Question

How to calculate the each individual's basis of the assets and liabilities to the partnership or corporation ?

Alternative Forms of Business Organizations Presentation

You are a partner in a local accounting firm and have been engaged by Andy Taylor and Floyd Barber to assist them in starting a new business. This business will sell new and used bicycles to the general public. Andy has been successfully selling bicycles out of his garage and believes that he needs a retail store to grow the business. Floyd owns a building that has been vacant for several years and has been looking for a business in which to invest. They are trying to decide if they should incorporate or form a partnership. They have asked you to prepare a short presentation for them that will explain the pros and cons of corporations and partnerships (your answer should not be limited to just tax considerations). Both plan to devote an equal amount of time to the business and share any profits or losses equally. Your presentation should conclude with your recommendation of the entity that they should adopt based on the facts as presented to you. You should list three primary reasons for your recommendation.

In addition to your presentation you should prepare a memorandum to them explaining the basis each of them will have in the partnership or corporation as well as the basis of the assets and liabilities to the partnership or corporation( hint: inside and outside basis). Include references and citations supporting your determination of basis of each asset and liability.

Andy will contribute the following:

Cash $10,000

Accounts Receivable $5,000

Inventory of Bicycles at cost $22,000 (sales value = $48,000)

Accounts Payable $2,000.

Floyd will contribute the following:

Cash $15,000

Land at cost $10,000 (market value $15,000)

Building

Cost $ 120,000 (market value $80,000)

Useful life 40 years

Residual Value $20,000

Accumulated depreciation to date $5,000 (2 years @ straight line method)

Mortgage payable $70,000, interest only, payable monthly, balance due in 8 years.

Answer 1

Let us first evaluate the advantages and disadvantages of the partnership firm and corporation

Advantages of Partnership firm include following

Quick Decision making- In Partnership firm, decision are made quickly as they require the consent of each partners to get approval

Limited Liability partnership (LLP)- In the partnership firm, liability of the partners are limited to the amount or funds invested by them separately and they are not personally liable for amount more than there invested capital in the partnership.

Increase sense of Ownership- In the partnership firm, partners have right to manage all the decisions. This include higher level of authority and accountability for each partner in the firm.

Disadvantages of Partnership firm

Limited number of Partners- Partnership firm can maximum have 20 partners

Unlimited Liability- Expect in the case of LLP, Partnership firm generally have unlimited liability i.e. partners will be personally liable for losses in the partnership firm

Let us look at the advantages and disadvantages for the corporation

Advantages of the Corporation

Separate Legal Entity- A Corporation have a separate legal entity and identity of its own separate from their founders, promoters and shareholders

Perpetual life- Corporation is the going concern. No matter manager comes or go, corporation have a perpetual life as the ownership will tend to change over the period but the corporation will remain its existence for perpetual life.

Ease of fund raising- A Corporation can easily raise the funds from the public by issue of shares or debenture financing through bonds

Disadvantages of the Corporation

Agency problem- Since the management and shareholders of the corporation are different agency problem arises due to conflict of interests between the shareholders and the management of corporation

Dominance by few investors or shareholders- Since a few shareholders have majority of equity stakes in the corporation, most of the decision made in the corporation are majorly dependent upon the few stakeholders having majority of stakes in the corporation.

Based on the above advantages and disadvantages of both partnership firm and corporation. Andy and Floyd should start LLP (Limited Liability Partnership firm)

• In the case of LLP, both the partners Andy and Floyd would have limited liability as per there invested amount of capital.
• LLP would have all the benefits of partnership firm including the limited liability of partners. Other benefits of partnership firm are mentioned in the table including quick decision making, increase sense of ownership, ease of formation etc.
• Since there are only 2 members Andy and Floyd they should ideally start Limited Liability Partnership to have more authority and accountability in the business.

If they both decide to start the partnership firm, then both will be entitled to 50-50% of profits/ loss from the business or as per the terms decided by both of them based on the amount contributed in the bicycle business.

Let us calculate the capital brought by each of the partners in the business

Andy's contribution	Basis of asset and liabilities brought in
Cash $10000	Cash is an asset shown in the Balance sheet of the company- Asset side
Accounts Receivables of $5000	Accounts Receivables or debtors are the asset for the firm shown in the Asset side of the Balance Sheet
Inventory of $22000 ( sales value of 48000)	Inventory are assets for the company and shown in the aseet side of the balance sheet whereas once it is sold then will be shown as Sales revenue in the P& L Account and cost of inventory will be deducted from the Balance sheet
Accounts Payable of $2000	Accounts payable of $2000 are the liability for the firm and firm needs to pay 2000 to its creditors and are shown in the liability side of the balance sheet

Hence the total amount of capital brought in by Andy = ( $10,000+ $5,000+ $22,000- $,2000)= $35,000

Now let us calculate contribution of Floyd in the business

Floyd contribution in the business	Basis of asset and liabilities
Cash $15000	Cash is an asset shown in the Balance Sheet
Land at $10,000	Land is an asset shown in the Balance sheet. It should be recorded based on the historical cost and not with the market value hence $10,000 should be recorded based on historical cost principle.
Building (120000-5000)= $115000	Building is an asset hence recorded in the Asset side of the balance sheet, the historical cost of the building is 120,000 and accumulated depreciation charged till date of $5000 hence $115,000( 120,000-5,000) should be recorded in the Asset side of the Balance sheet.
Mortgage payable $70,000	Mortgage payable is the long term liability for the business payable in the 8 years hence shown in the Liability side of the Balance Sheet

Hence Total contribution made by the Floyd will include ($15,000+ $10,000+ $115,000 - $70,000)= $70,000

All the Assets such as Land and building should be recorded as the historical costs values based on the historical costs principle rather than the market value. Assets should be recorded based on historical prices in the Balance Sheet.

Based on the capital contribution of both the partners Andy and Floyd they should share the profits/loss in the 1:2 ratio respectively as Andy brought $35,000 and Floyd contributed $70,000 in the business

Andy have 33.33% Equity stakes in the partnership firm whereas Floyd have 66.66% equity stakes or ownership in the business based on the capital amount invested in the partnership firm.