0 0 0
Interest on drawings 0 0 0
$35,000
Residual loss $17,500 $17,500 $35,000

In the calculations above, it can be noted that the partners do not have salaries, interest on capital and drawings. Therefore, the loss of $35,000 will be shared in the ratio of 1:1. Thus, the share of loss for Bill is $17,500 while, for Kerry is $17,500.

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