Partnership Accounting: What Business Owners Need to Know

The basics of accounting for a partnership business are similar to accounting for a sole proprietor. However, there are some key differences that are worth knowing when it comes to crunching the numbers. 

A partnership differs from a sole proprietor in that a partnership is a collection of multiple sole proprietors. For multiple sole proprietors to form a partnership, the business itself must be incorporated. Partnerships are easier to form than corporations because, with a partnership, an agreement (preferably written) between the partners is all that is needed. 

Let’s take a deeper look into accounting for a partnership business. 

What Are the Three Methods of Accounting for Partnerships?

There are three different methods used when conducting accounting for partnerships. When new entities are added to a partnership or when previous partners leave, the methods will be used to evaluate each individual’s contributions to and stake in the company. 

1. Exact Method

The exact method aims to assign an exact book value to the capital interest that one of the partners holds. This depends on who owns what, so a partner who invests more will have great assets to their name. 

2. Bonus Method

With the bonus method, a new partner’s investments may or may not equal the book value of that individual’s capital investments. If the book value of the capital investments is exceeded, then the difference is distributed to the old partners as a bonus. If the book value is less than that of the capital investments purchased, then the bonus will be given to the new partner. 

3. Goodwill Method 

When a new partner makes an investment not equal to the book value of what is purchased, it is recorded as an intangible asset referred to as “goodwill.” Goodwill is the difference between the market value of the net assets of the partnership and their book value. Factors contributing to this difference include marketing position, expertise, customer base, location, and the partnership’s business reputation.

Transactions Associated with Accounting for a Partnership

There are several different transactions associated with accounting for partnerships:

Contribution of Funds

A debit is taken from a cash account, and a credit is applied to a separate capital account whenever a partner invests funds into a partnership. Typically each partner will have a separate capital account that tracks the balance of the investments from and transactions to a partner.

Contribution of Other than Funds

When a partner invests other assets in a partnership, a debit is applied to the asset account that “most closely reflects the nature of the contribution.” At the same time, credit is given to the partner’s capital account. The valuation of the asset is determined by its market value. 

Distribution of Funds

The distribution of funds may be applied directly to a partner’s capital account or temporarily recorded in a “drawing account” until those funds are transferred to the capital account. 

Withdrawal of Funds

A credit is applied to the cash account, and a debit is drawn from the partner’s capital account whenever a partner pulls funds or other assets from the business. 

Withdrawal of Assets 

If a partner takes assets other than cash from the business, a credit is applied to the recorded asset, and a debit is deducted from the partner’s capital account.

What Tax Forms Does a Partnership File?

Regarding taxes for a partnership, partners must file an annual information return reporting income, deductions, gains, and losses from their operations in a given accounting period. However, it does not pay income tax and instead serves as a “pass-through” for profits and losses to its partners. 

Partners do need to report their share of the partnership’s income or loss on their personal tax returns. Partners should not be issued a Form W-2. Instead, they file using a Schedule K-1 (Form 1065). 

There are five steps partnerships can take when filing their taxes:

1. They’ll prepare their IRS Form 1065. 
2. They prepare the federal Schedule K-1, which includes the percentage share of profits, losses, capital, and liabilities. 
3. File Form 1065 and K-1 forms. 
4. File their state tax return for the partnership, though it’s important to note that these procedures vary by state, so check with your state’s Department of Revenue to ensure you do everything correctly. 
5. The last step in the process is to file personal tax returns. It can be important to consult with a tax professional on these matters to ensure everything is done correctly.

Work With Experts Who Specialize in Partnership Accounting

Navigating the complexities of partnership accounting requires a deep understanding of the various methods and associated transactions. From the exact, bonus, and goodwill methods to comprehending various forms of contribution and withdrawal. Each aspect forms an important part of the partnership's financial framework.

Due to the complexity involved, it's recommended that you partner with accounting professionals who specialize in partnership accounting. Their expertise helps ensure your business's financial management is accurate and compliant and offers you peace of mind and the freedom to focus on business growth.